'Early Matters': Creating Value through Operations at Portfolio CompaniesPublished: April 26, 2006 in Knowledge@Wharton
As increasingly large funds bid up the price of private equity transactions, firms are becoming actively focused on creating value through operations at portfolio companies to generate the kind of returns partners have come to expect. According to speakers at the 2006 Wharton Private Equity Conference titled, "Driving Returns: Value Added Investing," the most important element of operational performance is getting the right management team, which requires private equity owners to make a swift decision about whether to keep or let go of existing senior executives. After that, speakers on two operations panels said, private equity firms need to drive returns through management incentives, tight monitoring and forward-focused strategies.
"The only way to get value is by helping portfolio companies grow at some rate faster than their competitors," said Dan Haas, leader of Bain & Co.'s Private Equity Group and moderator of a conference panel titled "Operational Value Add." Over time, Bain has discovered several keys to adding value to a portfolio company. First, he said, funds must take an active role and structure deals that suit their own strategy. "What's most important is you get the [deal] right for the size of the fund, the style of investing of the fund and the culture of the fund," he said.
Finally, Haas said, Bain has learned that "early matters." Citing Bain's experience with "hundreds of companies," he noted that "returns on deals where the private equity fund got involved in the first year of ownership performed two times better than when the fund gets involved at a later time."
Sunil Mishra, managing director of JP Morgan Partners, said that in a typical deal he puts 30% of his time into the transaction and 70% into operations, beginning with a diagnostic look at the company to detect weakness and develop strategic priorities. He said he tries to build a sense of trust with portfolio company managers and introduces solid metrics including weekly and monthly reporting. Reports on portfolio companies are also circulated among partners to double-check those involved directly in the deal. Sometimes, Mishra said, partners become too close to their companies and don't see problems brewing. "We use this tool in a structured way to decide if there is an intervention needed."
James A. Quella, senior managing director at The Blackstone Group, said his firm has run into the same problem. "Often the guy who did the deal is not always the most forthright. There's usually a deeply personal relationship between the partner and the CEO, and when there is air turbulence it is not automatic that the deal partner will come in and say, 'I need help.'"
'A Meaningful Stake'
The early days following a transaction are critical, and most private equity firms devise strategic plans and reporting metrics to track the plan's progress even during the due diligence phase. The plans can address everything from whether to sell off divisions, how to invest capital, compensation, and governance. Some private equity firms install their own managers with operational experience to run companies and others hire third-party consulting firms, like Bain, to help devise a strategy.
John Abraham, partner at Kodiak Venture Partners, which funds technology start-ups, said future operational excellence is rooted in the initial equity structure of the deal. Entrepreneurs and top management should be allowed to retain a substantial equity stake in order to guarantee they will continue to work hard to develop their companies. "We want to make sure intellectual capital has a meaningful stake in the company," he said. Other incentives are less tangible: Beyond financial compensation, venture backers need to provide some emotional support as well. "We empathize with entrepreneurs. We've been there. I've been a CEO and I understand it's a lonely job."
Once the company's management and incentive structure is in place, fund managers step up monitoring and reporting at the companies to make sure goals are being met within set time frames, the panelists said. The first months are critical and many funds require managers to have 100-day plans.
"We focus on trying to make things happen very early on," said Oliver C. Ewald, managing director at Audax. "Post-transaction change is accepted. You are in an environment where change is expected."
In a turnaround situation, speed and decisiveness are even more important, said Dick W. Boyce, a partner at Texas Pacific Group. In this kind of deal, fund executives are not looking out three to five years, but one year at most. To give managers the data they need to make quick decisions, TPG requires portfolio companies to file weekly flash reports on results and to pay close attention to cash management. Many companies that have not had to cope with the kind of leverage behind private equity investment pay little attention to cash management, Boyce noted.
Boyce has been deeply involved in portfolio companies, using experience he gained from a career in operations and consulting work with Bain. From 1997 through 1999, he was president of CAF, Inc., a consulting firm that provided operating oversight and support to various companies owned by TPG, and he served as the CEO of clothing retailer J.Crew Group, Inc. Boyce was senior vice president of operations for Pepsi-Cola, North America, before joining TPG.
