Without a crystal ball it is impossible to know which private equity firms will outperform their competitors. But consultancy McKinsey, in a survey of private equity houses, claims to have unearthed the key elements showing how active ownership can lead to outperformance.
In “Why some private equity firms do better than others”, McKinsey consultants Conor Kehoe and Joe Heel analysed deals by 11 large buyout houses boasting better-than-average track records. It found that, while many firms follow the right steps, few do so in a consistent and systematic way.
They concluded that company outperformance represented two-thirds of value, with the rest down to market or sector increases. The study said the key elements were:
0Seeking out expertise before committing to a deal, such as insights from the board, management or a trusted external source.
0Substantial and focused performance incentives, usually equalling 15% to 20% of the total equity. The most successful arrangements called for a significant commitment by CEOs.
0Better value creation plans that are executed more effectively. Management’s plan is part of the process but the best new owners view it sceptically and develop their own, well-researched viewpoint to challenge it.
0Devoting more hours to the initial stages of deals. In the best-performing deals, partners spent more than half their time on the company in the first 100 days.
0If a change in management is needed, it should be implemented early in the investment.
James Stewart, a director at mid-market house ECI, says he goes along with most of the McKinsey claims and adds that many of the factors contributing to successful larger deals also apply to mid-market transactions.
Seeking expertise before committing to a deal is essential, he says, and can be achieved in a number of ways, such as through external commercial due diligence or the private equity house’s own experience in a particular sector.
“Probably the most important source is the network that a private equity house will have developed through contacts with experienced managers in that relevant sector,” he says.
Stewart is also in strong agreement over the need to devote time to a new investment early on, noting that those deals that turn out to be most successful have frequently benefited from a good start.
“In the early days, management often need a lot of support, especially if it’s their first private equity-backed business, and we can help in areas like improving credit control, cash collection and reducing costs.”
But one area where Stewart is less convinced by the McKinsey survey is on the suggestion that the new owners of a company challenge management’s plan for the business.
He says: “Most successful investments are where there is a common plan developed between the management and investor group, rather than each party developing separate ideas and challenging each other.”
But Stewart adds that this communal approach may be less evident in large LBOs, in which there is a lot of financial engineering. In such cases, he says, it may be that management is more removed from the investors and thus there is more of an expectation that management is delivering an agreed plan.
But Ernie Richardson, chief executive at venture house MTI Partners, is also wary about the idea of investors challenging management: “It suggests that you’re imposing a plan on management when what tends to happen is that the business plan changes a lot during due diligence and ends up as a hybrid of the original management plan and the venture investors.”
He argues that investors need to let management get on with their role. “Otherwise the risk is you turn up one day to discuss an important decision and management are sitting on their hands waiting for you to take that decision, which means you’ve blown the relationship.”
When it comes to replacing management, the proposal that any change should be carried out early on applies more to buyout scenarios than in VC deals, says Richard Anton, a director at VC firm Amadeus.
He says: “In VC businesses you need time to get the business off the ground before you can attract third-party management, whereas if you’re acquiring, say, Woolworths, you can get high-quality managers in there quickly.”
He cites the example of Cambridge Silicon Radio, which floated last year: “It was a year after we got involved that it had built enough of a track record to attract the chief executive we wanted to accelerate growth.”
And what about limited partners, do they feel the McKinsey findings tally with what GPs are delivering? Stefan Hepp, chief executive of SCM Capital Management, says he agrees with the McKinsey model although much of it is fairly obvious.
“The difficulty is actually knowing whether a particular GP is, for example, spending half of his time on the investment in the first 100 days because we can’t verify that.”
He adds that through discussions with the GP and analysing its record, the LP will try to get an idea about how the GP actually operates: “There’s a difference between those GPs that just talk about these things and those that actually put them into practice and usually you can sense whether someone is telling the truth.”
Hepp also stresses that outperformance is usually about more than good active ownership. “It can be about buying assets at the right time in the cycle and about judging the outlook for particular sectors. If you pick a sector which experiences double digit growth in the years after the purchase then you’re going to make money.”
McKinsey’s Conor Kehoe says that, while all 11 private equity houses surveyed were following the five steps to a certain degree, what separates the good from the great are the individuals involved. “Much boils down to the individual partner working on the deal,” he says.