How Do Private Equity Firms Create Value?

In the Hollywood version of a hostile takeover, the boss would grab control of a company, throw out the slackers, move into the corner office and start barking out orders. The message is, “it’s my way or the highway!”

But what makes for good drama on the screen doesn’t necessarily work in real life. When a private equity (PE) firm buys a portfolio company, it’s much more like a romance instead of a war movie. For the new partnership to work, both parties must really believe they will be better off together instead of alone.

A successful PE investment is the result of careful research before the purchase, smooth relations with the firm afterward, creation of a clear plan focused on just a few priorities, and disciplined execution. This model for PE success was relayed by five PE executives who spoke on a value creation panel at the 2013 Wharton Private Equity & Venture Capital Conference.

While the strategies for managing each portfolio company can vary widely, the panelists agreed on a key feature that leads to success: Instead of micromanaging, PE owners must furnish the company with a top-quality CEO (ideally for the duration of the investment) and provide the leader with advice and support along the way.

Picking the Best Fruit

A critical element of success comes at the earliest stages — before the investment has even closed — with the careful selection of the portfolio firm, said Bill Fry, managing director of American Securities.

Most PE executives agree that the ideal target is not a train wreck but a firm with just a few areas that need improvement. Sometimes a firm has grown too big and complex for the founder to manage alone. The company may need financing, help in streamlining systems and operations, or advice on which products or services to develop next. But at its heart, the ideal target firm is sound. Typically, the PE firm seeks to target a good core business “that maybe has lost [its] way,” said Ashley Abdo, managing director of M&A at The Gores Group.

When a target firm starts offering itself to PE partners, it may produce a list of 12 ways to grow and improve performance, said Fry. Sometimes the target’s investment bankers push the firm to produce a long list, thinking multiple options for enhancing performance make the analysis look more thorough and make the deal appear more promising.

“Over time, as the company is pitching it, they come to believe all 12 of those things,” Fry said.

But in truth, the company may only have three or four areas that present real opportunities. A PE firm needs to separate this wheat from the chaff during the due-diligence process that precedes the decision to buy, he noted. Then it needs to get the target’s management to focus on “what they really believe in versus what they are selling,” he explained.

“The flip side of that is, if there are 12 things [that need improvement], you probably don’t do the deal,” added Abdo. Moreover, the target firm must not present too much risk of loss, he continued. If there is not enough “downside protection, we don’t even talk about the upside.” Capital protection is the name of the game, said Abdo.

Provided due diligence and preparation are 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 accelerate growth,” said Tom Shaffer, director at Alvarez & Marsal.

CEO Cooperation and Cohesion

Whether the target company’s CEO came with the purchase or was installed by the PE owners, the panelists agreed that this leader must be an eager supporter of the new owner’s strategy. Several said they used a 100-day plan that starts on the day the deal is closed. This plan does not leave time to bring a resistant CEO around, though executives with qualms do often see the benefits of the PE relationship once the strategy becomes clear.

“Once the CEO comes over and says, ‘Okay, these [PE] people are smart people and they can help me,’ we usually do pretty well,” Fry said.

For instance, the CEO may be a founder whose firm has grown too big to handle alone. If the PE partner has a clear strategy, “you’ll literally see the CEO relax in his chair and say, ‘thank God there’s someone coming in to help,'” said Shaffer.

The experts provided by the PE firm are not there to tell the CEO what to do day-by-day, but to flesh out the CEO’s staff, said Abdo. Thus, added Shaffer, the PE firm tries to avoid a “combative model” and instead works to provide reassurance that the CEO and PE experts are on the same page and working together. It’s important to “allay those concerns,” he said.

“I would add that it’s all about alignment,” said Seth Brody, operating partner at Apax Partners. The CEO and the PE management team must share a vision, and managers of the portfolio firm must be replaced if they don’t share the PE owner’s views, he argued.

Aligning Interests on the Inside and Outside

The panel’s moderator, Geraldine Sinatra, a partner at Dechert LLP, a law firm that advises various players in the PE arena, asked how the PE firm makes sure the acquisition’s management is on board with the strategic plan.

At American Securities, this process often begins with a breakfast the morning after the sale closes, since legalities and other issues can limit contact before the deal is complete, said Fry. A series of meetings, and then a retreat a couple of weeks into the partnership can help ease the worry and clear away the sense of mystery, he said.

Some PE firms conduct large meetings that include the acquisition’s managers, customers, vendors and suppliers, noted the panelists. These gatherings make each player better aware of the other’s concerns and allow individuals to have more face-time with one another.

Another technique to ensure goals are aligned is to bring together the CEOs of all the PE firm’s portfolio companies once a year, said Abdo. “It’s a very powerful couple of days,” he said, “part catharsis, part networking.” Often, the CEOs find they are facing similar challenges. Sharing their concerns with one another leaves them feeling less isolated and more connected, said Abdo.

PE firms also typically put their own people on the acquisition’s board to ensure the new strategic plans are being executed. The people installed on the boards could either be PE executives or outsiders with useful expertise. American Securities usually puts two outside directors on the board of each portfolio firm but ensures these senior people operate with a style that’s “non-threatening to the CEO,” said Fry.

In addition, it’s important to link compensation for the firm’s senior managers to their success in implementing the PE firm’s detailed strategic plan, said Abdo. That can be very critical in ensuring goals are aligned.

CEO Stability

Another key to value creation is stability in the corner office, according to Fry. “We start and finish with the same CEO about 80% of the time,” he said.

Meanwhile, The Gores Group has often used its most successful CEOs on subsequent acquisitions. “We like to have relationships where they want to come back and do another deal with us,” said Abdo.

Despite all these efforts, things don’t always work out. The PE firm must move quickly when projects start going off the tracks, Abdo noted. He recalled a case where The Gores Group bought a Belgian company that was in financial trouble. Gores installed a growth-oriented CEO, but the overleveraged firm also needed to cut costs. After some cuts were implemented, the CEO felt that more cuts would wreck the business, but Gores feared the firm would go bankrupt if it didn’t continue to trim. Eventually, the CEO had to be replaced.

“If you’ve got that misalignment, you can’t just continue to operate,” he explained. “One of you is right, and one of you has to go.”

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