The number of public companies have declined 20% in the last 10 years. This trend continues as more companies go private. The number of private equity deals are at an all time high and so are valuations. There is a massive amount of dry powder waiting to be invested as pension funds keep pouring more money into private equity to boost their own lagging returns. The total private equity industry assets in the US are now equal 20% of the S&P valuation.
High valuations and endless capital put pressure on PE firms to invest in more and larger businesses and expand value creation strategies. Firms are adding even more operating partners, technology experts and industry advisors. The PE funds are using their industry and operational expertise to target more and larger carveouts from conglomerates. The complexity of such divestitures require more sophisticated technology tools. Also there is an increasing number of business rollups in industries where the firms have experise. Rollups tend to shape new business models and leverage digital technology even more than traditional buyouts. As a result, PE firms are expanding their use of technology in value creation strategies beyond backoffice, sourcing and reporting tools of the past.
There is a push to digitize all back office and put those processes in the cloud. There is a change in the use of analytics with the focus more on predictive analytics and not on reporting. Most firms have a cybersecurity initiative, sometimes even mandating security practices and tools to the portfolio companies to reduce business risk. Many firms are even experimenting with using machine learning and artificial intelligence especially in supply chain, maintenance and customer interactions. There is a belief that digitizing business models more predictably increase exit valuations than other operating strategies.
Technology partnerships rarely fail due to lack of technical or project management skills. Having spend most of my career in business development (partnership development) roles, I noticed certain patterns beyond the textbook answers on success of strategic partnerships. I hope noone needs to be reminded any more for the need of an executive sponsor or a governance process as advisors still often do. I want to highlight the nuances in leadership and execution that I believe make technology partnerships work. The scope of partnerships range widely from co-marketing and unspecific alliances through co-development or joint ventures to acquisitions and mergers. Regardless of these vehicles certain success elements are common to all.
Business development should create long term value through non-core relationships. Having a partner to deliver the same product or service to the same customer segments you are already engaged with is not really a partnership but outsourcing. True partnerships open avenues to operate outside the current swimlanes, customer influences, segments and product categories of one (or both) of the businesses.
The fundamental truth is that business development cannot be managed or measured the same way as sales is. But it should be managed and measured with similar rigor and business outcome orientation.
So here is the executive summary of what I have learned in my years in business development:
- Make sure business partners have common objectives – Most partnerships have several unrealistic or unstated expectations on either side. Unless both parties are aware of those critical expectations it is impossible to attain success that meets both side’s goals. These discussions have to be explicit and needless to say, both sides have to win given the same business outcomes. Ideally key program executives on both sides should have some of these outcomes in their compensation plans. It cannot be overstated enough that both sides must win and must win often for partnerships to survive.
- Select the right partnership format for any given goal – The financial and resource needs of a longer term co-marketing effort vs a product co-development are very different and clearly produce different business results (mind-share and sales leads vs tangible viable products that may or may not succeed). In my experience and probably rightfully so, most early partnerships are under-resourced for the stated objective. There is nothing wrong with starting small if the expected results are small as well. On the other hand, some partnerships start with lofty goals, due diligence and joint venture, which is fine as long the the expected failure rate is baked in the calculus (be a venture capitalist vs a cash flow oriented investor).
- Balance technical, commercial and program management skills in your partnership team – Most partnership teams are biased towards certain skills, either too technical and end up with technically viable but commercially poor results or too commercial and expect bankable revenues in pilot stages of a partnership. Balancing the roles in different stages of the partnership from concept (technical) through commercial due diligence through execution stacks the odds of success. By the way, never expect the core business to divert resources to step in to augment shortcomings in BD skills.
- Adopt a startup mentality: Fail early and Pivot often – I believe every business development team should think like a Lean Startup. Leaders should remember that noone knows what the ultimate business model will evolve into so experimentation will be key. Once the team understands the goals they should know it is OK to fail and course correct.
- Partnerships should be structured by executives – It is fine to have executive sponsors, but not enough. Most partnerships are structured and operated at a level in the organization that cannot divert the necessary resources, make commercial or technical roadmap changes or tradeoffs. Making all issues an executive escalation is a sure way to slow down or kill the partnership. The radical point here is that partnerships must be formulated by key executive teams and once they are up and running can be handed off to operational and sales managers for proper execution. The criteria for the right executive level is that the person can make the technical or commercial trade-offs necessary and have the backing of the board.
