Going beyond organic growth
Adding value is now seen as a critical aspect of any private equity transaction. But, says David Hutchings, the newly created head of private equity at Albourne Partners and ex-head of European private equity at Cambridge Associates, "if you talk to the incumbent management, private equity firms and strategy consultants, they may each claim responsibility". It is not surprising therefore that it can be
difficult for an investor to get an understanding of where and how value is truly being created.
During the 1980s and 1990s, the market was much simpler and adding value was not seen as a requirement for private equity investments. Following the anti-inflationary policies instituted by US Federal Reserve chairman Paul Volker in the early 1980s, stock markets saw two decades of growth and private equity expansion.
As a result, private equity firms such as 3i were able to make huge numbers of private equity investments with a philosophy of "eyes on, hands off", confident that by doing little else but waiting, they could list the firms at higher multiples in a rising market.
Introducing leverage into such private equity transactions further boosted an already buoyant sector.
Those days, of course, came to an end with a grand finale in the form of the TMT bubble, which destroyed the image of venture capital investing as well as its track record. An industry that was deploying $5bn (€3.8bn) in commitments from 1980 to 1997 saw an explosion in investment between 1998 and 2001 that averaged $57.7bn a year, according to David Hughes at Invesco Private Capital.
The fallout, inevitable in hindsight, has focused the minds of private equity investors on what skills private equity firms truly possess, as well as shifting the industry completely away from venture and into buy-outs as the main component of any portfolio.
In today's market, with most commentators expecting only single-digit returns from listed equities in the developed markets, the potential for private equity to generate extraordinary returns purely from financial engineering has rapidly diminished.
Moreover, buy-out firms have to pay premiums of the order of 15-20% on average over the market price to gain control, and after taking away management, performance and transaction fees on top of that, together with a strong possibility that exit multiples will not be any higher, it is not surprising that there is now a strong emphasis on increasing earnings.
As Duke DeGrassi of Hamilton Lane argues: "Adding value is much more important now; 20 years ago, the amount of equity was 10% of the capital structure. Now it is 35-40%. So today, a lot more equity is required and the private equity firms are less reliant on financial engineering. Today you have to assume that multiples on exit will be less, not greater, so you have to create value."
While the challenges in creating value above the expenses incurred in transactions, are great, so are the opportunities.
"The most predominant factor in creating value over the last five years and for the next five years is the globalisation of business - being able to take a company from a local UK or German company to a national company and then into an international company," DeGrassi says. "Bigger firms can take a good product or service and expand it internationally. It can be done through a buy and build as well as through organic growth."
Although many private equity firms clearly do have outstanding teams and deal size makes it worthwhile to hire world-class consultants, Hutchings points out that "a large part of the added value may come from a change in horizons by the management. A stronger focus and motivation."
What sort of impact can vary across cultures though, with Simon Havers of Baird Capital Partners Europe observing that "if you back a management team in Germany, you may find they are begging for a new head office to report to".
But "more often than not, at the smaller end, private equity firms will change management or reposition management as they have often reached the limits of their capabilities," according to DeGrassi.
Indeed, getting the right management team and creating the right board, which may entail replacing existing senior executives, is usually seen as the single most influential act by any private equity firm.
The initial period following an acquisition is seen as critical and, as DeGrassi says, the 100-day plan has become a buzzword in the industry: "Sometimes the private equity firms actually implement a plan and sometimes it is hype."
Havers adds: "100 days is passé. Now it is 90 days." Having a clearly defined, short-term set of actions over a set timeframe does however generate a sense of urgency and enables some painful decisions to be taken during a period when staff and management may be expecting them.
At the end of this period, the firm and its owners can focus on implementing a new strategy, establishing a new culture and creating a new team dynamic around a restructured board and senior management team.
Most private equity firms would claim to be able to add value beyond replacing or remotivating the boards. There are many ways to do so, ranging from the use of captive consultants, establishing external boards of industrialists as advisers, to developing key sector expertise within the group itself. KKR is a good example of a firm with its own captive consultants in the form of Capstone.
On these different approaches, DeGrassi says other firms have a much looser relationship with executives on a board of advisers. "With Capstone, the professionals are captive. That is their job. On boards of advisers, it is far looser. Some people are active, some less so," he says. The use of external boards of industrial advisers is more controversial. Hutchings says he is "quite cynical about them in terms of their ability to create value".
He adds: "Some are good at opening doors, and asking the right questions. A lot may be more about deal generation, market insight and knowing where to look for opportunities."
But he says:"If you have the right senior management, the last thing they are going to want is people coming in to tell them how to run their business, but that is going to happen. If they are the right quality, they will say ‘leave us alone'. However, the advisers can come into their own for strategic advice such as acquisitions and exits. But how much value comes from control, apart from choosing the right chief executive?"
Groups with specific sector expertise are able to really differentiate themselves, particularly in the overcrowded middle market.
Silver Lake Partners, for example, focuses exclusively on large-scale investing in technology and related growth industries. "In technology buy-outs, Silver Lake is the expert," explains Hutchings. "For the biggest US technology buy-outs recently, they are likely to have initiated the deal, they bring in partners.
"Silver Lake's real coup was that it was the first group to recognise technology firms as providing opportunities for real buy-outs. Other buy-out firms had shunned the sector, and were wary of technology firms of any sort. So now other private equity firms bring Silver Lake in to deals. They broke the mould."
Another example is Providence Equity Partners, which specialises in communications companies around the world. "For a big communications deal, they would be the natural partner to be brought in. They know the market and have the contact base," says Hutchings.
Specific expertise can also be developed in other ways. Baird Private Equity, for example, has a team of 20 people based in China who provide three distinct services for portfolio companies, based around first sourcing new suppliers, then setting up local businesses to replace the suppliers and finally generating growth for their companies through developing distribution channels for their products in China itself, Havers says.
Few private equity firms have ventured so aggressively into China as Baird, which "saw manufacturing companies in its heartland in the US rustbelt massacred by Chinese competition," explains Havers.
But finding such innovative ways of taking advantage of the globalisation of business may well be the key factor that differentiates the private equity firms that can add value consistently to their portfolio companies.