Although some private equity firms are resisting the fashion, operating partners have become the must-have accessory of today's market.
Limited partners look for operating expertise at a private equity firm as returns from financial engineering seem to be nearing an expiration date. General partners realize this, as well as the difficulty in sourcing and winning deals without an industry insider. Therefore, operating partners are currently in great demand. Happily for the industry, former CEOs and other senior executives are equally attracted to the private equity opportunity, although these operating vets will hear different answers to the question: ?What's in it for me??
Models of operating partner compensation vary greatly. Some are deployed as part-time consultants who swoop down to work on a deal and receive some options in the process. Others are full partners at a private equity firm and participate in the economics of every deal, regardless of which portfolio companies they have spent the most time on.
There is no standard definition of these operators. At some firms, they are called operating partners; at others, industry partners, operating executives, executive directors, or for venture firms, entrepreneurs-in-residence. Depending on their expertise, these professionals will be involved in some or all of the stages of the life of an investment, from sourcing targets, conducting due diligence, handling operations, advising the portfolio company, and staying engaged right up to the exit of an investment.
Simon Francis, partner at executive search firm Christian and Timbers in Menlo Park, California, says that private equity firms tend to employ operating professionals who have one of three broad profiles.
First, private equity firms are hiring financial experts who have a track record of doing turnarounds. Francis cites the example of Jerry York, who was hired by Kirk Kerkorian to instigate change at the troubled General Motors. York was formerly the chief financial officer credited with turning around Chrysler with Lee Iacocca before moving on to fix IBM's internal processes under Louis Gertsner. At GM, in less than a year, York influenced the car maker to halve its dividend payments and cut the salaries of its top executives and board members. (He has since left GM).
Second, former management consultants with the strategic, analytical and communication skills to understand the internal processes of a company are being recruited to improve shareholder value. In other words, their mandate is to drive transformation. Francis says that these individuals sometimes work full time at portfolio companies as chief strategy or restructuring officer, or spend a couple of days each week with the management team.
The third category is that of the semi-retired, former chief executives who provide interim leadership to portfolio companies upon acquisition. These are the individuals who have ?been there, done that? several times over and know the industry inside and out, such as Mickey Drexler, who ran Ann Taylor Stores Corp. and Gap Inc. before being tapped by Texas Pacific Group to head J. Crew Group.
There is a clear trend in the operator market. Francis says that operating partners are increasingly coming inhouse: ?[Private equity firms are] saying, 'come be a permanent part of a team,' rather than hiring them for spontaneous, ad-hoc consulting assignments.?
The opportunity to be a true partner at a private equity firm appeals to many operators. John Dillon says that following his retirement from International Paper as chairman and chief executive, he decided he ?didn't need to go to the beach? and so explored possible arrangements with several private equity firms. But rather than be ?in a stable of CEOs? and do work that was ?more episodic than I wanted,? Dillon joined New York-based Evercore Partners, which offered him the chance to become a vice chairman and senior managing director.
?I didn't want to be a consultant per se, but more a coach, mentor and problem solver,? says Dillon. ?At Evercore, I sit on the investment committee and get a chance to talk about what's going on at company A, B and C.?
How much, who pays?
Each private equity firm that uses operating partners seems to have its own model for compensating those partners, as shown by few private equity firms who have shared their operating partner models and economics with us (see boxes).
Operators with advisory or consulting assignments are usually paid a salary, and sometimes a bonus. Those who sit full time at the portfolio company are paid by that company. But operating partners who work across a portfolio of companies or who advise fund professionals may be paid by the private equity firm, out of management fees.
Christian and Timbers' Francis says that operating partners can receive anywhere from $750,000 to $1.5 million in cash compensation per year, but it is equity that makes these relationships complex. There is carried interest, but also the potential for getting equity in the portfolio company in the form of stock options, restricted stock or warrants, as well as the opportunity to co-invest in the deal.