- Partnerships should have clear metrics and accountability from day one – However, leadership style, metrics and accountability should match the stage of the program. Early stage (Pilot Phase) the key metrics are there to encourage fail-early type pivoting or getting sufficient market feedback. Once key pilot projects are completed (Standardization Phase) the KPIs may become adherence to process metrics or adoption of best practices. Once the partnership is operational across the full scope (Scale Phase) the metrics should start looking like core business metrics (pipeline, revenue, NPS, delivery time etc) with the understanding that partnerships are typically outperforming the core in growth metrics and underperforming in efficiency (lower sales productivity or profitability initially).
- Process first, ideas second – It is easy to fall in love with a business idea. Before partnerships are formed, each party should be clear on what success looks like in each of the above stages and when course corrections are needed and yes, when the plug needs to be pulled to redirect resources.
- Contracts should include dedicating the necessary resources – Most contracts deal with IP issues and ownership of the commercial benefits of the partnerships and tend to neglect what each party has to keep doing in the early days of the program. It is very hard to start the project when results are unclear, it is easy to share the spoils once it is up and running, Contracts that specify expectations of people, executive time and even internal and external PR visibility of the effort will increase likelihood that the core business will support the partnership and not detail it.
- The core business will not understand or support the partnership in the early days and that’s OK – BD efforts are a distraction to the core business because they divert attention or resources from daily execution and do not enhance core metrics short term. The great book “The Other Side of Innovation” summarizes a wealth of research on this and I observed them all. Suffice to say, any support from the core should be pre-negotiated and appreciated when it happens.
- Brands do not partner, people do – In my experience it is a very critical realization. Having people in the BD team who like collaborating with others will be critical. It starts with the CEOs but true at all levels. Leadership teams should ensure the team fit and encourage collaboration.
I believe business development is the best growth engine in any company to bring ideas to market. All new innovation will need partners and all partnerships are different. The alternatives to successful business development are very costly whether it is decling revenues, lost marketshare or the excess cost of acquiring innovation we could develop ourselves through effective partnerships.
2017 was another watershed year in Private Equity. Almost all the buyout fund capital growth happened in megafunds ($5B and above) and valuations continued to rise to record heights (15 times EBITDA). There ismore capital available than attractive targets at those valuations. At the same time strategic buyers got more active and also introduced record level buying in corporate venture funds. All of this reinforced the trend that operational value creation continues to be essential not only for growing enterprise value but also winning the deals in the first place. Investment theses get more aggressive in their assumptions for not only operational improvements but also fundamental business model changes especially through digital.
Several of these trends impacted how we at SAP support the firms. Some of the trends impacting technology providers for PE value creation are;
- More sophisticated analytics and modeling especially in sales and spend analytics, even early adoption of AI and machine learning in investment theses
- PE focuses even more on top management talent even more especially in finance and sales. Whatever technology can enable star executives will be critical for growth
- Several firms adopting Digital First to drive business model change first and operational changes later (especially in retail, technology, consumer and manufacturing)
- Carveouts and add-ons continue to grow and require more technology integration and simplification than traditional buyouts
- The number of PE firms doubled since 2010 to above to 8,000 and the pressure to differentiate with technology increases
- Over 50% of companies are held for over 5 years which allows time for technology transformation
- Majority of exits are now to strategic buyers who value technology and process more
- Some firms (Blackstone, Carlyle) launched 10+ year funds and allow more time for transformation
The above trends coupled with the increasing ownership of the economy by private equity may bring in a golden age of digital transformation in PE.
For a good decade now most PE operating teams have gotten very savvy leveraging technology to enhance the investment thesis. Most started by predictive spend analytics to consolidate suppliers, improve contract performance and in general better understand drivers of drain on EBITDA. Depending on the scope of the operating team, many got deeper into the same analytical rigor and predictive models for direct and indirect sales modeling, pricing strategies and even various correlations between capital and operating investments and sales performance. Then the more complex areas of the business came to the fore, designing more agile manufacturing processes and distribution networks.
The true innovation of private equity is not that they solve existing problems better. It is that they solve it much faster and with surgical precision. While large public companies would have hundreds of competing “programs” with five- or 10-year expected returns, PE projects are much fewer and definitely shorter horizon. That’s where technology helped. It is a predictable and repeatable component of change in incremental process improvement. And Private Equity likes to repeat what works.
Something new is emerging at the best PE Operating shops. As private company valuations are at a sustained high level despite public market relief, digital technology is increasingly used as a key component of an updated business model. In the past, in investment theses technology was there to keep track of things or automate the mundane. The realization is there that the most valuable companies have a fundamentally different, digital process based business model from the lower valued peers. These trends have been very strong in China where cash flow based valuations assumptions could not justify exist value expectations, so they focused on public market valuation drivers especially in tech.
