I’m at an operating partner dinner in Calgary and this provided a great background for a conversation on the wide variety of operating partner models. Interestingly our firm holds these dinners around the world from New York to Beijing, London, Toronto, Singapore and other PE centers. We have seen the operating models work great in full control situations in LBOs, in minority investments and even in models where the sponsors clearly have limited say on the board or in operations.
What we learned is that industry/operating expertise translates directly EBITDA improvements and increased EV and both GPs and management are eager to explore those avenues.
Not that the operating models have standardized much. There are a couple of common themes emerging that are of interest:
– Operating Expertise provide differentiation in deal origination
This is obvious for industry specialist firms but general process expertise (procurement, sales, distribution) do play a key role in gaining support from management or promoters to back a certain sponsor for a deal. Interestingly, this is an emerging theme in markets like Brazil, India and China where capital is perceived to be abundant (ignoring the obvious regulatory hurdles in all these markets). The owners desire to retain control over the business may be somewhat mitigated by the investor’s ability to expand management expertise. Especially in markets like China and Brazil where backing good management is an insufficient investment theses given the competition for top leadership talent. The investor’s ability to provide best practices and a steady hand is critical in the growth of the enterprise.
– It is critical to get early wins and then getting beyond leveraged procurement
Most firms we work with realized that the most reliable way to add value to the portfolio is through procurement programs (ignoring turnaround situations that obviously demand a series of working capital and cash flow management actions).
The great thing about leveraged procurement is that there always seems to be a way to get a better deal, more reliable supplier and expending that across even a modest portfolio provides immediate cash savings.
The issue becomes that of diminishing returns. Once the program is established, the suppliers aligned, the analytics and KPIs are in place – where does the operating partner add value next?
It seems to be fairly inconsistent both in approach and results. Sales is one obvious target and both due diligence and post-close activities focus on sales effectiveness, territory alignment and other programs. Improving sales seems to be a very industry specific expertise once operators get beyond the basic questions of coverage, account profitability, cost of sales and segmentation. Depending on the market, especially outside NA and mature EMEA – true expertise is harder to come by.
– Repeatability of success is dependent on operating partner coverage
Private Equity loves repeating success. If something worked in one company let’s do it again in our next acquisitions. From an operating partner perspective, again, leverage procurement is perfect for this as many purchasing categories (office supplies, telecommunication, IT hardware, employee benefits) work easily cross-industry. Coverage emerges as a key problem from two angles 1) how many portfolio companies can a partner cover to assess, develop and support these programs 2) how can they get beyond procurement without having to bring in a wide variety of specialty consultants for different processes and industries. The more players are involved the less likely that a repeatable lwo-risk thesis can emerge.
– Learn to influence when you are not in control
We work a lot with minority investors, some in the States but mostly in Asia. The control issue becomes both a major impediment and also a differentiator to successful operating models. One of the largest Asian firms has a captive in-house consulting arm that is used as a differentiator in deal cycles (as stated above) but also has the necessary specialist expertise in both the industries and the thesis of the GP. When the consulting team is offered by the sponsor to management, they have a clear edge over an outside consultant. In effect, the minority investor becomes both the trusted advisor but also the integral element in the value creation plan without compromising the proper governance of oversight but not overstep.
Just a quick call out to an article that was in the New York Times on July 11th called “Private Equity Giants Use Size to Lean on Suppliers”. It focuses on the Blackstone Group and discusses shared procurement/group purchasing, one of the main value levers I mentioned in my post on June 13th. It also positions an interesting counter argument that group purchasing could strain relationships with critical suppliers while getting minimal benefits. I think it’s pretty clear where you draw the line on this one: commodity goods like computers, shipping, office supplies vs unique goods from strategic partners used for competitive differentiation.
Also interesting in the article…
If you aggregate their portfolio company revenues, Blackstone would be the 17th largest company and KKR would be the 5th.
