By Bassem Mansour
Private equity firms once were said to “buy ’em, strip ’em and flip ’em”: Acquire companies, drain their value and quickly sell off the remains. This was rarely ever the case, and today’s top private equity managers approach their investments with patience, financial support and a commitment to making changes that improve how their portfolio companies operate. This approach has benefits not only for fund managers and investors but also for companies, workers and communities. It’s the future of private equity, and it’s here now. Here are six rules that private equity managers are following to make a difference today.
1. Be Patient Investors
Private equity managers used to hold their investments for just a few years. That began to change during the financial crisis, when the average holding period for private equity investments rose from 3.3 years in 2008 to 6.1 years in 2014. Some, but not all, of that increased holding period came from funds’ inability to exit profitably from their investments: By 2016, despite an improving economy, holding periods still were 5.2 years.
For my firm, such patience has always been the rule: Our average holding period since 2001 has been about five years. Increasingly, it will be the rule for other managers. Operating in a low-yield, low-growth world, fund managers cannot expect economic growth alone to generate the type of enhanced value needed to make their portfolio companies attractive to buyers. Instead, they must proactively add that value, and that will take time and patience.
2. Add Structure
Privately held companies, especially those operated by founding entrepreneurs, often run up against the limits of the experience and intuition that brought their early success. Private equity managers can add value at such companies by putting in place robust structures. These include systematic processes and controls that can generate crucial insights that otherwise are not available.
Among the very first things we do in an investment is to implement meticulously designed reporting systems, with rigorously defined metrics and key performance indicators that can help a portfolio company’s leadership understand what really makes the business tick. In good times, such systems help identify ways to drive profitability. In bad times, they can provide an early warning system.
3. Provide Access to the Balance Sheet
Another way fund managers build their portfolio companies is by bringing critical strategic resources to the table, starting with access to financial capital. This means access to the balance sheet – capital for innovation, funding for research and development and money for market-shaping improvements such as entrée to new geographies, new talent, new equipment and new logistics.
Institutionalizing access to the balance sheet can provide a jump-start that portfolio companies desperately need, so we determine how much funding is needed, what the sources should be and how to deploy it to best advantage.
4. Add Human Capital
Private equity ownership can provide not only financial capital but also human capital. Private equity firms typically bring in directors and advisors from outside the company to improve operations. Some of these are specialists in turnaround situations. Others are longtime executives looking for a new challenge. In all cases, they bring expertise, experience and perspectives that otherwise might not be available. Outside directors and advisors with broad experience in diverse industries can make a real difference in guiding a company.
5. Use the Power of Scale
No matter how sound they are, smaller portfolio companies usually lack qualities such as size, scale and geographic and sectoral reach. In a world in which sheer size can trump other qualities, this limits their prospects.
When fund managers evaluate a potential acquisition, they search for other companies that can create scale, build depth and produce genuine synergies, whether by expanding a product line, increasing management and sales depth or providing access to new markets or customers.
This can be highly effective: A recent Boston Consulting Group/HHL Leipzig Graduate School of Management study found that “buy and build” deals generated an average IRR of 31.6% compared to an IRR of 23.1% for standalone private equity transactions. In our case, about half of our investments are in add-on acquisitions that complement platform companies.
6. “Rescue” Stranded Assets
Not all companies acquired by private equity funds are small private businesses. Many corporations have stranded assets that generate little value for their owners but that, in other hands, can be highly profitable. Private equity firms can take disparate assets from one or more owners and build a company around them.
This approach can be especially effective for non-core business units that do not receive the attention or investment they need to succeed. In many instances, these are not bad businesses: Sometimes they are the result of earlier acquisitions, or were the pet projects of long-departed senior managers. Regardless of their origin, they just are not good strategic fits for their parents. Yet, with support from a fund manager, they can thrive.
About a quarter of the companies we have acquired were divestitures or other corporate carve-outs, and we already have exited some successfully, selling them to acquirers who now find them attractive.
In the end, private equity funds really create value for investors when they exit an investment. The best private equity managers observe a certain discipline in this process. They are judicious about investments, and are careful about entering at the right time and paying the right amount. They also are careful to sell at the right time, not being greedy and avoiding the risk of trying to time the market. Doing this, and following these six rules, private equity managers can create win-win situations that benefit all stakeholders – sellers, buyers, a company’s workers and, of course, the fund’s investors.