The increased role of auctions, mega-funds flush with new capital, emergence of hedge funds as competitive bidders and more discriminating limited partners hint at how challenging it is to remain a top quartile fund. As a result, leading funds are working harder than ever to generate superior returns by sourcing proprietary opportunities, structuring innovative transactions and backing superior management teams.
Increasingly, there is a powerful addition to this list. More and more funds are embracing a more proactive, dedicated industry, strategy and operations capability to support both individual investments and the total portfolio. A generation of progressive deal partners combined with a new role-that of a senior portfolio partner or operating partner-is taking a much more hands-on role in enhancing value.
Pre-acquisition: Avoiding The “Winner’s Curse”
In a market increasingly defined by auctions, winning may simply mean paying the most for the company-hardly the best way to generate superior returns. This risk makes it vital for investors to determine one of two angles before pursuing new opportunities: “What do we know that others have not fully recognized?” or “What can we do with this business that others haven’t considered?” before establishing a bidding strategy. Answering these questions requires insight on potential and realistic operational improvements and a strategic perspective on where value will be, not where it was in the recent past.
There is no shortage of outstanding recent investments or funds that have successfully navigated these difficult waters. Whether it is KKR’s profitable structuring and management of Yellow Pages Group or Bear Stearn’s impressive growth of Aeropostale or DLJ Merchant Banking’s selective entrance into post 9/11 insurers, two trends are clearly highlighted: Gaining and leveraging unique industry knowledge within funds and developing detailed investment theses that combine financial structure with significant operating change.
Not a month goes by without a new example of funds utilizing either a new or more proactive approach to their pre-acquisition efforts. While certainly not an exhaustive list, perhaps in a few years we will see consistent adoption of:
*Probability-based models (e.g. Monte Carlo simulation) that change “what is our qualitative guess at the right multiple here?” to “do the conditions associated with a one in 20 year worst case result in a default?”;
*Proprietary valuation tools that highlight mis-priced assets over a five-year hold horizon
*Deal teams that integrate insight from multiple partners’ financial, industry and strategic/operating to gang tackle’ opportunities
*Expert-led proactive and ongoing processes to identify and pursue proprietary insights towards industry sectors and investment opportunities
Post-acquisition
The days of implementing a few layoffs and closing some unprofitable units with the intention of a quick return are gone. As more and more potential operating improvements essentially get priced into investments through higher multiples, funds must dig deeper, do more and do it faster.
To create superior returns, new owners must not only ensure a smooth implementation of business plans, they must partner with management to unlock additional sources of earnings growth to justify today’s multiples. Funds must provide vision in identifying new markets, expertise on logistics and working capital improvement, support for marketing and customer relationship management gains, etc. Selective examples of the change that may become the new standard include:
*”100 Day Plans” that are religiously monitored, measured and managed;
*Cross-portfolio purchasing and indirect expense reduction efforts that actually provide results
*Targeted use of change agents-both the larger, name brand consultants and a well screened pool of single-shingle’ subject experts
*Jump-starting initiatives with dedicated fund staff
A tell-tale sign of this change is that “100 day plans” now frequently begin in earnest 50 to 100 days before closing. Blackstone’s aggressive recent restructuring of Celanese is an excellent example of this philosophy and its return promise.
In the past, the deal partner and team, alongside the CEO, were forced to be a “jack of all trades” -not only excelling at closing the transaction, but then identifying the highest priority initiatives, developing realistic means to accelerate the process and finding resources to implement change and capture results. Few individuals can master such a task, let alone when the next attractive investment competes for everyone’s time. Further, today’s management teams-especially given their own equity participation- are seeking to partner with funds that bring more than just capital to ownership.
Certainly the differentiation from providing this level of support may be greatest for funds investing in middle-market companies. However, even funds focused on larger corporations must reap benefits from focused re-positioning of units, extensions into new geographies and lines of business and greater focus on profitability and return on capital. As a result, the differentiation provided by post-acquisition management is becoming recognized by funds and limited partners alike. Portfolio strategy and operations has moved from being the province of the largest funds like Blackstone, Investcorp, KKR and DLJ Merchant Banking to an ever-increasing number of investment groups.
Portfolio Management
Lastly, we are beginning to witness a transition in the management of private equity portfolios from a collection of individual investments to a more managed fund. All too often there is universal recognition of the benefits of diversification and the value of a high risk-return investment with low correlation to the portfolio’, but no real means to measure and consider the specific contribution of a specific investment. Further, funds must develop monitoring processes or metrics that support earlier identification of problems-present and emerging.
The portfolio measurement and review process must embrace these objectives and provide fund management with clear insights and information to guide ongoing investment decisions.
Conclusion
In summary, the ability to accelerate latent EBITDA improvements, reposition companies to exploit attractive new markets, identify powerful growth initiatives and leverage cross-portfolio purchasing has become a source of critical differentiation for funds, prospective management teams and their investors.
There is no one model for how to achieve this goal. Regardless, funds must explain to investors a clear strategy for achieving superior relative performance going forward and the portfolio management edge’ is an important component of that answer.
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