Last Friday Private Equity International (PEI) launched their first awards category for Operational Excellence in private equity. First I want to say, it is about time! Secondly, my biggest hope when I saw this was that these awards would help to show how successful firms are creating value through operational improvement rather than just select a winner based on the success of one portfolio company while the firm may not have a true focus on operational improvement. However after looking through the submission form and the metrics they are asking for it looks like we will get the latter. From my experience the top firms across the industry are all facing the same challenges with operational improvement. They are all grappling with the same questions; how many operating partners to have internally, what is the ideal profile, how should they work with the portfolio companies, how should they be incentivized, when to outsource operational improvement to specialized consultants, etc…. Many firms and portfolio companies could benefit from learning how other firms are approaching these questions, where they have failed, and what actually works. While I appreciate PEI’s new award category and think it is long overdue for firms to get the recognition they deserve for the value they create I feel the criteria for the awards miss the target on the most beneficial insight.
The submission form for the awards includes the following questions:
Private Equity firm name:
Portfolio company name:
Location of portfolio company headquarters:
Initial investment date (deal agreed):
Investment fully realised date:
Top-line revenue growth:
Employee numbers at entry & exit:
Market share growth:
Product number growth:
Exit multiple & IRR:
Average time per month spent with portfolio company (days):
The last question and the narrative portion just start to get at the heart of it. All the metrics are great for showing a business has improved over the period of PE ownership but not HOW or if the PE firm actually made a difference. It is also unclear if the winners of the awards will be judged on the success of one portfolio company or multiple portfolio companies (which would require multiple submissions). The biggest challenge with operational improvement is making it scale effectively with limited resources while adding value across a portfolio of companies. By adding questions that focus on how PE operating teams are structured and how they operate along with the performance data from the companies they work with we could begin to see which strategies and methods really work.
So, here are some suggested additional questions for next year’s submission form. These would begin to get at the heart of how PE creates value with operational improvement. Do you have any to add?
How many operating partners are fully employed by the PE firm
Are the operating partners aligned by industry or functional expertise
What percentage of the portfolio are the operating partners involved in
Typically who, beyond company management, is primarily responsible for the operational improvement plan at the portfolio company (company board, deal partners, operating partner)
How many operating partners typically get involved with a portfolio company, average time per month
Do the operating partner/partners have a specific expertise (lean, industry depth, IT, etc…)
Who do the operating partners report to (portfolio company board, deal team, the PE firm)
When do the operating partner become engaged with the portfolio company (due diligence, part of 100 day planning, drive execution during holding, prepare for exit)
Do the operating partners typically also sit on the board of the portfolio company
A great new book recently hit the shelves by Jason Scharfman. While the topic is operations due diligence – this is the first book of its kind to get beyond financial due diligence into the risk in the operations of the business. What is uncovered in due diligence gives the eventual buyers an edge assuming operational value creation is in their arsenal beyond selecting good management and holding them accountable with proper incentives.
The book itself addresses many topics that cross over to value creation and portfolio management including:
– difference between operational due diligence and ongoing portfolio management needs
– using operational data in deal negotiations and ongoing operations
– creating ongoing monitoring of operations as part of board governance
– leveraging generalist and specialist operational advisors
While the book caters somewhat to both GPs and LPs, it sets the stage to provide a framework on how DD and ongoing value creation should be discussed in the industry.
James Grebey’s Operations Due Diligence is out almost at the same time. The book has a very similar holistic treatment of the various aspects of Ops DD including sales, personnel, financial, manufacturing, IT etc. There is limited discussion of using the findings in ongoing operation so slightly less relevant for our topic.
When it comes to value creation itself, very few titles are emerging since Orit Gadiesh’s broad review of the impact PE firms make.
Many times value creation strategies are specific to a particular company; they can be based on industry dynamics or take advantage of market changes for example. PE firms are excellent at identifying these strategies and creating value based on them, the PE business model depends on it and so does their carry. What about the opportunities for creating value across a portfolio of companies and how can a PE firm take advantage of them.
There are a few ways to look at cross portfolio value creation. The key is to identify the common denominator across the companies and to leverage that denominator so it generates value. Many firms do this already in a single source model that is dependent on internal resources and bandwidth. A distributed model is more effective at scaling however I’ve only seen a few firms use it and only in one area. Depending on the portfolio of companies the common denominator could be based on the following.
– A line of business like manufacturing, procurement, or supply chain
– A business area like CEO, CFO, or CIO
Industry and line of business are very similar. They have obvious common denominators and strategies. This is also where most PE firms are focused and leveraging a single source model. PE firms predominantly have deal teams and/or operating partners with extensive industry or functional expertise that are responsible for transferring knowledge across the portfolio. Simplistically, they dive into a company, build the 100 day plan with management, monitor execution to the plan, and then leverage that knowledge into the next portfolio company. The significant downfall of this approach is that only the current engaged company is benefiting from the PE firm’s input. Why not leverage a distributed model where there is a common denominator and drive value by spreading the learnings and challenges across the portfolio.
