How venture-backed companies do better than others¹

 Barbara Monda, MBA MIP
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Many studies² on the impact of Private Equity on companies' performance show the existence of a virtuous cycle between PE and entrepreneurship all over the world.

 In particular, venture-backed companies³ seem to outperform the benchmark under several points of view. For example, the study by AIFI-PricewaterhouseCoopers shows that in 2008 venture-backed companies sales grew by +17.7%, gross margin by +9.82% and number of employees by +8.4%: comparing these results  with the benchmark, whose results are +3.29% Sales, -4.10% Ebitda and +0.20% Employes  (see figure 1), it is clear that  venture-backed companies performance is higher than average; in particular the fact that they succeeded in increasing marginality even in a period in which the benchmark registered a negative result, can be traced back to a better management leading to higher efficiency.

Figure 1 (Source: AIFI-PricewaterhouseCoopers)

• Bringing strategic support, know-how and managerial skills to the company. In fact, most SMEs lack of that kind of objective-driven culture which is oriented to continuous performances measurements.
  Private Equity brings the ability to define and value strategies, to select and hire experienced managers who will work side-by-side with the entrepreneur and introduces effective performance and accounting control systems.
• Introducing effective performance and accounting control systems, which are often lacking in SMEs
• Introducing more and better incentives to the management (e.g. stock options), which lead to a better organization and human resources management and to an environment working by
  objectives.
  In fact, after a buy-out, venture-backed companies tend to introduce⁴ incentive pay-schemes also for non-managerial positions to encourage employee alignment and commitment to employer goals. The percentage of adoption of incentives related to result and profit related pays or bonuses (PRP) increased respectively from 25.9% and 31.7% pre-buyout to 31.1% and 38.5% post-buyout.
  45% of companies reported that the training programmes increased after the buyout
• Allocating financial resources to the acquired company, which allow high levels of investments to sustain company's growth
• Exploiting their network to help the company, especially to support the internationalisation process 
• Increasing the reputation of the company: the presence of a PE fund in the shareholders structure gives a better credibility to the company, with positive effects both on the financial market (banks will trust the company more, because they know that the fund before investing has performed a deep due diligence and this was concluded with positive results for the target company), and on the clients and suppliers, who will see the presence of the PE fund as a guarantee and will therefore be willing to concede better conditions (with effects on the working capital)
• Introducing systematic rules for the corporate governance, with a clear distinction of roles for management and shareholders; this point is particularly noticeable in the case of exit through IPO and for family business with a succession issue

Historically PE funds have always looked at large companies, because they bring larger profits than smaller companies with the same effort; time is a precious resource for Private Equity Funds managers, and generally speaking it's more convenient for them to invest their time in increasing the margin of a company with higher sales than investing it in increasing by the same percentage the margin of a company with lower sales. Recent statistics⁵ show that trend is changing, and the threshold now is much lower: in 2008 the total number of Private Equity operations in Italy have been the ever-highest number of 372 on 284 companies; of these, 88 operations (on 67 companies) have been of early stage capital, for a total of 115 Mln € invested; average has been 1.3 Mln € for each operation.

 The difference with 2004 is dramatic: looking at the value of capital invested by Private Equity Funds, in 2004 only 22.6% was dedicated to SMEs⁶, while in 2008 the number more than doubled, jumping to 47.7%.

The reason for this change in trend is basically “necessity”: as there are no big deals around, PE funds have no choice: the only possibility is investing in smaller companies.

Considering also the increase in absolute terms of the capital invested by Private Equity Funds⁵ (1,480 Mln € in 2004 and 5,458 Mln € in 2008), it is clear that the world of Private Equity can have a central role in the development of the real economy by investing money in SMEs.

The bad news is that investments in Private Equity in Italy are today still very poor. In fact, according to EVCA⁷, only 0.110% of the Italian GDP is invested in Private equity, which is a very small amount if compared with UK, where PE accounts for 1.103% of GDP, or with Sweden (0.585% of GDP) or France (0.363% of GDP); European average investment in Private Equity is 0.354% of GDP.

Why PE is so underdeveloped in Italy? What can be done to increase investments in PE?

To answer these questions it is necessary to take a closer look at the characteristics of investors in PE. This has been done in the companion article “Italian Market for Private Equity”. The thesis there exposed indicates that factors include financial culture and investors' risk-aversion, while the government could play a central role in order to incentivise investments in Private Equity. 

Although the market of Private Equity in Italy is underdeveloped if compared to other European countries, encouraging signals are showing: AIFI reports⁵ that in 2008 more than 5.4 billion Euros have been invested by Private Equity Funds, with an increase of 30% with respect to 2007; this amount has been split on 372 operations (+23% wrt 2008) on 284 companies (figure 2).

¹ The concepts exposed in this article have been adapted from the content of the Elective course in Private Equity held at MIP School of Management by Marco Giorgino    , Full Professor of Finance at Polytechnic University of Milan.

² There are several statistics regarding PE impact on companies, for example:

-    NVCA/Global Insight, 2007: Venture Impact 2006: Venture Capital Benefits to the US Economy

-    BVCA, 2006: The Economic Impact of Private Equity in UK

-    EVCA/CMBOR, 2005 e 2006: Survey of the Economic and Social Impact of Venture Capital and of MBO/MBI in Europe

³ companies participated by a PE Fund

⁴ EVCA/CMBOR, 2008: Impact of PE-backed Buyouts on Employee Relations 

⁵ Source: AIFI – PricewaterhouseCoopers, 2008

⁶ with sales less than 50 mln €

⁷ Source: EVCA Annual Survey of Pan-European Private Equity & Venture Capital Activity 2007