Friday Letter You say you add value…

Operational improvement is critical nowadays – but which GPs really do it?  

There was plenty of talk at Private Equity International’s Operating Partners Forum 2012 in New York this week about LPs wanting to be shown how exactly firms improved their investee companies. The challenge for GPs is to come up with ways of demonstrating their operational prowess.

Recently limited partners have been impressed with firms formed by teams of both deal and operating professionals. One of them is Rubicon Technology Partners, which was formed recently by three individuals with complimentary skill-sets: John Hodge, a former senior managing director and senior advisor at Blackstone focused on technology investing; Andy Gesell, former partner at Court Square Capital investing in technology and telecom; and, interestingly, Steve Carpenter, former CEO of Ventyx, a division of global power and automation technology company ABB.

Rubicon says its philosophy is built around a strong focus on operations. LPs we’ve talked to like the sound of the firm, and its fundraising will be an interesting benchmark for the first-time manager model with an operational bend.

However, what became clear at the Operating Partners Forum was biographies evidencing partner backgrounds in industry alone will not guarantee a group’s popularity with investors. LPs want a granular understanding of how a given GP uses the managerial talent on its team to build better, more valuable companies.

As John Castle, chairman and CEO of Castle Harlan and a private equity veteran of nearly 50 years, put it: LPs are not satisfied with simply hearing that a manager took ‘x’ and turned it into 3x – they want to know how the result was achieved, and if the value creation can be replicated.

For LPs to analyse whether a firm’s portfolio enhancement executives are genuinely worth their keep is not easy. A good start is to call or visit portfolio companies to find out who was driving specific improvements. Who did all the work – was it the GP, or was it in fact the management team?

This is of course time-consuming, and by no means every LP has the bandwidth and resources to do this kind of diligence. At the Forum, it was a telling moment when a senior operating partner from a leading firm told the audience: “We could show our LPs so much on what we do with the businesses. Few ever ask.”

Frustrating as that may be, the challenge for GPs is to find ways of demonstrating how their chosen approach to operational improvement works in practice. How do you break out the operational improvement component of an IRR or MOI number?

GPs need to continue thinking about this, because there is no end to managers who boast of their operational improvement skills to LPs (one of the reasons we launched the Operational Excellence Awards).

This is the GP differentiation battleground of the times. Just as every firm claims to be top-quartile, most shops today claim to be experts at building better companies. LPs are trying to figure out who actually does it and who simply talks about it. Those firms that truly have a convincing story on this need to figure out how to tell it.