As digital disruption as an investment thesis component settles into the PE playbook we will see many more examples of such transformations as APAX Partners taking a traditional publisher and turning their business model into an ecommerce powerhouse (Autotrader UK).
We recently completed some analysis of enterprise software purchasing trends in mid-market and large enterprise businesses. We looked at industry data from the last 7 years and came to a few interesting insights. Private Equity has been known to be conservative in IT investments. As our data shows, as PE becomes a larger part of the economy, they also shift more to cloud solutions in their software choices.
Here are a couple of insights shown in the graph. (Company specific data was removed to show trend)
- Private Equity owns a bigger portion of midmarket and enterprise-size businesses in the US. Industry estimates range from 20-25% in midmarket ($100-500M revenues) and 8-12% in enterprise ($500M and above). We found no analysis on EBITDA basis but assume similar ratios.
- PE operating teams are expanding to focus beyond sales growth and spend management into enterprise IT projects
- As the number of PE portfolio companies grow, we saw the growth rate of PE portfolio driven projects far exceed the growth of non-PE owned company purchases
- This accelerates the trend of more surgical, function-specific cloud projects driven by the investment theses vs enterprise-wide transformations
- The growth of functionally focused projects actually accelerate digital transformation of purchasing, talent management and digital commerce.
I had a chance to re-read the great study from INSEAD on the emerging new models of value creation ( VC 2.0). The research contrasts traditional value creation models to a new and more comprehensive framework.
Traditional value creation elements tend to be:
- EBITDA impact – focusing on operational value creation, process improvements, technology improvements which ultimately translate to growth of free cash flow. This cannot separate impact of general industry growth from PE impact on the specific company
- Multiple impact – focuses on basically changes between entry and exit price levels. Mostly ignores economic cycles and industry shifts.
- Net debt impact – shows the overall improvement in cash position and ability to generate free cash flow. Most relevant in LBOs and not growth equity
The report argues that in recent years academic research shows no clear differentiation from industry peers vs PE backed companies in the above value creation strategies.
To measure the real impact of PE outperformance over industry in the businesses they transform, the report proposes a set of new frameworks. The analysis narrows down value attribution to value creation strategies vs general industry movements, i.e. the company-specific alpha.
The report attempts to deconstruct value creation into more drivers than the 3 traditional ones, seperating industry infleunces. Using a sample of 28 investments they found the following conclusions:
– Revenue growth was 68% of the total value creation, confirming the most impactful and most elusive area of repeatable value creation theses
– Margin improvements accounted for 16% of the total value creation. This is notable because most PE operating teams tend to focus on this much more than top line process strategies
– The rest (22%) was multiple expansion due to market conditions and industry cost of capital
The report has a series of case studies and a lot of other insights. Well worth the read.
Last week we had our 22nd global PE operating partner dinner. This event roams around the globe and so far had our dinners in New York, London, Beijing, Hong Kong, Singapore, Seoul, Tokyo, Sao Paulo. The primary purpose of the dinners is to bring together operating partners and experts focusing on value creation in the fast paced world of private equity and exchange ideas on what works best to accomplish that goal. Reflecting on the last few years a couple of themes are emerging recently in these discussions:
1) Procurement is getting more sophisticated
While several firms established operations / resources teams to improve elements of working capital and maximize free cash flow, only few firms have a repeatable and scalable engagement model for their portfolio. The strategies are limited to spend visibility and negotiated discounts and terms but contract compliance to these leveraged procurement arrangements still elude many. More sophisticated strategies involving cross-portfolio auctions and dynamic pricing are out of scope for most firms. Leveraged procurement is still very labor intensive in PE with GPOs and procurement consultants and limited use of modern marketplace and auction tools.
2) Web and mobile commerce tools are more common
Some PE firms explicitly focus on improving sales effectiveness with a broader implementation of multi-channel commerce strategies that can improve marketing and sales effectiveness but also open entirely new markets for their companies especially in low-tech industries. Surprisingly after a two decades of e-commerce, many portfolio companies have neither a comprehensive multi-channel platform nor a mobile marketing / sales approach in place to address an entire generation of customers.
3) Value creation levers are being commoditized
The strategies that are effective (like spend visibility and leveraged procurement) are highly commoditized and can neither give competitive edge to the portfolio companies nor differentiate the GP’s value creation approach in the eyes of the LPs. More importantly as procurement tools in the market mature, the procurement value creation opportunities in new targets will be less significant as the companies will have had access to GPOs and e-procurement tools as effectively as the GPs.
