Approach Private Equity's 'Value Bridge' with Caution

Abstract

Private equity (buyout) firms are well paid for what they do. Supporters justify these high rewards by pointing to the way buyouts “create value”. They argue that the private equity ownership model allows buyout firms to run companies better than is possible under other ownership models. Running companies better makes the overall economic pie bigger. This is both socially and privately valuable, so it deserves high rewards. “Value creation” therefore plays a key role in the private equity story. That means it should be measured in an accurate and meaningful way. Unfortunately, the standard tool that private equity practitioners use fails this test. Their simple model, known as the “value bridge”, is accurate in the sense that its numbers add up. But although the numbers in the “value bridge” are mathematically true, they are also misleading. They routinely overstate the impact of running companies better, and understate the impact of high debt (“financial engineering”). A better way to measure “value creation” in private equity is already available in the academic literature. It starts from economics, not accounting, and breaks down the profit on a buyout into three main factors: the return on a stock market comparable, the impact of high debt, and a residual that may include the effect of running the company better. Vested interests have no incentive to use this more meaningful approach. But others – investors, policy makers and academics – should take an interest.