Private equity firms are becoming more sophisticated in how to award compensation to operators. Not only is equity dangled as a powerful incentive, but the amount of equity is also awarded strategically. Michael Segal, partner at law firm Paul, Weiss, Rifkin, Wharton & Garrison in New York, says that performance-based vesting is becoming increasingly common.
?It's typical for half or more of a manager's equity to be subject to some sort of performance vesting, not just the passage of time,? says Segal. ?Sometimes it might be an operating target such as EBITDA set by the board every year. But often the performance target is the return to the private equity investors, who are saying, 'We don't really care about the cash flow targets, all we care about is how much money our investors get back from this company and that's going to be your performance target.'?
This trend toward performance-based vesting became more pronounced when US accounting rules changed in early 2006, says Andrew Gibson, Atlanta-based tax partner at law firm BDO Seidman. Unlike the prior rule where performance vesting could cause variable accounting treatment the amount of expense, the new rule introduces more certainty in financial statements. Gibson explains, ?under the new FAS 123R, the amount of expense is determined on the grant date and then is spread over the vesting period but will not change based on the stock price changing.?
As more operating partners become employees of private equity firms, some are given carried interest on top of cash and equity in individual portfolio companies. Operating partners with long term relationships with the private equity firm may get carried interest in the fund. Those with advisor or consultant-type relationships may be given preferential investment in deals by way of a ?friends and family? fund, which does not pay carry or management fees. But this form of compensation is usually awarded only when the operating partners have proven themselves, which may take one to two years.
Potential complications in structuring operator compensation include delineating who gets credit for a company's success ?the operating partner or someone else. In the event of a failure, firing an operating partner creates questions as to what the exit package should be. Indeed, deciding how to pay an operator for success is complicated enough.
Operating Partner Compensation Model A
Unnamed North American middle-market buyout firm
This firm (which wished to remain off the record) seeks to invest between $20 million and $70 million per deal in the buyout of profitable companies. Over the past several years, the firm has increasingly sought out operating executives to work on individual deals ?to form post-acquisition operating plans, sit on boards of directors, and provide other services to the portfolio companies to which they have been assigned.
?I think that for guys who have been pretty successful in their careers, who are in their 50s, taking on these assignments is satisfying for them,? says a partner at the firm.
An operating partner's salary in these deals is not heady by Clevel executive standards ?they should expect to make between $100,000 and $200,000 per year ?if the investment pans out,? says the partner.
At the outset of the deal, the operating partner helps plan a budget and a strategic road map for the company, and in the process, an option package for him or her is structured. Options are structured with a strike price and usually vest over five years. ?If things don't go well, the operating partners are treated just like a member of the management team,? says the partner.
Operating partners are never asked to co-invest in a deal, but they may if they are interested in doing so. Operating partners at the firm are kept ?in their silo of expertise? and are not invited to invest in any other sectors pursued by the private equity firm.
They also receive director fees for sitting on boards, which are typically roughly $25,000 per year. An appearance at a strategic planning meeting might include a fee of ?several thousand per day.? All salaries and fees are paid for by the portfolio company in question.
Operating Partner Compensation Model B
Genstar Capital, a middle-market buyout firm based in San Francisco
Genstar Capital seeks to invest between $25 million and $200 million in recapitalizations and buyouts in companies with $50 million to $1 billion in revenues. The firm focuses on the industrial technology, life sciences, healthcare services and business service sectors.
Darren Gold, managing director, says that Genstar has three operating partner models. The first, which has been used for more than half of its deals over the past ten years, is an informal one, based on building relationships with senior executives that the firm has known for a while or been introduced to. These executives will source companies, then with Genstar, conduct due diligence and run the business upon investment. At the very least, Gold says that the operating partners will sit on the board of directors of portfolio companies.
The only compensation these executives receive is an ability to co-invest directly in the portfolio company and, if they become involved in running the portfolio company, options. Chief executives typically get between three percent to five percent ownership of the portfolio company; Genstar typically carves out an industry-standard option pool of roughly 10 percent of a company's equity for its senior management.