4) Great value creation innovation in emerging markets
Many mature market GPs look to their peers in the same markets for insight and best practices. As we worked with many firms, I noticed that some of the most creative value creation ideas will come from markets where management talent and workforce quality is less predictable. In places like China, GPs implement technologies like mobile commerce at a much faster rate to leapfrog the ineffective processes and work around the cost and churn of hyper-competitive talent markets.
I just returned from a trip to Japan talking to a dozen private equity firms about market and economic outlook.
Bain’s recently published report on the next decade’s massive capital abundance talks about a baseline of low return expectations. One way many firms countered this in the past was increased allocations to emerging markets.
Somehow the global economic outlook is troubling. Europe is in perpetual bailout mode, Japan is still in negative growth, the US has that nice fiscal cliffhanger. On the emerging side, India is in a political and regulatory chaos, China just closed its IPO markets. Brazil seems to have an upswing in activity as some western firms like KKR expand operations.
Hopefully all this global gloom will mean increasing value creation focus in the firms to regain ground on the IRR.
After all the capital is there in abundance and needs to be put to work. And public equities, bonds and commodities don’t seem to save the day for LPs. This may just be the beginning of the golden age of operational value creation.
Ever since I got involved with Private Equity operators and their many times straightforward, simple and obvious finds for value creation, I wondered why management couldn’t find the same paths to success prior to change of ownership. Taking financial engineering aside, which is arguably a major value creator, what is most astonishing is how many companies’ core operation performance improves under PE. While there is no definite answer, the seed of the truth lies somewhere in the following areas:
The oldest and biggest value creation argument has been – “while we back management we are quick to bring in the best talent”. Recruiting great performers does not sound like rocket science to me. Why can’t a company upgrade their managers and functional specialist before PE shows up?
Performance and Rewards
The outsize rewards of meeting and exceeding EBITDA targets are a major lever. This may be one of the most important. Many companies I met had a hard time with their incentive models both on the upside and the downside. Without PE owners managers would rather keep a narrow band of rewards between top players and bottom performers than create a competitive workplace. Over time the underperformers stick around and the top athletes leave for a workplace that better rewards them for delivering twice as much. If you think you have meritocracy try this test: if your top sales guys deliver 2x the expected do they get 2x of the bonus? How about your CFO or CPO? How about delivering half? Is that half or none of the bonus pool? I rest my case.
Knowing What Works
Having been involved in performance benchmarking for a decade now, I’m convinced that the average company is woefully unaware of where they stand against their peers in most but a few functional areas. Benchmarking becomes a tool to justify a pet project to the board vs. a way to discover and fix weaknesses and exploit strength. PE brings this discipline to bear.
This is huge. I spent the early years of my career in projects like ‘improvement portfolio optimization’, which was a way for a company to rationalize and prioritize hundreds and sometimes thousands of initiatives. Most projects remained on the books and I believe the average large corporation still has hundreds of competing and parallel programs, most with massive negative impact on the business in distraction, wasted resources or simply sunk cost. PE has an unparalleled ability to cut down the chaos and focus the business on very projects with quantifiable results. And executive compensation tied to the results.
Initiative du jour is so true it is a cliche in most companies. Beyond the question of focus above, the cash flow pressure of debt paybacks many times create a culture of thrift, attention to real business cases and results. My former boss at a public company had this approach even without PE: whatever the project needs in terms of resources – give them half. Mostly the projects will still come in on time, delivering the results and not wasting too much time and resources in navel gazing.
The key point here is this: almost all operational tools PE deploys are available to management teams. If they had the focus, discipline and right talent they would be able to reap similar returns to PE firms without surrendering most of the rewards.
In the last few months China’s Private Equity revolution got a lot of attention due to the Focus Media LBO, touted as largest to date. Apart from size alone, I do think the shift from minority non-control investments to LBOs is very interesting. While I leave the regulatory and financial engineering aspects of these changes to other specialists, I do think control will inadvertently bring a need for more active investors, operating partners and more effective operational methods. Maybe Brazil and India will follow…
In fact, as we work with several large indigenous Chinese PE firms we noticed a unique value creation approach. Instead of just tweaking operations, some PE houses use western best business practices to help grow businesses. In addition, some firms use IT to solidify and enforce business rules and optimal processes. As one operating partner described it to me, it is a lot harder to secure the necessary talent to upgrade management (job competition in major Chinese cities is enormous). Instead of just “hiring and backing good managers” as the traditional GP approach goes, more firms train managers in world class processes. As this experiment unfolds, China may invent a new approach to value creation in emerging markets that other GPs in India and Brazil will be hard pressed to replicate.