Operating partners are carrying more weight around private-equity firms of all sizes, with one notable exception: in many cases they have a limited role in the valuation process. That is curious because operating partners are supposed to be the very people who have the most intimate understanding and experiences of the sectors they specialize in.
Most commonly operating partners have a larger role in identifying investment opportunities, and in informing the evaluation process. But once a target company is in the portfolio, there is often a more limited role for operating partners in the quarterly valuation reports. At the time of exit, the role of the operating partners is highly varied. But overall, if value creation is the central driving force in private equity today, as is widely asserted, there seems to be a disconnect somewhere.
There is no one answer, just as there is no one operating model that fits for all firms. But broadly, both operating partners and investment partners say that while the role of operating partner is growing, a distinction will remain. “The question of why don’t operating partners have a greater role in valuation is a little unfair,” says Frank Schiff, investment partner at MidOcean Partners. “There is a strong view in the industry that while the roles of operating partner and investment partner are converging, they are not going to merge. Nor should they.”
Schiff was a panelist at the PEI Operating Partners Forum in New York earlier this fall. “This topic was a central one on my panel,” he says. “There was a lot of discussion about how a good operating partner is very much aware of multiples and valuation, but his real job is to improve operations. The investment partners are responsible for the deals – starting them, finishing them. As an OP myself I know that our job is to execute on deals. The OPs are well versed in valuation and how deals get done. They help to create value, but there is a difference between creating value and quantifying value.”
The question of relative roles between operating partners and investment partners is a very fine one, agrees Jim Corey, partner at Blue Ridge. “It is a complex topic because you have very different types of operating partners. There are the former CEOs who are generally involved early, in the start of deals. Then there are the consultants, either former or still-active, that are more involved once a target is in the portfolio.”
It is their role that is changing the most, says Corey. “Years ago, those type of consultants would mostly have input after the deal closed. They have been working their way up the timeline of the transaction and now get involved in late-stage due diligence. But at that point the valuation is usually already set.”
Complementary roles
The very existence of the Operating Partners Forum was evidence that “this is a very good time to be asking these questions about their role in valuation,” states Markus Lahrkamp, managing director and national practice leader at professional services firm Alvarez & Marsal. He was a moderator at the conference.
“There were more than 150 partners at the event,” says Lahrkamp, “but if you had held something like that just a few years ago there would only have been a few dozen people. One of the most common topics was the evolving role of the operating partner. There is a great deal of inconsistency around the business today. Part of that is because no one model fits every firm.”
As an example of what is possible, Lahrkamp notes one firm based in New York that “has a bench of a dozen OPs. They are organized by expertise and very much get involved in due diligence and value enhancement. On valuation – the actual calculations – the OPs still take a back seat, but only because those are driven by the fixed financial benchmarks.” So there is not a great deal they can add.
The essential point is that “operating partners are not excluded from valuation, it is just not their primary job,” says Schiff at MidOcean. The two positions are complementary, and are converging to some degree, but important distinctions remain. “Operating partners are focused on how to grow the business, rather than the more mundane calculations of market multiples and industry comps.”
Another important point, Schiff adds, is that valuations are often affected, and sometimes driven by factors outside an individual company or even an industry sector. Understanding those is the responsibility of the investment partners and it is every bit as important as the industry insight that the operating partners bring.
“It is a collaborative effort,” says Schiff. “I would much rather the operating partners put their effort into taking the portfolio company that we bought at 5x or 6x and driving it to 8x or 9x. That is their best and highest use. It is functional and not calculational.”
In fact there are plenty of cases today where operating partners are closely involved in the valuation process, says Corey at Blue Ridge, but it is not broad across the field. “It might be happening at 20 percent of the private equity firms, and varies greatly firm to firm.”
In a similar clarification to Schiff’s, Corey notes, “Some of the valuation function is highly technical in a financial sense, such as questions of leverage and investment banking. There needs to be a financial expert. But that finance also needs to be informed by knowledge of the company and of the industry.”
Looking ahead Corey sees the operating partner role in valuation continuing to grow, deal by deal, firm by firm. “As operating partners demonstrate their value through the life cycle of a transaction, they will move back through the timeline of the deals.” That seems to be determined, he observes, by the tenure of the operating partners. In older firms they tend to have a bigger role in valuation. But also in new firms that have been formed by established partners moving out on their own from a larger organization and setting up shop for themselves.
Operating partners are also moving down the time line says Corey. “In some firms they are involved in the exit plan, notably identifying who would be likely buyers? So it’s more than just going in one direction up or down the deal process, operating partners are evolving to permeate the process at both ends.”
Older and younger, firms or partners, is not important as the track record of value creation, Lahrkamp concurs. Another determining factor is the type of investing the firm does. “Firms working in distressed situations often have a deep bench of captive operating partners. The firms that invest more in steady growth companies generally tend to rely more on management in place for that growth.”
In any case, Lahrkamp stresses that, “the role of operating partner is not imposed from the outside. It develops within the firm. The different panels at the conference showed everyone the variety of operating models. There is a lot of noise today around this topic, who is good at the spreadsheet and who is better with boots on the shop floor. Some firms are comfortable one way, and some are very hesitant. The important thing is that people are thinking and trying.”
Indeed, Corey says that “we are helping some firms craft playbooks. They have matured to the point that they are trying to make the collaboration of operating partners and investment partners methodical and standardized. This is definitely an accelerating trend. The successes operating partners have delivered has earned them a role in the deals as they are executed.”
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