The business model for private equity is changing, and the ripple effects are being felt far and wide. From its early days (1960s and 1970s) as a response to inefficiency in the capital markets, through a heady expansion phase (1980s and 1990s) that saw an extension of the model to sub-specialties (industry, situation, size, etc.), and the institutionalization of the asset class (2000s and 2010s), private equity has become an established force in the market, a driver of M&A activity, and a factor that must be considered by executives in every industry and niche.
Theory vs. Practice
A working paper by professors Paul Gompers of Harvard Business School and Steven Kaplan of the University of Chicago, investigates the broad philosophical approaches, deal sourcing activities, and key value creation activities of established private equity firms post-transaction.
The fruits of this academic labor are a treasure trove of data. Key points include:
- Valuation. Private equity valuation approaches deviate from academia, with the former focusing on comparable transactions, while the later emphasizes the discounted cash flow methodology. This finding may cause consternation in academia but is utterly unsurprising to any finance professional.
- Staffing. Despite a growing appreciation for the value of governance and operational engineering in generating strong returns, the largest private equity firms continue to be staffed primarily with deal professionals. This finding highlights a challenge that private equity firms will continue to struggle with as the source of value creation migrates from financial engineering to operational improvement.
- Sourcing. Deal sourcing appears to be an area of weakness for even the largest and most established PE firms, with over well over 50% of closed transactions having come from non-proprietary sources.
As private equity returns experience mean reversion and the amount of private equity capital under management continues to expand, the traditional business model of private equity firms will shift as well.
Key areas of change include:
Precedence of Operational Value Drivers. The large amounts of capital under management and limited number of attractive investment opportunities has driven up deal multiples as private equity firms find themselves bidding against one another as well as growth hungry strategic acquirers for nearly every opportunity. In the face of these competitive pressures, Private equity firms will increasingly need to focus on governance and operational issues to drive compelling value creation in their investments.
Investment Hold Times. The irony of private equity is that an asset class that was originally created in response to market inefficiency has become a driver of inefficiency, as private equity firms have been challenged to deliver value in a traditional 3 to 5-year investment horizon or, alternatively, have been loath to divest attractive portfolio companies at the end of that span when additional upside is perceived.
Pipeline Management. Even the largest and most established private equity firms evaluate far more investment opportunities than they ultimately close on. The institutionalization of the asset class will continue to push these firms to reassess their internal processes as they look to more efficiently manage their resources in assessing and pursuing investment opportunities.
Deal Sourcing. Deal flow is an increasingly vexing challenge for PE firms, especially the challenge of developing anything close to proprietary deal flow. As private equity continues to mature, PE firms (especially those active in the middle market) will look to expand their partnerships with executives able to provide contacts and insight that may lead to an edge in sourcing investment opportunities in a given industry. While many firms have taken steps along this path, the number and intensity of these partnerships is only likely to increase in the years to come.
Structural Changes. Private equity firms have incurred the wrath of many of their limited partners with adherence to a committed capital structure that some LPs now see as being at odds with their own best interests. As a result, co-investment opportunities and fund less sponsor (private equity investors who source their transaction capital on a deal by deal basis) structures have grown considerably in number and sophistication in recent years.
Source: “What Private Equity Firms Say They Do”, April 2015, Harvard Business School Working Paper. Paul Gompers, Steven N. Kaplan, Vladimir Mukharlyamov.
Performance in Distress
While the model is changing, private equity firms have long generated returns through financial engineering. As any MBA student can tell you, an increase in debt, all things being equal, increases the risk of bankruptcy. And yet, private equity portfolio companies outperform comparable companies when they do find themselves in a turnaround situation. How?
A study by McKinsey & Company shed some light on this phenomenon.
Simply put, private equity firms align management incentives and structure governance in their portfolio companies in such a way that problems are likely to be recognized earlier, and addressed more comprehensively, than in other companies.
Governance in particular is a strong factor. The study’s authors break this factor into three components:
- Alignment. The Board of Directors engages with senior management to sets goals and timelines. CEO guidance is useful, but lack of CEO involvement does not slow the process.
- Planning. The Board of Directors drives for information and sets reporting requirements. Management is held accountable and specific goals are set for the turnaround.
- Execution. The Board of Directors works with the CEO to make decisions on senior management, then supports the senior management team as it seeks to execute the turnaround. Throughout this stage board involvement is much more proactive than it would be for a healthy company.
As a veteran of dozens of distressed situations, in roles including advisor, board member, and interim executive, I can definitively say that the overwhelming determinant of success in a distressed situation is prompt and decisive action.
Private equity has grown to be a major asset class and a force to be reckoned with across geographies, industries, and situations. As the asset class reaches middle age, private equity firms will need to address points of tension in their model, and the ripple effects for advisors, executives, portfolio companies, prospective targets, and strategic acquirers will be considerable. Understanding the roots of this asset class, the ways it generates values, and the changes that are in progress, is crucial for any market participant.
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. David is also a recognized thought leader on the topics of business transformation, change management, interim leadership, restructuring, turnaround, and value creation. He can be contacted at: firstname.lastname@example.org.