A decade or two ago, a private equity (PE) fund could scan the landscape, pick off companies at bargain prices, tidy them up and then sell them at a profit amplified by leverage. Simple. But today, the industry is more mature, and each firm faces more competitors scouring the market. Underpriced firms are harder to find, sometimes impossible. Money is harder to borrow. Flipping bargains for profits is not so easy.
So, how do successful PE firms make money in this increasingly efficient environment?
Today, many firms agree that value creation begins with due diligence — the research that identifies a target firm's unrealized potential before the acquisition is made, said Bob Juneja, senior managing director of Irving Place Capital, speaking on the "Value Creation" panel at the 2012 Wharton Private Equity & Venture Capital Conference. "You have to be right," added Andy Africk, senior partner of Apollo Global Management. "You cannot make money on the buy-side as you could in the early days — but you can hurt yourself."
Nor can a PE firm step in and create value by simply cutting costs, said David Hooper, a partner at Centerview Capital. "I think most of the [PE] companies have gotten aggressive on costs, but now the focus is on 'How do we grow the top line?'"
It's not that purchase price doesn't matter. The PE firm, said Africk, must pay a "safe and sane price" to acquire a company. But the real value is created afterwards through operational improvements. Apollo, he recalled, once bought a satellite company for a reasonable price of 6.5x EBITDA (earnings before interest, taxes, depreciation and amortization) and later sold it at a multiple of 9.5. The gain came from major upgrades like adding cellular and Internet service to the system, not from a bargain price.
"The only way to really create value is by having operational expertise, insights, contacts," said Hooper. To achieve that, Centerview draws on a stable of executives with deep experience in the industries it invests in, such as consumer products.
Justin Miller, a partner at Bain & Company, said his firm stays focused by sitting down at the start with managers of portfolio companies and hammering out a list of the three to five key goals to achieve over the ensuing few years.
And at KKR Capstone, the process of remaking the portfolio company begins with a 100-day plan that includes a very clear idea of the target's profit potential, said director Todd Cooper. "When the deal closed, on day one I had a target, I had a number in my head," he said of one acquisition. Often, value is created by zeroing in on the potential improvements unique to each portfolio firm, but also by finding similar needs in two or more firms in the portfolio. Office supplies, for example, can be purchased more cheaply in bulk.
The process, added Hooper, generally begins with a deceptively simple question: "One, do we understand what this company does and how it makes money? It sounds like a very basic question, but it's a very important one." Centerview evaluates the firm's position in the market and the talents of its management, and asks what has to be done to take the firm to the next level.
One of Centerview's acquisitions was a frozen-pizza maker that was doing well. But Centerview believed annual sales could be boosted from $200 million to $500 million.
"We could bring resources to the company that they could not get by themselves, including things like superior sales talent," he said. Because of its size, Centerview could get sales meetings with large retailers that would not sit down with the pizza firm itself. Centerview also boosted its access to retailers by placing former executives from big-name firms like Kraft, Gillette and Nabisco on the pizza firm's board.
"For the [pizza firm's] CEO to be able to pick up the phone and talk to these guys is very important, and something he might not be able to do under the previous management," Hooper said. Centerview also brought in additional executives and directors with industry expertise. "We're one year in — maybe, to use a baseball analogy, in the second inning. But it feels good."
Part of the Team
At many portfolio firms, management focuses too much on the next quarterly board meeting, devoting excessive time and effort to making an effective presentation, Africk stated. "I tell my management teams I don't want that. If I learn something at a board meeting, I'm not really doing my job." Instead, Africk works to reduce the stress of facing big quarterly deadlines by making managers at portfolio firms feel Apollo is part of the team on the ground, not just overseeing from on high. "I'll call management maybe every two or three days." The trick, he said, is to keep up-to-date with the portfolio firm without interfering with day-to-day management.
This kind of interaction can be constant at the start, but then the PE team is well advised to back away and let the firm's managers run the company, getting more involved again only if things are going wrong, Cooper added.
"If you get to the point where you need to micromanage the chief executive, you need a new chief executive," Juneja said. "The most important decision we make is the hiring and firing of that CEO."
This is another area where a PE firm with a good reputation can wield more clout than the portfolio firm on its own, said Miller. Because a CEO wants to work with the PE firm, he or she may be willing to join a portfolio company in a less-than-ideal location, he added.
"If you don't get the right person as the CEO of the company, you are going to fail," said Hooper.
It's also critical for the portfolio firm's board to include people who not only have expertise in the firm's line of business, but who also understand the life a CEO leads, said Juneja. "The CEO job is really a very lonely one," he said, noting that some of the best board members are former CEOs "who can serve as a source of non-judgmental information."
'The 1% Possibility'
While PE firms have long employed leverage to boost results and still do, in today's environment it is critical to be conservatively levered, so management does not face a constant stream of balance sheet alarms. In doing so, managers are then willing to spearhead initiatives even if they are costly in the short run, Juneja said.
However, if the strategy does rely on significant amounts of leverage, the PE firm should not select a target that requires a major overhaul, added Africk. "A wholesale transformation in a highly leveraged environment is not a good idea. It just doesn't give people degrees of freedom to make it work."
Despite all the due diligence, careful hiring, cost cutting and monitoring, things often don't go as planned, said Africk. "One thing that's not well understood is how great [internal rates of return] are made," he noted. "It's as much about the saves as about the wins…. It's going to happen that your thesis was wrong, and it's going to happen that the macro-environment [goes] against you. What [distinguishes] the great private equity firms is how they react to that."
It is critical, he added, to control emotions when things go wrong and to have "safety factors" built into the plan from the start, such as capital structures that can withstand setbacks.
It is also important to look backward at why some deals worked and others did not, said Juneja. In an analysis of opportunities it had considered over the years, his firm found that the deals it should have done — but did not — in retrospect caused it to miss out on chances to triple, quadruple or quintuple its investment. The deals the firm completed — but should not have, given the outcome — typically caused it to lose half of the investment. In other words, the good opportunities that were missed were more costly than the bad deals that were done. On a close call, it could therefore make sense to do the deal, since on balance the potential gains might well outweigh the potential losses.
Often, the potential gains are hidden, and the successful PE firm is "open to the 1% possibility," Miller added.
"It's a full-contact sport," Cooper concluded. "It's a lot of fun. It's very fulfilling. But it's very hard."