CEOs of portfolio companies are also given the opportunity to invest in other Genstar deals.
The second model is a more formal relationship, involving about a dozen senior operating executives comprising Genstar's strategic advisory committee. These executives are paid an annual stipend, in addition to receiving the opportunity to invest directly on a deal by deal basis. But Gold stresses that the advisory committee members are not employees of the firm.
Genstar's third and most recently developed operating model is at the core of a new industry investment strategy ?a software and software services vertical. To establish a foothold in the space, Genstar brought on board Mark Hanson, former head of corporate development at Siebel Systems (now owned by Oracle Corp.).
For its next fund, Genstar is considering establishing a ?friends and family fund? to give senior executives it has relationships with the chance to invest through the fund with preferential economics.
Operating Partner Compensation Model C
Unnamed middle-market buyout firm focused on Europe and North America
This firm (which wished to remain off the record) seeks to invest between $20 million and $200 million per deal in tandem with other financial or strategic sponsors.
The ?operating partners? do not assume the role of CEOs of the portfolio company, but rather apply their expertise to sourcing, and accelerating the change spelled out in the investment case as board members.
This firm divides its deal professionals into three types of partners; finance partners, operating partners and industry partners. While all three will be involved with an investment from sourcing to exit, the finance partners spend two thirds of their time sourcing deals and structuring the investments. Operating partners work by an inverse ratio, spending two thirds of their time in the post acquisition phase to guide and monitor the changes at the company.
Industry partners are devoted to a given market segment with their expertise on industry dynamics tapped when the firm sources deals. They are also brought in to make strategic decisions over the life of an investment.
The compensation of industry partners is closely tied to the investments they work on. It is a mix of salary from the firm and equity in the applicable portfolio companies, dictated exclusively by the performance of deals within their industry.
Operating partners are partners in the firm alongside their finance brethren, with the most senior of these having a full vote on the investment committee. Their compensation, like their contribution, is spread beyond a given industry segment.
While the operating partner package is structured similarly to a traditional GP with a mix of salary, bonus and carried interest, a partner at the firm admitted that the structure differs slightly for the operating partner, with total compensation slightly lagging that of the finance partners, though the gap between them has only shrunk over the years.
Operating Partner Compensation Model D
Clayton Dubilier & Rice, a New York-based buyout firm
From its inception in 1978, Clayton Dubilier & Rice has been the firm that pioneered the concept of operating partners. In the early days, founders Joe Rice, a corporate lawyer and financier, and Martin Dubilier, a protégé of Harold Geneen of ITT fame, worked closely together in a shared office to build businesses across a range of sectors. And the basic model continues today. A source at the firm says that Clayton Dubilier's operating partners are treated equally in every respect and lay claim to ?half the economics of the firm.?
Today the firm, which also has an office in London, has eight operating partners, including an operationally focused vice chairman, Charles Ames, the former chairman and chief executive officer of Reliance Electric and Uniroyal Goodrich. These partners are full time investment professionals at the firm, and have a full vote on all investments. Jim Berges, vice chairman of Emerson Electric and Charlie Banks, former CEO of distribution giant Wolseley plc are the most recent additions to the CD&R operating team.
CD&R's operating partners are involved in all aspects of the investment cycle from sourcing and portfolio company oversight to will work within his area of expertise, these professionals share in the wins of each fund as a whole.
A recent major success story for the firm was its sale of document services chain Kinko's to FedEx for $2.4 billion. Kinko's had grown under the leadership of Clayton Dubilier operating partner George Tamke, a former co-CEO of Emerson Electric who had experience moving companies into higher-growth lines of business.
Among the fans of Clayton Dubilier's operating partner model is David Swensen, the chief investment officer of Yale University. He has said: ?By combining operational and financial skills, CD&R exemplifies the potential for unusual value creation.?
Giving operating partners half of a firm's economics remains a highly unusual model in the private equity market today.