The private equity industry never had it so good. You may disagree with this statement, but some data points are irrefutable. Take cashflows, for example. Private equity firms have sent more cash back to investors than they have called from them for the last six years, according to Cambridge Associates data cited in Bain & Company’s 2017 Global Private Equity Report. Fundraising is also booming; more capital was raised in the first half of this year than in any six-month period since the financial crisis, according to PEI data.
When PEI introduced the Operational Excellence Awards in 2012 it was against a much trickier backdrop. Fundraising was a slog for GPs, exit activity was hampered by an IPO window that remained shut for much of the year and private equity was being used as political football courtesy of Mitt Romney’s presidential run. The awards were a way for victorious GPs to showcase the value they create not only to limited partners, but to the wider financial community and the general public.
Many firms were still wrestling with boom-era buyouts that had been hit hard by the global financial crisis; they had yet to prove their operational and financial mettle.
But prove it they would. A recent study, Private Equity and Financial Fragility During the Crisis by academics Shai Bernstein, Josh Lerner and Filippo Mezzanotti, shows that companies backed by private equity experienced greater debt and equity inflows in the immediate aftermath of the 2008 crisis than their peers and enlarged their assets and market shares. Private equity could be said to have had “a good crisis”, partly because of the pervasive low-interest rate environment, but partly also because GPs focused their capital and resources on their portfolio companies.
Five years on and the question is whether the ability to enact operational improvement in private equity is still something that GPs need to demonstrate and that LPs need to scrutinise.
The answer is ‘yes’, according to Katja Salovaara, senior portfolio manager for private equity at Finnish pension fund Ilmarinen. “You need to grow a business, both topline and earnings, to make money: that is the reality of today’s private equity market,” she says.
“It is ever more relevant,” says Jim Strang, managing director and head of EMEA at Hamilton Lane. “If we start to head towards a more difficult period in the economy, then the importance of this gets amplified.”
There’s the rub; private equity’s recent stellar performance has been buoyed by increasing asset prices which cannot continue forever. Whether the economic cycle breaks in the next quarter or in 12 months’ time, most private equity firm’s today are investing on the assumption that they may be exiting at a lower multiple than they invested.
As Blackstone’s global head of private equity told PEI in April, his team is making assumptions in their models that the exit multiple environment will deteriorate and the amount of debt firms will be able to borrow as a multiple of earnings will be lower. “That’s leading us into companies where we can do a lot to them during our ownership to really transform the profitability, either through consolidation or operating margin restructuring, or by buying things that are out of favour,” Joe Baratta said.
“Our ability to act as a good custodian and value-added industrialist in our portfolio companies is way beyond what it was even 10 years ago,” Baratta added, noting that the firm has become more sophisticated in human resources and recruiting, and is better able to take advantage of the scale of its portfolio in procurement of things like healthcare.
Blackstone is far from alone in touting its improved operating capabilities. “You would have a hard time finding a GP that does not tout its operational excellence,” says Georges Sudarskis, the former head of private equity for the Abu Dhabi Investment Authority, who now runs his own asset management and consulting business. “It would be foolish for them.”
Hamilton Lane’s Strang lays out the challenge for GPs, “Now that everybody does it, you need to explain how you do it better.”
The challenge for LPs is identifying what model the GP professes to have and then understanding whether they have the credentials, the personnel and the track record to deliver it.
GOING OVERBOARD ON OPEX
While being a good custodian of a portfolio company is imperative, private equity firms and their limited partners can become too fixated on operational improvement, says former ADIA PE head Georges Sudarskis.
“From the LP’s perspective, there are myriad elements to a successful deal; operational efficiency is just one,” Sudarskis says. “Indeed there are well-publicised examples where a GP might achieve its target of operational improvement, but the deal eventually does not provide the fund and its LPs a meaningful return.
“For instance, Toys R Us, while in the hands of private equity owners for a long time, had a satisfactory operating profitability, had gained an enviable place in manufacturers’ mindshare, and would have been labelled a good deal, had it not been for an unsustainable debt burden.
“In the same vein, EMI was an operational success in spite of all the naysayers, but it was at the wrong moment of the cycle, the refinancing didn’t take place and the investment was lost.
“Conversely sometimes you find the GP did not focus on operational improvements and the deal is still a perfect home run.
“LPs in a blind-pool fund will always fixate on one tangible, fundamental element of the GP’s narrative, whether it is financial leverage, acquiring assets cheaply or as is often the case, operational capabilities. It simplifies their internal processes (easy to demonstrate) and allows internal consensus-building. Note that this emphasis on operational excellence is not claimed by VC firms, only by buyout shops. Have you ever wondered why?
“Where GPs are often designated as vultures or locusts, when they can show they consistently seek and achieve operational improvements – new markets, R&D, embracing digitisation – apart from when you make redundancies – it looks good, solid, and it reassures the LPs. It is good PR material.”
Look out for more on PEI’s opex winners, announced next week.