I’ve seen only a few clients take a distributed approach and only in one area, the office of the CIO. The CIO is a natural selection; they share similar challenges regardless of industry and when leveraged strategically can drive significant value for the business. For example, consumerization of IT, bid data, and social media are just as relevant challenges and opportunities for retail and consumer businesses as they are for an oil & gas, healthcare, or technology company. By effectively connecting the CIOs across a portfolio they can share learnings, best practices, and challenges while building a network that can yield a significant competitive advantage. The firms I’ve worked with that do this well and see a benefit connect their CIOs in person bi-annually in a forum with thought leaders to share their insight. They also take time during the sessions to present case studies within the portfolio to engage the CIOs in relevant discussions.
So what are the other areas that can benefit from a distributed knowledge sharing approach? There are obvious ones like procurement and lean. What about innovation or sustainability? Which areas are more effectively driven directly by the PE firm vs the portfolio companies themselves?
While talking about refining business models is very common in Venture Capital discourse it is rarely discussed in PE literature. Bigger companies can benefit just as much from a structured review of the business model that leaves the world of spreadsheets and LBO models and brings management to the fundamental question – how do we make money and what alternatives are possible.
All operationally focused firms have exceptional tools at work to address many aspects of working capital, pricing, procurement and other operational improvements and all great PE firms have fantastic eye for talent and the outstanding way to motivate management. One tool that recently resurfaced from Europe on Business Modeling could help make the 100-day plans or GP/Management alignment discussions even more productive.
What started as a Ph.D. thesis on Business Models by Alex Osterwalder is now a global phenomenon. Not since the late 80s business process reengineering has there been a similar holistic methodology for looking at the business beyond figures and KPIs into structure and end-to-end alignment.
Business Model Generation analyzes all businesses, departments and teams in 9 categories:
– key partners
– key activities
– key resources
– value propositions
– customer relationships
– key channels
– customer segmentations
which results in a certain
– cost structure and
– revenue model
The final outcome of a business model is represented on a “Canvas” somewhat similar to a value chain model. What I found unique about the approach is the visual mapping that allows teams to reach consensus, tradeoffs and specific strategies based on the insight gained. The method which is now a major book series was developed in an open source fashion and many private and PE-owned businesses seemed to be active on their forums.
Here is a little video overview of the method and a “canvas” we created mapping some value creation strategies to their model.
Since 2008 there has been increasing focus on operational value creation and even firms that traditionally shunned operating groups established a role for portfolio support or a resources team. While PE organizations may be shifting to seeking more of the alpha in improved sales and operations, PE conferences and associations still seem to be primarily about dealmaking, deal structuring and networking.
Reviewing the 2012 industry conference agendas it is clear that operational value creation is still considered more of a special interest group in these events than the major thrust of the value.
- In the DowJones PE Analyst Conference only 1 out of 20 sessions address value creation and operational improvement.
- In BRIC countries where growth equity and minority holdings dominate a similar story emerges in the regional events like PE Latin America forum where no such sessions are planned. China’s International Private Equity Forum was a major event with over 40 session and again no discussion on operational value creation.
- IFC and EMPEC’s joint conference on Global Private Equity had a great plenary session dedicated to value creation in emerging markets raising the profile of the discussion in such a great forum.
- Increasingly PEI Media emerges as the though leader in value creation with their repeated commitment to the operating partner focused event.
- The Wharton Private Equity Conference in February dedicated only 1 out of 10 sessions to value creation
- Harvard’s VC and PE Conference the same month had no discussion on the topic
- Kellogg’s PE conference dedicated 1 of 6 panels to value creation.
There still seems to be a great opportunity to learn and share more for the operating professionals on the topic.
Last week I posted on the general value creation levers PE firms focus on to create value in their portfolio companies. While the levers will differ by company and industry I believe there is a playbook out there PE firms are following. I discussed this with one of our PE clients this week and got an interesting response. He is a PE operating partner focused on technology initiatives in the portfolio. Below is his ranked response to the question “what do you think are the top value creation levers you typically focus on”:
– Technology infrastructure
– Security – technology as well as people and processes
– Sales force effectiveness
What I found most interesting about the discussion was the focus on top line growth related levers, they’re not the standard process efficiency, cost cutting, or shared service initiatives you would expect from an IT professional. He said the focus on technology infrastructure as the number one priority is to ensure the business has the foundation for growth.
