On Modernization, Maturation, and Maestro

Private Equity is the Peter Pan of the financial services industry; it hasn’t grown up, (and is hasn’t needed to). With its corporate raiders, hostile takeovers and Barbarians at the Gate, the ‘80s gave rise to a Private Equity (PE) boom, which hasn’t yet abated.

Success obfuscated the need for maturation. Until now.

The 2018 PEI Operating Partners Forum gave voice to the quiet whispers of an industry caught mid-epiphany. While panelists and participants articulated varied perspectives on the industry and its evolution, they all shared one unifying conclusion: PE’s new bottom line is value creation – and that value creation is serviced, in large part, by portfolio operations.

THE PRIVATE EQUITY PARADIGM:

The traditional PE business model is a capital deployment vehicle. As a result, it often lacks corporate infrastructure, (whether in the form of operational efficiencies, marketing strategies, talent development or even succession planning). It also often lacks an operational paradigm for driving value creation within its portfolio companies, and for scaling.

That’s a problem for an industry experiencing record growth.

Biggie said it best: “Mo’ money, mo’ problems.” Total AUM is now approaching $3 trillion, with over a $1 trillion more in dry powder. What was a $2B fund in now a $4B fund. And, what was a $4B fund is now a $5-$15B megafund. Industry growth brings with it a host of new issues, but two in particular are serving as the forcing mechanism for firm maturation:

1. The Sophisticated Investor: LPs are demanding that funds have an effective plan for scaling and for recreating past returns in a new market environment.
2. A Seller’s Market: A scarcity of deals has put management in the driver’s seat. They want to be wooed by a buyer’s expertise in adding portfolio-level operational value.

Put it all together and the model for the next generation PE fund starts becoming clear: It’s a firm with an established and standardized approach to value creation at its portfolio companies.

Less clear is how to create that model. Firms can’t all follow the same roadmap. Convergence may be a friend to competition. Duplication is not.

What’s the bottom line? PE firms must grow up. They must modernize and brand their unique approach to operations. To do so effectively, they’ll need to answer four critical questions:

1. Where to fall on the operations spectrum?
2. How to win friends and influence management?
3. How the $%! to pay for it?
4. When (and where) to tech?

Let’s dive in…

1. WHERE TO FALL ON THE OPERATIONS SPECTRUM?

There’s a traditional PE protocol: invest in businesses with a financial upside and a management team who, with sponsor guidance, can help exploit that upside.

And then there’s a new wave of firms, which follow a more ‘industrial’ playbook. This playbook isn’t particularly concerned about management strength. Instead, it relies almost exclusively on a prescriptive approach to business operations, where sponsors run portfolio companies more like divisions than independent operating companies.

Is this new way the PE way of the future? Probably not for all firms.

The industrial playbook tends to follow a software sector specialization that allows it to be far more prescriptive than a diversified firm. And, management at many targeted investments would balk at the proposed lack of partnership post-close, rendering too many good deals DOA.

That said, recognizing the increased priority LPs and management teams place on proven approaches to value creation, firms must understand the importance of developing protocols that fall somewhere in between the industrial and traditional PE way. And then, they must understand the PR importance of branding those protocols as unique to the firm.

The real question the firm must ask is not whether to fall on the portfolio operations spectrum, but rather, where on it to fall?

2. HOW TO WIN FRIENDS AND INFLUENCE MANAGEMENT?

Deal structuring, not value creation, has always been the PE gold standard. LPs hadn’t really prioritized operations until valuations skyrocketed.

In this era of abundant capital, however, management teams are conducting reverse diligence on their PE fund suitors, seeking those who will work to create the most value in partnership with them. To win, PE firms must walk a fine line: presenting themselves as value creation partners, not overly prescriptive dictators.

In finding that balance, fund sponsors need to credibly assert the importance of partnering with, not parenting to, management. At the same time, having some standard operating procedures can help ease communication with the more independent management teams in their portfolio. They allow the fund sponsor the ability to say ‘our requests and assessments are not a reflection of your poor performance; instead, they are part of our standard protocol.’

When ‘it’s standard,’ PE firms can also become more comfortable requesting detailed and complex financial reporting from management to help all stakeholders align around the broader value creation plan: KPI reporting, quarterly forecasting, 13-week cash flow forecasts, etc.

The question that must be answered is more a PR one than business one. How do we communicate our operating perspective to management in such a way that we are perceived as having an effective approach, without too heavy a hand?

3. HOW TO PAY THE PIPER?

This hadn’t been much of an industry question until it became the industry question. Just a few years ago, the large scale in-house operating group had become the en vogue model for executing value creation plans. There’s since been a movement toward retraction, with a more conservative footprint of on-staff Operating Partners (OPs), and a larger network of external consultants.

But, in the now infamous 2014 ‘Spreading Sunshine in Private Equity’ speech, Andrew Bowden, director of the SEC’s Office of Compliance Inspections and Examinations, highlighted concerns over how firms compensate OPs, arguing that though they walk, talk and otherwise act as a member of the PE firm, they’re actually paid by the fund or its portfolio companies. For the SEC, this was fundamentally a disclosure issue. For PE firms, it’s a money issue: how to pay for robust operations without dipping into GP dollars?

Firms have typically dealt with this push-pull dynamic by varying OP compensation according to firm structure. Where there are Operating Partners that are on staff and leveraged across the portfolio, they are usually paid for from the GP management fee, get base/bonus, and participate in the carry pool.

The extended network of external Operating Partners sees a wider range of compensatory arrangements including retainers, fee-free co-invest relationships and, at times, equity within the companies for which they provide deep dive services.

But there are even more unique arrangements the PE firm could employ, especially in service to a more standardized approach to operations. For example, the PE fund could institutionalize the building of clearly defined post-close roadmaps, created during the diligence phase. These roadmaps would not only draw upon the fund’s institutional knowledge of unique value creation levers, but it would provide real direction in what levers to pull (and when to pull them) in order to effectively operationalize the roadmap.

Creating this roadmap during diligence would not only make post-close value creation more efficient and effective, it would also allow the firm to pay for the roadmap as part of the transaction costs.

4. WHEN AND WHERE TO TECH?

The great irony of PE is that while the industry has finally begun to recognize the value of software as an investment, it hasn’t yet really embraced technology’s potential to transform private equity, either in how deals are sourced or value creation plans are employed.

But, PE is on the cusp of a major turning point. Technology promises to transform and automate the data available to GPs and LPs.

As a result, we’re seeing firms leverage the use of PE-specific CRM solutions to integrate and execute sourcing and deal management strategies.

As with many of the sea changes in private equity, it is the LPs driving change. Yes, they’re interested in technologies that improve transparency with GPs, but they’re also demanding non-Excel tech answers when undertaking diligence on fund managers: does the fund have a clear view of its portfolio operations approach?

And, if they haven’t yet asked what technology the fund uses to support institutionalizing operations, they will.

To that, GP answers will vary wildly, but the question the LPs are really asking is ‘what technology enables centralized portfolio operations?’ And, ‘do you have that?’

These centralized data repositories do more than just satiate LP demands. They also provide a single source of truth for regulators, and create a means to flag early trouble signs before they become legitimate problems (think late reporting).

As increasing regulations and LP demand together create a forcing mechanism for PE technology adoption, GPs should be prepared to ask and answer the important questions about the firm’s data modernity.

In finding the right answers to these critical questions, PE firms will be able to define an institutionalized approach to portfolio operations that not only satiates LPs, but differentiates the firm in a crowded marketplace, and produces superior returns.

PEI convinced Pete: it’s time to grow up. Say goodbye to Neverland, and hello to the next, value-creating generation of PE.