Nowadays, LPs expect private equity firms to not only articulate a clear strategy for adding operating value to their investments, but also to demonstrate evidence of their past successes in having done so. Operating improvements can be generated at the functional, company or portfolio level. Most of the examples so far have been at the individual company level, and the best examples are recognised annually by pfm’s sister publication Private Equity International in their Operating Excellence awards.
When it comes to operational value creation, however, LPs need more than a few past case studies that represent retrospective, anecdotal successes. Just as they would evaluate any active investment manager, LPs need to differentiate 20–20 hindsight, luck and a rising tide that lifts all boats, from skill.
It is important to determine whether the firms are consistently following a stated strategy for adding operating value and whether it is broadly working. LPs should also look at cases where the operating approach was applied and did not work. They need to see an approach that works not just at a company level but across an entire portfolio, since that is what drives their returns. To that end, LPs are rapidly becoming more sophisticated in how they assess private equity firms’ ability to add operating value.
Listed in the box below are 14 questions that LPs are asking today, as well as questions they should be asking in the future. These are some tough questions and no firm will have perfect answers to all of them.
LPs are only recently able to distinguish alpha produced by their private equity managers. Operating value is just one component of overall return. So if it is difficult to measure incremental alpha on a portfolio basis, it is not surprising that it is even more difficult to measure the contribution from operational value add. There is just too much else going on.
Modest incremental improvements in a business with high multiples might dwarf more heroic efforts in a business with lower exit multiples. And since there is a tendency to work even harder on the underperforming businesses, there is always the chance that the best operational work will get overwhelmed entirely if the business ultimately fails for reasons beyond anyone’s control. The latter cases are especially frustrating for operating partners because they rarely see the light of day since no one wants to call attention to poor outcomes.
A six-point set of best practices for private equity firms can help them move the needle on portfolio returns through operational value add. I have seen these work at Welsh, Carson, Anderson & Stowe, or learned them from my peers at other private equity firms. They are not novel or proprietary – they will be familiar to any experienced operating partner.
- Start with a broad view of operational value add.
- Implement a systematic, repeatable process starting pre-closing.
- Resource the approach sufficiently for the mission.
- Apply the approach consistently.
- Continuously prioritise work with the companies.
- Measure the results and adapt over time.
Here, I explain the first principle from which all the others follow.
Start with a broad view of operational value add
When some people think of ‘operations’ they think narrowly of, for example, manufacturing plants, call centres, supply chain and logistics and, in fact, these do represent rich target areas in most businesses. In a private equity context, however, ‘operational value add’ is essentially the catch-all for everything that happens to the financials post-closing outside of multiple expansion, financial engineering and inorganic acquisitions.
Back these factors out of the returns, and the remainder reflects the impact of operating performance. So ‘operations’ therefore encompasses everything going on in the business such as talent, organisation, organic growth initiatives, pricing, process improvement, insurance, employee healthcare, quality, compliance, regulatory matters and information technology, to name a few.
In a more mature and competitive private equity market, with more secondary buyouts (the sale of a portfolio company from one private equity firm to another), many operating levers have already been pulled by prior owners. As a result, private equity firms and their operating partners have needed to further expand their view of how operational value add can help achieve faster, more successful exits. For example:
- Focusing the business on segments that attract higher multiples; exiting or de-emphasising segments with lower multiples.
- Changing the business model to attract a higher multiple, such as from episodic to recurring revenues. Examples include shifting the mix from products to services and from software to software as a service (SaaS) models.
- Aligning the business to dovetail with the most likely acquirer, whether financial or strategic.
- Determining which infrastructure investments absolutely need to be made during the holding period vs. those that can wait or would be better done by the acquirer.
- An example would be postponing an expensive new IT platform that would become obsolete upon integration with the likely buyer.
- Identifying and building demonstrable operating capabilities to underpin future projections. Such capabilities could include a dedicated team with specific skills, a customer database or a proprietary software tool.
- Designing operating metrics that will support a higher valuation upon exit and being disciplined to capture and document the historical trend of achieving them.
- Simplifying the business so that potential buyers can better understand it and value it. For example, outsourcing functions that are not core or exiting low volume or low profit product lines.
- Removing obstacles or unattractive elements of the business, such as discontinued operations, legacy obligations and leases. Similarly, aligning obligations such as leases or outsourcing contracts with expected exit timeframes.
- Performing pro forma synergy analyses to support valuations for different potential acquirers.
As you can see, there are many ways where operating input can contribute to a successful exit beyond the traditional narrow mindset of increasing revenue, EBITDA and cash flow. The ideal approach, implemented by some firms, is to start by drafting an outline of the future Confidential Information Memorandum (CIM)
or ‘book’ early in the process and work backwards to identify opportunities and gaps, and plans to address them. This is where investment bankers can provide valuable input on what will drive future valuations. Of course, so much can change over time that this needs to be a dynamic, continuous process.
15 questions LPs are asking today, and should be asking in the future
- Is your operating approach systematic and repeatable, and something that could be expected to work in the future?
- Have you resourced your approach appropriately for the task at hand? For example, if you are raising a larger fund, have you anticipated the additional resources you will need? If your focus is on distressed investments, have you lined up relatively more resources than, for example, would be required for a focus on light-touch growth equity investments?
- Do your firm’s key processes, such as your investment decision reviews and portfolio monitoring meetings, reflect increased focus on operational value add? Or are operational issues an afterthought?
- At what stage of the investing cycle do you engage your operating approach and resources? How involved are they in exits?
- Do you tend to buy companies that present opportunities to use the same proven tools over and over again? Or are the companies and situations so different that you need to customise your approach each time?
- How quickly do you formulate your operating improvement plans post-closing?
- What timeframe do your plans cover? With longer average holding periods, how often do you update these plans?
- How widely do you deploy the approach? For example, do you focus on making a big difference in a few investments or an incremental difference across many?
- Does your approach fit expected future conditions, including economic cycles? Are you too focused on growth entering a potential downturn? Are you too focused on cost entering an upturn?
- Do you anticipate changes in the types of investments you will make and have you adjusted your operating approach accordingly?
- Are your success stories representative or anecdotal? Are they ideally what investors could expect in the future? Or, at the other extreme, are they successful exits that have been reverse-engineered to emphasise the value added by your firm?
- How do you pay your operating team? How do you pay for them, from the management fee or do you charge the portfolio companies and how? Are your LP disclosures sufficient? Have they been vetted by the SEC?
- As the acid test, what would the portfolio company CEOs say on reference calls about your operational value add as a private equity firm? Would they say the same after you have exited?
- Do any portfolio companies continue to rely on your team for help even after the exit?
- Having satisfied many of these on a standalone basis, how are your approach and results differentiated from other private equity firms on any of the above dimensions? Are these differentiations sustainable or dependent on specific people in the firm?
Photograph by Megaflopp