Making Money the Old-Fashioned Way

Investment bankers are good at many things, but redesigning the inventory control system at a building-supplies manufacturer.

Investment bankers are good at many things, but redesigning the inventory control system at a building-supplies manufacturer, for example, is not one of them.

Having advised on the purchase, sale and financing of many businesses, investment bankers are deal-structure aces, capital-markets gurus, and they know a lot of people. These are valuable attributes to have resident in a private equity firm. Until recently, in fact, a great many private equity firms saw spectacular success based almost entirely on investment bank-honed skills.

Today, however, dealmaking talent is necessary, but not sufficient, for private equity success.

Dramatic changes in the market and economy have left many private equity firms staffed up for an opportunity that has come and gone. There is circulating the industry today a somewhat pejorative bit of jargon for what private equity firms did to produce returns in the erstwhile boom years: “financial engineering.” This term denotes the application of leverage and the negotiation of sponsor-friendly capital structures, among other things. “Financial engineering” does not denote any actions needed to transform and improve the core operations of a company.

When the economy was pointed in an up direction, the earnings growth at private equity-backed portfolio companies largely took care of itself. This made the work of private equity GPs much easier, or at least it played to their strengths. Indeed, the economic momentum, coupled with cheap and abundant debt, facilitated the impressive feats of financial engineering throughout the 2000s that allowed the private equity industry to grow to dimensions not previously imagined.

Most of the bold-name private equity firms that raised funds in the early 2000s went on to produce spectacular returns. These firms were able to raise much larger subsequent funds because of their great success with the early 2000-vintage vehicles, which had the good fortune of having acquired solid companies on the way out of a recession. The subsequent strengthening of the economy and loosening of the debt markets meant that GPs were able realize all kinds of value from their investments. Not only were these companies growing organically, their sponsors were able to pay themselves and their investors fat dividends through artful recapitalizations.

That game has changed, and as the economy and credit markets return to health, the private equity playbook of the last cycle will not be closely consulted. Leverage and can no longer be counted on to create sufficient value in a private equity investment. In addition, sea changes in technology and the interconnectedness of the global markets have left companies all over the world in need of more than just capital. They also need operational leadership and redirection. The private equity firm of the future will be able to provide all of the above.

Keeping customers happy

Mirroring the needs of their portfolio companies, what private equity firms need today above all else are partners who can indeed redesign the inventory control system at a building-supplies manufacturer. The stakes are high – if these GPs can’t help their investee companies perform better, their firms risk extinction in an increasingly Darwinian fundraising market.

The institutional investors who back private equity funds are slowly beginning to emerge from the debris of the economic crisis. These “limited partners” have less money but more questions for their private equity fund managers.

The good news for GPs is that private equity as an asset class remains relatively attractive to LPs, recent headaches notwithstanding. But these investors are increasingly choosey about the kinds of GPs they will fund. They and their investment consultants are now armed with several cycles worth of data on private equity fund performance, and have developed strong views on how to spot private equity groups that have special, alpha-producing ingredients. Increasingly, these investors believe that operational excellence is chief among these ingredients. They are therefore keen to learn not simply how much value was created by GPs, but how the value was created. Leverage, momentum and luck are not the right answers.

Of course, over the history of private equity’s development, it has always been difficult to find a GP who didn’t claim to be above all a business builder. Many private equity firms do indeed excel at building, changing and improving businesses. Others claim to, but have failed to fully cross-breed operating talent into their firm’s DNA. In the private equity business, there’s an old saw that would be funnier if it weren’t painfully true: many firms began life as “four investment bankers and a Rolodex”. But most have tried hard to evolve beyond this dealmaker genesis.

Structures created to deploy “operating guys” run a wide gamut across the private equity industry. One firm may have several senior, full-time partners with industry-specific backgrounds working ceaselessly with portfolio companies to effect change and growth, while another firm will call a retired CEO in from the golf course once a quarter to offer advice and contacts. Both firms will claim operational prowess.

Broadly speaking, the evolution of the private equity industry beyond four-bankers-and-a-Rolodex has produced several species of operating strategy:

Talent on the board.

Some private equity firms have added to the board of their management companies executives and former executives with years of experience in targeted industries.

Special advisors.

Executives with specific industry backgrounds often become advisors to one or more deals backed by a private equity firm.

Platform investing.

