The Secret Sauce: How Private Equity Managers Create Value
Imagine you’re watching a Hollywood movie like “Wall Street” where Gordon Gekko played by Michael Douglas takes over a company. In the Hollywood version of a takeover, Gekko would grab control of a company, throw out the under performers, break the company up into smaller pieces and potentially make millions in a short period of time. The message is, “it’s my way or the highway!”
But what makes for good drama on the silver screen doesn’t necessarily work in the real world. When a private equity (PE) firm looks to add a company to its portfolio, it’s much more like a romance followed by a committed relationship instead of an action adventure movie. For the new partnership to work, both parties (PE firm and the target company) must truly believe they will be better off together instead of alone.
Private equity has gained a great amount of influence in today’s financial marketplace, but few people actually understand the ins and outs of the private equity. In this article we will break down private equity from the ground up and examine the methods behind private equity transactions, how they generate returns and how investors can gain access to private equity funds.
Successful private equity investing is the result of careful research and due diligence before the investment is made. This is followed by maintaining a collaborative relationship with the acquired business post-closing combined with the development of a clear plan focused on just a few key priorities and disciplined execution. This model for PE success was relayed by five PE executives who spoke on a value creation panel at the Private Equity and Venture Capital Conference held at Wharton in 2013.
While the strategies for managing each portfolio company varies greatly, the panelists agreed on a key feature that leads to long term success: instead of micromanaging, PE firms must furnish the company with a top-quality CEO (ideally for the duration of the investment) and provide that leader with advice, guidance and support along the way.
Picking the Best Opportunities
A critical element of investment success comes at the very earliest stage, long before the investment has even closed. The due diligence phase is required to select the ideal company to add to the portfolio. A smart PE manager will analyze each aspect of the deal, including evaluating exit strategies prior to making an investment.
Growth-oriented private equity executives will agree that the ideal company is not a “train wreck,” but rather a firm with just a few areas that need improvement. Sometimes a company has grown to a size where it is beyond the capabilities of the founder to manage alone. Many founders / CEOs are good at building business, but they don’t excel beyond a certain point. The company may need financing to support growth, help in streamlining systems and operations, or advice on which products or services to develop next. But at its core, the ideal target firm is sound, has been in business for several years and has a solid foundation for continued growth and profitability. Businesses that have reached a plateau or stalled in their growth can make good candidates for PE firms. The PE firm can come in and work alongside management to take the company to the next level. When evaluating target companies, there are a host of things typically looked at says Craig Faggen, CEO of Triton Pacific – a Los Angeles based PE firm. In evaluating a PE opportunity, key areas of focus include:
- Defensible Market Position
- Experienced Management Team
- Potential for Growth
- Profitable and Sustainable Revenue
- Scalable Business Model
- Investment Risk / Reward Analysis
When an investment banker represents a company for sale they often spend several months preparing to ‘go to market’. It’s like going to the doctor for a comprehensive annual physical, making sure everything is in proper order. Part of this exercise is for management to generate growth plans with details on multiple ways they can grow the business.
In reality though, the company may only have three or four areas that present real opportunities to create value from a true PE perspective. A PE firm needs to separate the “wheat from the chaff” during the due-diligence process that precedes the decision to make an investment in a new portfolio company. Then, it needs to get the management team of the target company to focus on what they really believe in versus what they are selling. “If the company is so broken that there are 10 to 12 things or areas that need improvement, you don’t do the deal,” says Faggen. “There are always issues and opportunities at each company we look at. If we can clear the upfront hurdles, then it becomes more about pricing and structure to protect our downside.” Capital protection is the name of the game, and deal structure is used to protect shareholder capital.
With thorough and complete due diligence completed before the sale is closed, the PE firm does not have to waste time afterward figuring out the next move. “We’re looking at places where we can immediately focus attention and resources to accelerate growth,” says Faggen.
In a recent conference where a panel of private equity firms participated, they all agreed that whether the target company’s CEO came with the purchase or was installed by the new PE owners, the panelists agreed that this leader must be an eager supporter of the new owner’s strategy. In many cases and with many target companies, the CEO is the original founder.
Many PE companies use a 100-day plan that starts on the day the deal is closed. At Triton Pacific, they use something called the Value Enhancement Program(tm) to create value throughout their ownership of a business. It utilizes four distinct stages: 1). Strategic Planning Process, 2). Solidify Platform for Scalability, 3). Accelerated Growth, 4). Value Enhancement and Realization. Each of these four stages is highly process oriented and intended to maximize value.
For instance, the CEO may be a founder whose firm has grown too big to handle alone. The seller’s desire to partner with a private equity firm is as much about bringing in that expertise and creating even more value for the equity they left in the deal as it is about the shares they sold. The expertise provided by the PE firm is not about telling the CEO what to do day-by-day, but rather to work with the management team on key strategic and tactical issues. Contrary to what you see in Hollywood movies, private equity managers are more about collaboration and partnership to achieve results rather than the adversarial approach that is portrayed on the big screen.
In the PE world, it’s all about alignment. The CEO and the PE management team must share the same vision. If the alignment is no longer there or someone in a leadership position at the company is unable to execute the plan, this is when a PE manager uses their influence to have them replaced.
Aligning Interests on the Inside and Outside
Once an investment is made into a company, how can the PE firm ensure that management is on board with the strategic plans that have been discussed and outlined? This process often begins with discussions before the deal is closed and is solidified through a series of strategy meetings after the sale closes, since legalities and other issues can limit contact before the deal is complete. To align interests, PE managers are highly sensitive to developing motivational incentive programs such as annual bonus plans, stock options grants, and possibly exit bonuses to incentivize management to meet the overall investment return objectives of the PE manager.
To exert influence it is common for the PE manager to put their own people on the company’s board to ensure the new strategic plans are being executed. The people installed on the boards usually include partners of the PE manager and may include outside experts with deep domain expertise in the company’s industry.
Despite all these efforts, things don’t always work as planned. The PE firm must move quickly when projects start going off the tracks. If done well, the returns are very attractive. “Sometimes we just nail it with a company we invested in, creating tremendous returns for our investors and other times it’s about making sweet lemonade from lemons,” says Faggen. When PE works, there isn’t anything better – perhaps that’s why over time it consistently shines above all other asset classes.
For more private equity insights, check out monthly column Brad Blazar on Superior Returns from Private Equity here.
