A decade on from the global financial crisis, operating partners are a common sight at portfolio companies. Absorbed in the nitty-gritty of transforming a business during the ownership period, they have become a major cog in the value creation engine. As the number of operational specialists employed by GPs rises, the scope of their participation is also expanding.
Fierce competition for assets, high pricing and the need to originate more off-market transactions, as well as investment managers’ increasingly sector specific focus, are stretching the presence of operating partners across the investment cycle. No longer confined to stepping in on specific situations once the deal documents are signed, operating partners are increasingly involved pre-deal.
Watch participants at our Operating Partners Forum discuss the interface between operating and deal teams
This can be as early as bringing opportunities to the deal team, says Gail McManus, managing director of private equity search firm PER. “The operating partner will sit down with that team and say, if we want to invest in this industry, these are the things that really matter, these are the trends, this is where the sector has problems, this is where the opportunity might lie. Let’s talk about what we might do to take advantage of that. They are bringing knowledge and expertise. They are not there to grind out the deal.”
Using their bank of industry experience, operating partners serve as a valuable sounding board for investment partners scouring for deals. “When the guys go out to the market to look at potential investment targets, they come back to us and ask us about our experience within the industry, within similar management teams, [and] do we have any ideas on what kind of value creation initiatives the company can take on,” says Ewa Bielecka Rigby, head of value enhancement at Lloyds Development Capital.
During due diligence, operating partners ask a diverse and different set of questions to the investment team, says Fredrik Henzler, co-head of Partners Group’s industry value creation team. “The investment side is very much on the cashflow, the quality of earnings and the ability to repeat margin improvement. The operating and industry side more often than not takes more time to look at whether this is the right segment of the industry that we want to play in. While we’re looking at the same topic, we are taking different approaches to looking at it. We believe that makes a better investment decision.”
Operating partners are now present at the first management team meetings, notes Blue Ridge Partners managing partner Jim Corey. “One, that helps them build a trust-based relationship with the management team earlier in the process. It also allows them to make judgments about whether this management team is change ready and willing,” he says.
It is a two-way street. While operating partners have always interacted to a degree with the deal team, “what’s changed recently is that there has to be an underwriting case that is competitive in a market that is very hot”, says Amanda Good, HgCapital head of operations innovation team. Increasingly, operating partners are “being asked to find change agendas where the deal executives can make sure they win the deal”.
But ultimately, “it’s the deal team that calls the shots”, says Edward King, partner at executive search firm McLean Partnership, “sometimes much to the annoyance of portfolio and operations guys”.
The relationship between the operating partner and the deal team is “quite key”, says Fredrik Bürger, EY EMEA private equity value creation leader. “We see operating partners more and more frequently getting involved pre-deal, actually thinking through what can be done with a business, be that from a growth perspective, or a cost reduction perspective, whatever the investment thesis is. In my experience the most effective partnerships between operating partner and deal teams are when they work as one team and you don’t know who is who.”
This level of pre-deal engagement requires juggling time and focus. “It’s always a bit of a difficult decision, shall we get more involved pre-deal, because it takes our time [away from] working for our current portfolio companies,” says Rigby.
At one time, her team was involved in one out of 25 deals the firm executes annually. Now, she says, they participate in all major transactions. She believes it is worth it. “The earlier we can get to work with the management teams of our potential investments, the better results we can get out of ownership.”
The pay differential
The different approaches of investment and operating partners is reflected in the compensation packages, which are structured “completely differently”, says Gail McManus of private equity search firm PER McManus. Generally speaking, she says: “Many operating partners are often paid as consultants and may or may not be an employee. They are probably paid a proportionate rate for days involved. They’ll have some sort of retainer or monthly fee.”
Operating partners tend not to be employed full-time or get a bonus, she adds. “They will receive carried interest or co-invest in the deal.” The potential for upside rather than cash compensation, “that’s the win”, she says.
Bringing in an operating partner early accelerates the instigation of business transformation initiatives once the deal closes.
“You can put together a plan before you own the company so on day one you can go ahead and start implementing,” says Rigby.
Investment partners may be very welcoming of the additional support provided by operating partners in generating dealflow, setting the scene for value creation and securing the asset, but the two roles remain very different.
“In private equity houses you have a lot of really smart people who are great with numbers and working out a great way of being able to fund an acquisition of a business and hopefully come up with the right price to pay for it,” says Mike Mills, target value leader at KPMG.
“You don’t often have people who have been in there, done that and [have] run businesses in the industry and have really deep operational expertise. And that is exactly what operational partners are doing, either from a sector perspective or from a functional speciality – pricing, supply chain, procurement, whatever it happens to be.”
The jury is still out on the appropriate operating partner model. “A number of funds have chosen to outsource their operations team to consultants, and not have it in-house,” says King. “It’s a cost save, they don’t need them there permanently but perhaps on a deal-by-deal basis. They are on retainer and the funds use them when necessary.”
Paul Reading, partner in EY’s private equity value creation team, draws a further distinction between operating partner styles. “For some private equity houses, it’s functional specialists, to some it’s generalists. What’s more important than the model itself is that the model is aligned to the firm’s investment thesis,” he says.
Looking forward, some industry participants predict that eventually the role of investment and operating partner will merge. “If we look at the model currently, we have operating partners and deal doers and in many ways they are in two separate camps,” says Reading.
In future, there could be “operational deal-doers, or deal-doers with more operating experience. So we’re going to see a convergence of those two separate skills sets into one role”.