Many private equity firms put together teams of executives specifically for building, acquiring or piecing together companies in targeted markets. In some cases these executives will go on more than one “round-trip” with a private equity sponsor if the experience was mutually rewarding.

Call in the consultants.

Although they tend not to brag about this, many private equity firms hire business and strategy consultants to help them set strategic directions for their portfolio companies. This advice is paid for by the portfolio company itself. Some private equity firms, such as Kohlberg Kravis Roberts, own affiliated business consulting firms that provide this work.

Driving with a “dashboard."

Among the most important trends of the past five years has been for private equity firms to provide centralized resources to their portfolio companies. This approach is often called a “dashboard” because it provides the GP a cross-portfolio control of costs and corporate governance. For example, a private equity firm may require all of its portfolio companies to buy into the same healthcare system, managed by specialist staff at the GP level. In addition to seeking savings through group purchasing, an increasing number of private equity firms are hiring experts in the capital markets, human resources, technology, communications and financial management specifically as resources to be utilized by portfolio company executives.

All of the above strategies are steps in the right direction, and have on many occasions been executed with great success by private equity firms. But the private equity firms best positioned to succeed in the long term will be the ones that fully weave operating talent into the fabric of their partnerships. This will be the firm model to beat as private equity regains its footing and again begins to play a major role in the corporate world. It is a model that will reshape the fortunes of many private companies as well as redraw the career maps of many talented executives.

The full operating partner model will be succeed most often because it creates the most powerful alignment of interest between the operators and the other members of the firm.

There are three layers of success in private equity – success of the deal, success of the fund, and success of the franchise, or firm. The most powerful incentive structure ties private equity professional to all three forms of success. In many cases, however, operating talent brought on board a private equity endeavor participates only in the upside of a specific deal or deals. It is, of course, essential that the, say, semi-retired specialty-retail executive advising on a private equity firm’s specialty-retail investment be given options in the company. But this advisory structure doesn’t answer several important questions: Does the firm have the full attention and energy of this operating executive? If the investment goes sideways (as many have recently) will this operating pro throw him- or herself into stabilizing the business? Is the success of this deal repeatable? Is a meaningful percentage of his or her net worth tied up in the deal? Does this person take a view on the future of the firm itself, its quality of deal flow, its adoption of industry-leading practices?

Crucially, can the private equity firm raise its next fund by showing how much value was created by a hired gun?

The private equity firm of the future is one in which the “operating guys” are full partners in the firm, sharing in the economics of each deal, each fund and the firm management company itself. These are full time jobs, not consulting assignments. An operating partner, correctly installed, is very involved in the investment committee, sourcing, reviewing and debating the merits of each investment opportunity, especially in his or her own area of expertise. The partner has made a significant investment of his or her personal wealth directly in the deal and in the fund that sponsored the deal. As a full partner in the firm, the operating guy cares deeply about the future of the franchise. Just as this partner seeks to make improvements to the underlying portfolio companies, he or she also seeks to build a firm that is systematically good at building business in key industries; a firm that carries the keys to operating improvement from deal to deal and fund to fund; a firm that proves to investors that operating prowess is in its DNA.

That’s the ideal, anyway. Consummating this ideal marriage of financial and operating skills is in many cases a big challenge for today’s firms. Private equity is a relatively young industry, and therefore the problem of “founder economics” is pervasive. A person or group of people who have built very successful firms often find it difficult to pass economics and control to a broader group of people, including operating partners. Some of these founders wonder why they should give precious points of carried interest in the next fund to a group of people who largely were not responsible for their being a next fund. They’d rather keep a retired CEO on the payroll than suck up the significant expense required to lure a successful executive at the height of his or her career into the partnership.

But if these founders care about the future of the firms they painstakingly built, they’ll need to broaden ownership and create permanent, economically compelling roles for operators. The private equity opportunity has changed, and investor appetites for private equity funds have changed along with it. The next ten years of the “top quartile” will be populated by firms that have helped companies race ahead of the incredible changes roiling global business. To do this they will need to partner with the limited number of executives who can see these changes coming, and who possess the brute managerial force to steer their companies to victory.

The private equity firms that get this model right will, in turn, attract operators who will view private equity as the best platform for their talent – the most independent, flexible, rapid and potentially lucrative way to build the right businesses in the right way at the right time.

------------------------------------- David Snow is the editor in chief of PEI Media, a global provider of news, data and events to the alternative investment industry. Its Web site is

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