Following the meltdown of global credit markets, the private equity industry is vulnerable. The industry is entering a Darwinian phase, where survival of the fittest will mean a return to performance-driven value growth. Adapting to the changed conditions will require a greater focus on the operational performance of portfolio companies, which in turn raises the challenge of whether the financial skills of private equity practitioners will need to be rebalanced more toward operational capabilities.
We recently looked at a sample of PE investments that were exited at the peak of the market in 2007. Within this sample, the average return on equity over the ownership period between 2004 and 2007 was an impressive 57%. This superior return on equity was driven by applying traditional PE tools of a leveraged finance structure, a clear strategy and an incentivised management team plus a mixture of debt repayment, multiple uplift and EBITDA growth. In our sample the average multiple uplift was between 10x on entry to 17x on exit. Through the multiple lift alone the private equity firms were able to earn a good return, without having to improve their portfolio companies’ performance. During this period the average annual EBITDA growth for our sample was 8%.
Looking forward, given fairly moderate multiple uplift assumptions, in order to maintain the historical levels of return on equity, we estimate that the EBITDA growth will have to rise from 8% to more than 22% – a potentially unrealistic scenario given the current economic outlook for the next two to three years, in which ‘securing downside’ is the order of the day. We believe that the funds that will be successful over the next five years are likely to be those that can generate the highest levels of EBITDA growth.
A change of emphasis from finance-driven debt repayment and deal-driven multiple growth towards operations-driven EBITDA growth will have far reaching implications for the way PE funds are structured and the types of skills that are needed for them to develop.
A shift from capturing exaggerated market opportunities toward creating ‘intrinsic’ operational value within portfolio companies will demand a thorough scrutiny of the target’s core operations prior to acquisition, followed by longer holding periods with continuous value creation beyond the 10-day programmes. Many PE funds are now looking to adopt a more hands-on and active approach to the management of their portfolio companies.
To successfully address this challenge, funds take different approaches, but there appears to be a growing consensus that operational skills are needed to complement existing investment skills.
To gain these skills there are a number of options. Some funds are developing a specific industry focus in order to develop in-house expertise and gain intellectual synergies across the portfolio. Others are hiring senior industry experts to coach management teams, or are building in-house performance improvement teams to work with portfolio management teams on specific initiatives, often supported by consultants.
There are funds that are focusing on best practice sharing, promoting CEO forums or executive exchanges across portfolio companies. Others are considering going against the core principles of independence and accountability by combining non-core back office functions, such as indirect sourcing categories in order to extract cross-portfolio synergies.
The more difficult issue to address though is how to support management teams of portfolio companies without impacting their autonomy and accountability and without deteriorating the investor / management relationship. Suggesting that a management team might benefit from operational help from the investor requires tact and credibility.
Credibility comes from having a structured value proposition which focuses on specific industries or operational issues and is supported by a competent team with a strong track record. Tact is a more difficult attribute and may require a different set of skills or experiences or simply a different investor story from the outset.
The private equity industry is moving into a new era in which a more hands-on operational ownership model will replace the deal-driven approach that has served the industry so well in the past.
This change will not be easy as it goes to the very core of what has made private equity successful and demands a change in the core skills of the industry. Many funds are already re-grouping and refocusing their efforts on operational value creation and if any industry can demonstrate its ability to respond to a challenging market environment and to adapt successfully to Darwinian forces, this industry can.