Employee Ownership in PE Deals

PE firms pursue new angles to drive returns

There’s an interesting piece out today from Financial Times arguing that increasing equity ownership by employees (think: employees across a PE PortCo, not just c-suite leaders) has a role to play in driving value creation & returns in the face of higher interest rates.

TLDR:

1) Heightened interest rates are a headwind to PE returns and are pressuring private equity firms to seek new drivers of returns

2) This is leading some PE firms to increase employee ownership of PE PortCos with the hope that increased ownership = increased performance

As a quick refresher, higher interest rates increase the cost of debt in a leveraged buyout, which reduces cashflows and often reduces the total leverage used in a deal… both of which are headwinds to returns.

Leverage has been an important driver of returns in private equity historically over the last two decades (particularly in the 2000-2007 era). See the chart below from GSAM referencing this Institute for Private Capital research paper.

If cheap leverage is going to be less reliable as a driver of returns, the FT piece argues that wider employee ownership at all levels (c-suite to entry level) may be a key to unlocking value creation.

“Who knows better than current workers where money is wasted, sales opportunities squandered or processes need improvement.”

The nonprofit Ownership Works (founded by a KKR partner) has been leading the charge on employee ownership and used KKR PortCo CHI Overhead doors as a proving ground. Over the 7 year hold period of KKR’s investment CHI Overhead Doors, Ownership Works says that:

“All 800 employees at C.H.I. received a payout on equity, averaging $175,000 through the ownership program”

“On an organic basis, EBITDA increased almost 4-fold. C.H.I.’s EBITDA margin steadily improved over a seven-year period, ultimately increasing by more than 1,400 basis points from 21% to well over 30%. Revenue grew by nearly 120% organically.”

The key challenge for PE investors will be quantifying and triangulating the impact of employee ownership (vs. other value creation efforts in a deal).

Firms will need to figure out how to make employee equity plans meaningful enough to motivate employees beyond their existing compensation plans.

As more PE firms start adopting these programs (over 30 are involved with Ownership Works), this will be an interesting new value creation lever to track.