Boyce noted that TPG also tries to install reporting that focuses on the future. For example, when he was working on a turnaround at J. Crew, he learned that putting a catalog out in front of consumer panels before inventory was ordered allowed managers to predict top sellers 90% of the time. That prevented the company from running short on hot items and getting stuck with excess stock eight or nine months later when the clothes were in stores. "It's crucial to get managers to think about what's the better predictor, rather than being a person looking in the rear-view mirror," he said.
Fund managers often have the experience and resources to introduce tools to help measure important trends that a portfolio company would not have developed on its own. "One thing we pride ourselves on is getting a fundamental data-driven understanding of the market," said Mani A. Sadeghi, managing partner at Equifin Capital Partners, which specializes in private equity deals in the financial industry. "In many cases, we find conventional wisdom, or what people believe, is just wrong. When you [analyze the data], what seems crazy is really smart."
Under New Management
When shaping the governance structure of a portfolio company, the nature and goals of the controlling private equity fund is an important consideration. For example, Ewald's company, Audax, only takes on companies in which it can have complete control of the firm's equity and, as a result, does not devote a lot of time to portfolio company boards. "We find that formal board meetings and a board structure makes [more] work. We don't need it," he said.
Instead, Audax focuses on monthly review meetings during which financial metrics and other measures of performance and service make up half the agenda. The other half of the review meeting is devoted to discussing key initiatives going forward.
On the other hand, Boyce noted that when the time comes to exit an investment through the public markets, there is a downside for fund managers who do not develop a portfolio company's board structure. "It's easy to be lazy about the board when you have control," he said. "But you're not really preparing the company to be a public company."
As private equity firms raise increasingly large funds topping $10 billion, many are forming consortiums to buy and manage huge portfolio companies. In August, a team of private equity firms, including Bain Capital, The Blackstone Group, and Goldman Sachs Capital Partners, acquired SunGard for $11.4 billion. Then, in December, Ford Motor Co. sold its Hertz division to another group of private equity investors including Clayton, Dubilier & Rice, The Carlyle Group and Merrill Lynch Global Private Equity for $15 billion.
When it comes to managing consortium deals with more than three partners, Boyce said the participants must agree up front that one group will control certain aspects of managing the acquisition. "You can't have multiple hands solving the same problem." Quella added that involving two or three partners in a deal is workable, but when it gets up to around seven, the number of egos and competing goals present serious challenges to making a transaction work.
For large firms, like Blackstone, Bain and Texas Pacific, there can be opportunities to build value by managing across portfolio companies, the panelists said.
Quella said Blackstone has an automated web-based reporting system that is used by all its portfolio companies to feed information back to the firm. That information is then analyzed centrally, allowing Blackstone to detect trends and leading indicators for other companies in its portfolio. A natural resource company, for example, could provide Blackstone signals about the direction of material prices for industrial firms in its portfolio.
Blackstone has also set up a central buying cooperative to purchase office equipment, paper and other non-core supplies for the firm's portfolio companies. The system has created savings of 15% to 40% for some of Blackstone's companies, said Quella. The purchasing group is independent of Blackstone, so companies can continue to use it after they go public, he pointed out.
Decisions about management structure and systems are likely to become more complex as the rise of huge megafunds allow private equity firms to take on increasingly large public companies and subsidiaries. Quella said he expects to see $3 billion to $4 billion companies going private. He said his firm is fielding calls from managers of public companies who are under pressure to deliver short-term earnings growth every quarter and increasing scrutiny through the Sarbanes-Oxley legislation and state attorneys general. "Their hands are tied," he said. "A lot of really good senior managers are coming to the conclusion that private equity ownership is a superior way to create value, and these large public companies are increasingly becoming the target market."
Still, the ultimate goal of private equity firms is to sell refurbished companies to the public markets at a premium. To achieve that, fund managers ultimately need to remain focused on their exit plan, according to panelists.
Sadeghi said the exit plan is a living document for his firm's portfolio companies and is reviewed constantly with the management team. "We are always asking, 'Are we making progress, and what has changed?'"
