Private Equity, once a niche asset class, has over a period of 40+ years navigated a path toward acceptance and respectability. Across a wide range of stakeholders as diverse as institutional investors, investment bankers, lenders, and executives, private equity has successfully managed the leap from misunderstood upstart to respectable guardian of the status quo. Despite this impressive track record of acceptance, the core tenets of private equity remain misunderstood by many business leaders. A chasm has grown between the key tenets of private equity investors and the business leaders they rely on to execute their investment theses, with the inevitable result that value creation opportunities remain unrealized and otherwise promising leaders find themselves unable to thrive in the context of private equity ownership.
While there are many metrics by which the relative success of an investment can be assessed, from the perspective of business leaders who aspire to succeed in the context of private equity ownership, understanding three elements common to all investments will be sufficient:
- Investment Amount. The amount of equity capital devoted to an investment over the investment’s lifetime.
- Investment Return. The amount of capital returned from an investment.
- Timing. The timing of the above two elements.
From the perspective of a private equity investor, an optimal investment outcome will be one that yields compelling nominal returns on a sizeable equity investment, generated over a reasonable (i.e. within their targeted holding period) time frame.
Put simply, a $20 million profit will look very different through a private equity lens when generated on a $5 vs. a $50 million investment, and it would likewise be viewed very differently if the profit was generated in 1 year or 5.
Same Reality, Different Lens
I have served as an interim executive or financial advisor at several private equity portfolio companies, and my experience has been that many business leaders do not understand the above elements or have not thought through the implications of the private equity model. Often, I found myself deputized into an unofficial “translator” role, conducting an odd version of internal shuttle diplomacy as I sought to render intelligible the actions and expectations of private equity firms to a company leadership team and then communicating the insights and strategies of the leadership team in a manner most readily useful to their private equity partner.
The irony of this experience is that both private equity firms and the leadership teams they work with need each other. Their skills are complementary, and both groups are laser focused on value creation (though left to their own devices they will tend to reach the same destination through different paths).
Private equity firms are generally most comfortable driving value through deal structuring, strong governance, a keen sense of the capital markets, and an analytically rigorous focus on KPIs to assess performance vs. plan. This approach is a strength in terms of lending insight and context, but a weakness in that it can lead to blind spots related to idiosyncratic factors at the portfolio company level.
Business leaders, on the other hand, have a tendency to have a deeper but more narrow focus. The benefit of this approach is that business leaders are very attuned to the strengths of their own company and the opportunities before it. The chief weakness of this approach is that business leaders have a tendency to over-estimate their relative position in the market, and often inadvertently push for changes that would degrade investment returns.
Private Equity has become a fixture in the business landscape, largely because the discipline that it insists upon has been shown to be an incredibly effective driver of value creation. For business leaders seeking to ensure that they are prepared to thrive in the context of private equity ownership, the key is to understand the model and its implications. Those business leaders who align themselves to the private equity model by striving to become increasingly effective partners in value creation will find their collaboration efforts to be highly fruitful. Those who resist, however, will struggle.
About the Author
David Johnson (@TurnaroundDavid) is Founder and Managing Partner of Abraxas Group, a boutique advisory firm focused on providing transformational leadership to middle market companies in transition. Over the course of his career, David has served as financial advisor and interim executive to dozens of middle market companies. He is also a recognized thought leader on the topics of business transformation, change management, interim leadership, restructuring, turnaround, and value creation. David can be contacted at: firstname.lastname@example.org.