Building your franchise

In search of ‘franchise value’ at the private equity firm. By Chip Hughes

Recently, two pioneering private equity firms saw ?end of era? transitions, but the respective ends could nothave been more different.

In 2002, Leonard Green announced his semi-retirement from the firm he founded, and then suddenly died. But despite this, Leonard Green & Partners went on to raise a $1.85 billion Fund IV.

By contrast, in 2004 Ted Forstmann announced that his firm's current fund would be its last ? there would be no plans to continue beyond the legendary founder's retirement from the private equity scene.

What accounts for the differing fates of these two firms? Franchise value.

In the context of a private equity firm, think of franchise value as the value of the firm's right to raise and invest money under the firm's banner, even in the absence of the original founder or founders of the firm. Or, put another way, as the value of the institutional momentum of a private equity firm, independent of who happens to be working there at any given point in time.

As the contrast between Leonard Green and Forstmann Little illustrates, successful private equity firms can and often do build franchise value, but it isn't automatic. They have opportunities to do so within each core activity of private equity investing: fundraising, deal flow generation, transaction execution, portfolio company oversight, and exiting transactions.

Successors to founding partners may face some issues with respect to track record attribution, but franchise value arises from their ability generally to lay claim to the firm's track record. They have the opportunity to portray their investment charter and overall strategy for building value either as fully consistent with the past, or, at worst, as a very natural evolution. Furthermore, successors can portray themselves as having absorbed the founder's skills and perspectives from an ?apprenticeship?position, and as having fully integrated the benefits of learning from the master.

How to build franchise value in fundraising: Provide potential successors with extensive exposure to LPs, both during and between fundraising campaigns. Assign clear accountability for transactions to potential successors, thereby enabling them to claim a portion of the firm's track record as their own. Adopt a consistent investment charter and business strategy over time, only adapting to changing conditions in an evolutionary manner.

Developing consistently attractive deal flow may be the greatest challenge facing private equity firms today, and the one that most directly affects results. It is also an area where franchise value can be pivotal. A longstanding, successful firm benefits from intermediaries that know what sortof transactions are attractive to them. Furthermore, intermediaries may contact these firms during their own pre-marketing processes, giving them an early look at potential transactions. Investment bankers also have a keen sense of where their own bread is buttered, so they are likely to provide ?guidance? to a bidder that is also a client. This guidance can be pivotal in winning an auction without overpaying by so much that a deal's economics are threatened.

A firm with franchise value will also have a network of executives with experience in an area of interest to the firm, giving them sources of relevant investment ideas, a set of sounding boards for prospective investments and a potential ?bullpen?if the target's executives don't measure up. This kind of institutional momentum can't be easily replicated within a given industry, so it represents a very important source of franchise value.

How to build franchise value in deal flow generation: A pattern of consistency in the types of deal done is very helpful ? eclecticism makes it very hard for a firm to attract quality transactions based on past history. Ensuring that all those associated with a particular successful deal feel very well rewarded is also vital ? intermediaries and executives will extend themselves when they know they won't be forgotten. Allow prospective successors to the firm's founders to play a role in the distribution of this ?patronage,?so that the reciprocal benefits are experienced not only by the founder(s), but by the firm as a whole.

Effective transaction execution is often a function of the quality of professional support a firm has ? accountants, attorneys, and other due-diligence-oriented professionals. From the perspective of their clients, professional service firms always have one thing in common ? regardless of the overall firm's reputation, they are only as good as the particular individuals assigned to the project. The best individuals in these firms also have one thing in common ? they're in more demand than they can personally satisfy.

The upshot is clear ? a firm with a stable of committed professional service providers, who will make the firm's work a priority, has a real advantage, and this too is a source of potential franchise value.

How to build franchise value in transaction execution: Manage the firm's professional service providers aggressively with respect to the assignment of particular professionals to the work. Find ways to support the career advancement of those doing exceptional work, especially at a junior level ? these people won't forget who helped them achieve partnerships or other career advancements. React quickly to weed out those who aren't measuring up. Allow prospective successors to the firm's founders to play a role in this process, so that the resulting gratitude and fear accrue to the firm, not just to the founder.