This discussion reminded me of another paper by Booz on what PE firms are doing for top line value creation and organic growth. The paper mentions similar levers like category evaluation and expansion, sales force effectiveness, and pricing. According to the paper, “The Next Winning Move in Private Equity” PE Firms will need to do three things to capture additional value from organic growth; add new growth capabilities, rebalance how they engage with portfolio companies, and lastly find ways to make growth net free.
How a firm attacks these three areas will depend on the size and focus of the firm and is similar to the considerations for how a firm would build out its operating team. So how does/should a PE firm balance its operating team to focus on growth and operating strategies? At what size and number of portfolio companies can a firm afford to invest in these capabilities internally vs outsource? Does a KKR Capstone approach, with dedicated operating partners that focus on growth and operational improvement, feasible for a mid market firm like Riverside? The market is becoming more and more competitive for deals and firms are also being forced to differentiate for LP investment while also needing to drive real value and generate the super returns LP’s expect. Figuring out the unique balance and focus of the operating team will be more and more critical to a firm’s survival.
Value creation from a minority position has always been more difficult. Beyond the obvious reasons (minority vote and marginal board presence) there are several other challenges. Markets with dominant minority positions like MENA, India and Brazil for example have other similar characteristics:
– The owners / promoters want to retain control of the business and yield little in corporate governance
– Limited debt/leverage in deals also means more limited upside incentives for management
– Focus primarily on growth and limited tools or desire for operational performance improvement
The report published by Booz&Co jointly with the MENA PE Association highlight some of these difficulties in value creation specifically in MENA. I found their insight fairly universal in minority investments. In many ways minority investors are limited both in their tools (few strategic and operational improvement levers) and their multipliers (no leverage). The report offers a couple of prescriptions:
- Retain or hire managers with track record in value creation and operations improvement methods
- Do not compromise in governance. Make sure you have the necessary board and management influence on value creation
- Agree in writing to a 100-day plan and even an exit plan prior to the investment and make it a condition of the deal
- Implement effective KPI / performance monitoring systems
There are also great examples of global buyout firms successfully adapting their operating models into non-leveraged, non-control makers like India. Blackstone has been featured as one such firm in the India Economic Times. Blackstone successfully created synergies (cross-sell, collaboration) between their portfolio companies as a way to increased value.
In my last post I discussed that based on their analysis of their own internal portfolio the Partners Group determined that approximately 75% of value creation came from direct operational improvement. I’ve been searching for other papers and publications that quantify the “alpha” attributed to operational improvement in PE investments and have found a limited number of them. There are plenty that argue the value of an operating team and a focus on operational improvement but very few that quantify the impact or discuss HOW operating teams are driving value. The 75% of value creation the Partners Group attributes to direct operational improvement is considerable and regardless of whether you believe the results or feel the impact is much lower it is still very relevant and important to better understand how operating teams are driving value and what models work best in PE.
There is a recent Booz & Company paper “Value Creation Tutorial What Private Equity has to Teach Public Companies” that lays out a nice framework for the discussion on where PE firms are focusing their operational value creation efforts in the portfolio.
Any business creates value by increasing profits or improving capital efficiency. The PE investment thesis and operational improvement plan will obviously differ based on numerous factors. However we’ve seen that procurement and sourcing is almost always the first priority in a new acquisition, it is the low hanging value for the firms I work with. Most of the time this is the first operating partner a PE firm will hire fulltime. He or she will focus on spend analysis, maverick spend across the portfolio, and reducing spend with suppliers across the portfolio. Many times a shared service entity for procurement is established to drive down costs on commodities by leveraging volume across the portfolio. This is a tried and true lucrative and effective strategy for PE firms. So what are the second and third critical levers for PE firms, where do they focus beyond procurement?
A huge portion will depend on the business , however it’s also going to depend on the PE firm and the expertise of the PE firm’s operating team. So how does a firm choose and build its operating team around particular value creation strategies and expertise? Should a firm leverage its operating team more for growth related strategies or cost cutting?