Many a private equity firm has foundered after suffering fatal growing pains: the problems that come with rapid growth or sudden success. Pfm has gathered some top tips from experts on how to ensure that scaling up a private equity business doesn’t sacrifice its core strengths. The key is to keep the good habits of smaller firms, while developing the sophisticated structures and processes of the bigger players. It can be a complex task.
1- Prepare for growth
The business model and governance must be ahead of growth, not behind it, says Mounir Guen, chief executive of fund placement agent MVision. There tend to be three points at which a firm changes and the business model and governance must be reconsidered: when it reaches about 35 people, 75 people and 150 people. Institutional innovation is required. On a broad level, management needs to have a very clear understanding of the composition, responsibility and development of the team. Everyone needs to know what the firm stands for and what its business model is. On a procedural level, bigger firms need a huge infrastructure: HR, internal legal and internal compliance, for example. They also need a clearly defined hierarchy: what does an analyst do? What does a vice president do? What do partners do and what do you do to qualify to be a partner? They also need procedures. Everything that happens has to be documented, and the firm has to know the answers to questions such as: what if somebody makes a very big mistake on a deal?
2- Create a focused vision
We look for private equity funds that have a focused vision and defined strategy – one that the general partner keeps to even as its fund sizes grow, says Vicky Williams, senior investment director at Cambridge Associates, an investment advisory firm. Too often, we see fund managers that have developed an impressive track record in the small or mid-size bracket move into larger deals as they raise ever increasing pools of capital, and then struggle to replicate their earlier success.
This might be because of increased competition, or because they have to pay higher entry prices in a more intermediated, efficient market. A larger fund size is not necessarily a bad thing – our research shows that funds with more than $1.5bn have lower capital loss ratios than sub-$500m funds. But we look for managers that can deploy capital at a sensible pace and typically with the same operational improvement strategy. This is a playbook for transformation that works for all kinds of companies, big and small.
3- Learn to say no
There is great pressure to extend fundraises to new investors, with significant interest in private investments from investors in the Middle East and Asia. But we are wary of fund managers that grow assets under management too quickly, says Williams. For example, if a fund manager were to double its fund size in the space of one funding cycle – three to four years – alarm bells would start to ring.
Such dramatic growth raises questions about asset gathering and fee structures (is it motivated by management fees rather than carried interest?), team stability (does the manager have the right number with the right capabilities going forward?), legacy portfolio workload (because the team is heavily occupied with a large new fund while trying to deal with old commitments as well) and strategy drift. When a fund manager cannot adequately answer these questions, it is better to say “No” to new investors—however tempting it is to say “Yes”.
4- Balance speed with good governance
Private equity is much less cumbersome than some large institutions, but growing firms still face the challenge of how to maintain the speed of decision-making and execution, while ensuring the investment committee is as well-informed as when there were just a few directors, says Jonny Myers, global head of private equity at law firm Clifford Chance.
The investment committee needs to retain its investment rigour but accept that more of its working week is tied up with investment decisions, because more things will be presented to it – often at short notice. It also has to ensure that it gets to see the potential investments at a number of stages, so that it has the opportunity to examine them properly.
5- Keep up the conversation
Growth poses a communications challenge, says Myers. Expanding into new regions, opening new offices or increasing the product range means you have to work harder to maintain staff communication. To do this, you must ensure that you encourage an ethos of individual contribution to team discussions. And the debate needs to be wide and open, especially within the deal teams, to avoid simply following one individual on the team like sheep.
6- Embrace technological innovation
Growing private equity firms tend to find that their myriad front, middle and back-office systems and service providers are no longer capable of meeting client service, investment and operational needs, says Giles Travers, director of alternative investment funds at SEI Investment Manager Services. These systems cannot cope with the increased volume of investment strategies, investor demands and regulatory requirements.
To retain competitive advantage, private equity firms need to adopt and integrate new technology for the next stage of growth in areas such as investor relations, data management, portfolio-company monitoring and regulatory reporting. Private equity firms that can use these to build a scalable and flexible operating platform will be better placed to deal with the evolving fund-raising and investment landscape.
7- Look at what you can outsource
As private equity firms look to expand, they should consider whether to invest in the technology and staffing resources to handle the greater compliance requirements and greater reporting demands from investors, or to outsource to a third party service provider in order to reduce operating costs. Outsourcing can also offer value-added opportunities including independence, access to the expertise of external staff and improved technology, says Alan Flanagan, global head of private equity and real estate fund services at BNY Mellon.
This article is sponsored by Deloitte. It was published in the September supplement with pfm magazine.