In an era of high transaction multiples, portfolio company oversight is where the action is ? a private equity firm needs to build value in its portfolio companies beyond where the companies' natural momentum will take them. This means a move from a crisis managementmentality ? hands off until there is a problem ? to a steady engagement with each company in order to drive change.

Achieving this effectiveness in portfolio company oversight requires a team of private equity professionals with complementary skills and an effective approach to teamwork. It again demands effective outside support, this time including consultants and, if needed, turnaround experts, as well as attorneys and accountants. It requires a network of executives willing to serve as independent board members or even ?executives-in-waiting.? Finally, it requires a disciplined approach to corporate governance, both for the ?normal? situation and for investments that become troubled.

How to build franchise value in portfolio company oversight: Focus on building a deep bench of seasoned private equity professionals with complementary skills. Ensure that each understands his or her role in each situation, and has a clear mandate to take aggressive action in his or her area of responsibility. Designate potential successors as lead professionals on transactions, in order to build their skills and credibility with investors, intermediaries, and professional service providers. Above all, develop a welldefined and consistent approach to portfolio company oversight, pursue that approach in a disciplined and wellresourced manner, and document both the approach and its application.

Successfully managing exits requires three things: First, a realistic view of the likely prospects of the investment in question;second, access to quality information concerning market conditions for a particular property; and third, experience with the exit method of choice.

How to build franchise value through exits: Develop, document, and rigorously pursue a disciplined review process, using networks of outside executives, friendly intermediaries, and other outsiders as sources of objectivity. Syndicate the exit decision-making process beyond the founder(s) to the group of prospective successors.

Many private equity firms are built around the personal skills of a charismatic founder or founders, investment professionals whose savvy, credibility with investors and other relevant outsiders, and decision-making skills are leveraged by a constellation of worker bees who execute particular tasks, but who aren't true investment professionals in their own right. Many of these firms do not have well-established disciplines, because the disciplines are inside the head of the founder. Similarly, many of these firms are able to successfully pursue very eclectic investment strategies, because the success depends on the skill and instincts of the founder, not on any fundamental insight or set of connections in a particular area.

Some of these firms have been very successful, but from the perspective of building franchise value they are inherently limited, because the value of the firm is equivalent to the value of one or two individuals. When these individuals leave or retire, there may be a brand name, but there is limited value, because the sources of value have gone.

Building franchise value, then, is all about two things. First, it is about building a roster of true investmentprofessionals, people who can collectively, even if not individually, raise money, select investments, build portfolio companies, and make effective exit decisions.

Second, building franchise value is about developing a clear, consistent investment charter and strategy, and a set of welldefined, preferably well-documented investment selection and oversight disciplines. This is a way of distilling and institutionalizing the investment experience of the private equity professionals within a firm, of moving beyond one individual's capabilities and into a pattern of predictable, repeatable success.

This all begs the question, though, of why bother? Two reasons: First, as the private equity market gets tougher, it is harder for a firm to succeed without bringing institutional as well as individual skills to bear. When Ted Forstmann started Forstmann Little, the private equity industry was virgin territory. Now there are hundreds of firms with billions of dollars of capital chasing transactions.

Second, there is real wealth to be created in franchise value, in the form of a chance to go public, or at least to create ownership rights that go beyond those associated with ongoing employment with a firm. Ownership rights to a share of the carry (usually embodied in an entity that serves as General Partner of a Fund) are universally well articulated. Everyone knows what their share is, and what the vesting provisions are, and usually some share of ownership survives the termination of employment. Ownership rights to a share of the franchise value have traditionally not been defined at all, as they were seen as having no value. By building franchise value, a founder stands a chance of capturing value created by virtue of the institutional momentum the firm has developed through much hard work.