Abraham said general partners in private equity deals must constantly monitor the investment thesis that justified doing the deal in the first place. If results deviate from the thesis, private equity investors must reevaluate the strategic plan. If new capital is needed, investors should think about the transaction as if it were a new deal and only invest based on the merits at that time. If the additional investment cannot stand alone on its own merits, the company should either be folded or sold. "Then of course you need the discipline and intestinal fortitude to close the company when it's not working -- just shut them down."
Shake-up vs. Partnership
The best way to avoid that fate, and build healthy returns from improvements in operations, is to choose the right managers and devise strategies to help them run portfolio companies successfully, according to speakers on another panel titled, "Selecting and Working with Management Teams."
Kevin Prokop, a director at Questor Partners Funds, said that about 80% of the deals he is involved with focus on distressed companies in need of a turnaround. Usually that means a major management shake-up. "We've found that turnaround management skills are a unique and different skill set than managing a company in a growth mode or status quo mode," he said. "The makeup of the DNA of the managers we bring in will tend to be different than the makeup of the team that created the situation. That creates the opportunity for us. We don't object to leaving management in place, but those deals tend to be few and far between."
Greg Mondre, managing director at Silver Lake Partners, specializes in technology and growth industries and tries to partner with management when possible, mainly because the high-tech industry is so specialized and it is difficult to find new managers. "There are a lot of private equity firms buying bad companies and making them o.k.," he said. "We choose to make investments in good companies and make them better."
Praveen Jeyarajah, a managing director at The Carlyle Group focusing on leveraged buyouts in the U.S. industrial sector, said his firm generally prefers to partner with existing management, but he said senior partners are spending an increasing amount of time working on systems to improve management of portfolio companies. "We've found that in the first year of operations it is really good if someone from the firm, the lead deal partner and the deal team in general, gets to know the CEO and the CEO's direct reports and can really assess if they have the human capital to meet the plan," he said. Carlyle, as one of the nation's largest private equity firms, can also help firms by bringing in senior advisors, including Louis Gerstner, who turned around IBM, and George Sherman, former chairman of Danaher Corp., the tools and equipment manufacturer.
A '360-degree View'
When a change in management is needed, many of the panelists agreed that speed is critical. "Often the private equity partner does not make the change quickly enough," said George T. Corrigan Jr., senior client partner at search firm Korn/Ferry International. "Then they come to a search firm. Meanwhile, time is ticking."
Corrigan outlined some initial screens to find good managers for private equity investments. First, Korn/Ferry looks for other managers in the same industry or for candidates within a company considered to be a management academy, such as General Electric or Danaher. He also looks for managers who are experienced in managing cash. Finally, Corrigan added, he likes to find managers who are "a magnet for talent" who will be able to draw more quality managers into the portfolio company.
William Woo, managing director of Ironwood Equity Fund, a small firm that specializes in buying from founders through referrals, relies on standard reference checks to screen for talent, but also interviews people who have worked with the candidate to develop a 360-degree view of the potential hire. Woo also encourages companies to check his own references before doing a deal to establish credibility and trust.
Questor Partners Funds' Prokop has learned early on to listen to how existing managers explain their company's problems as a clue to who needs to be replaced. "If the manager says, 'The market went against us,' or starts talking about general economic conditions, then they generally don't have their arms around what specifically went wrong," he said. "On the other hand, if they tell you crisply, 'Here's five things that happened and three things to address each of these five points,' then you know you've got a management team that has its act together."
Peter Cornetta, principal in H.I.G. Capital, which specializes in transactions involving family-owned businesses, said his firm has to screen carefully because founders often install a son or daughter to take over management of the company. When it comes time to sell, the founders represent that it is the next generation running the company, but Cornetta said he often finds the parents are still critical to keeping the business on track. "But it is the son or daughter that our partnership is with going forward, so we spend a lot of time understanding the capabilities of that individual," he said.
Once a team is selected, employment contracts can be used as a tool to improve results by forcing incoming management and private equity owners to discuss the touchy subject of what will happen if the partnership does not work out. "Employment agreements are key tools to force you to deal with the situation in advance," said Woo. "It's like a prenup."
As the Operational Value Add panelists noted, incentives are key. In the technology sector, competition for top executives is intense, said Mondre, who added his firm uses incentive packages to hire the best. "The one nice thing about private equity is you can create incentive packages that you are not able to achieve in public companies" by granting hirees additional equity options.