PE Firms Need to Create Deeper Operations Capabilities
There is a saying among older Private Equity (PE) investors: A successful deal is 70% buying cheap, 20% selling high and 10% operating well. This formula has two consequences. First, within PE firms, investment is accorded primacy over operations. Second, founders often do not get meaningful operating support from their PE investors. This formula is changing fast. It is becoming increasingly difficult for PE firms to buy cheap, for three reasons:
First, founders are becoming savvy. There is an ecosystem of consultants, bankers and fellow founders who advise them on how to extract maximum value from PE investors. Consultants advise on building the compelling “story" and how to game the due-diligence process. Bankers ensure competition among the PE firms. Fellow founders share cautionary tales enabling better negotiations. More founders now know how to maximize deal values.
Second, the growing number of PE firms is raising competition and pushing up deal values. Decades of easy money has enabled many new funds to emerge, many with formidable dry powder, making cheap deals even harder to source.
Third, given the information networks created by journalists, consultants, and bankers whose livelihoods depend on deal volumes, it is getting difficult to do bilateral deals. PE firms prefer bilateral deals directly with founders to limit competition. But deep information networks are making it progressively difficult to keep bilateral negotiations under wraps.
It is difficult to buy high-potential companies with capable founders cheap anymore. The ones available cheap are invariably challenged in some way (e.g., less capable founders, difficult industries, poor client portfolio) and are the ones which will require disproportionate operating interventions after investment.
It is becoming equally difficult to sell high. Secondary sales often happen to other, often larger, PE firms. Ironically, as described above, PE firms are obsessed with buying cheap and hence it is tough to do deals above fair market value. The option of selling to the public through Initial Public Offerings (IPO) still exists but is available only to the largest PE firms that can do large, late-stage deals. And like founders, the public too is learning from mistakes and getting savvier.
Therefore, the operations lever is becoming increasingly important for PE firms to sustain returns. However, the investment teams, who have traditionally enjoyed primacy in PE firms, are not ideally suited to flex the operations lever. They are bandwidth constrained as their job is to find the next deal. And they are capability constrained, as most are direct recruits from business schools or consulting firms, with limited operating experience. They may know what is to be done, but as most operators understand, that is different from getting it done. Founders prefer advisors who know how to get things done.
The larger PE firms realize this and have been steadily building operations capabilities. KKR has Capstone, its in-house arm of operating experts who ensure value maximization of portfolio companies. TPG and General Atlantic have deep pools of domain experts integrated with the investment teams who ensure value through operations. Many of these experts are ex-founders and ex-CEOs who have scaled businesses themselves. For example, ChrysCapital recently hired Sanjay Jalona, the ex-CEO of LTI, to drive its technology and allied investments.
But beyond the top-tier PE firms, this operations challenge is stark. The mid-market is where most new funds emerge, increasing competitive intensity. The relatively lower size makes driving bargains difficult during purchase. Most mid-market funds exit through secondary sales to larger PE firms, who rarely buy high.
Therefore, PE firms need to think strategically about this changing formula of successful deals. It is not an easy transition – the investment DNA (that focuses on buying cheap and selling high) and the operations DNA (that focuses on painstaking incremental improvements over long durations) are fundamentally different, requiring very different teams.
And there are different ways to build operations teams – in-house or through partnerships with consulting firms, as domain-experts or generalists who can be deployed across portfolio companies, as a network of experts who can be leveraged part-time (as is being curated by companies such as IndusGuru) and so on.
Going forward, the PE firms with the strongest operations capabilities are likely to deliver the highest returns.
This column was written by YCP Auctus Partner Abhisek Mukherjee, and was initially published by Mint, one of India's most esteemed business news publications. The content may be viewed on livemint.com.