Do private equity companies add more value to portfolio companies through their ability to do financial engineering and take on more debt, or do they add more value to their portfolio companies by enhancing their strategy? (1 min)

Enhancing strategy adds more value as the impact is far more permanent than temporarily playing around with the capital structure. Strategic shifts may last a lifetime, while capital structure changes will only affect the company until the PE firm sells the company.

This is often asked by mid-market PE funds, which are typically more involved with driving their portfolio company’s strategy. In fact, they may be extremely hands-on with deciding on which growth strategy to pursue and which segments or geographical markets to expand in. They may also be heavily involved in improving margins and efficiency, as mid-market companies haven’t implemented best practices, especially in the areas of finance, accounting, and IT, while PE firms have lots of experience with that and can easily replicate these best practices in any portfolio company. They may also monitor management closely and even make staffing changes in senior management if it will improve the organization.

Meanwhile, financial engineering may help a PE firm win the deal in a hot auction by leveraging more than the competing bidders, as well as implementing unique capital structures, management options or earn-outs that incentivize management to both perform and stay. However, even though this does drive some value and it can certainly enhance returns, it’s unlikely that it will add as much permanent value as fundamental changes to the company and its strategy. Financial engineering is usually more self-serving, while fundamental changes to the company may last for the entire lifetime of the firm even well after its sale.

Even with large-cap PE funds, the answer is still that changes in strategy add more value than financial engineering. These funds may not be as hands-on, but it is hard to argue that simply levering up a company actually adds more value to the company itself, even if it does enhance returns. Even if true, virtually all PE firms would prefer to market their ability to add value through strategic insights than their ability to “play with numbers.”