Everyone in private equity is talking about operational value creation, and its importance to performance in the next few years. So in that sense, the thrust of a new paper by the Boston Consulting Group, entitled “Private Equity: Engaging for Growth”, comes as no surprise: the consultancy argues that it has become increasingly difficult for GPs to deliver stellar returns, given the lack of available debt, the absence of meaningful multiple expansion and the general economic gloom. All of this, as it rightly says, puts a premium on operational value creation.
As Paul Zwillenberg, one of the co-authors of the report, tells Private Equity International: “It’s become more and more difficult to deliver above-average returns. You can’t bank on multiple expansion and a lot of the low-hanging fruit on the cost side has already gone. So a solid business plan that drives the operational value creation at the top and bottom line is absolutely critical.”
But what’s really interesting about the paper is that it attempts to quantify the scale of the operating challenge private equity is currently facing. Based on a financial model with some fairly conservative assumptions (covering exit multiples, debt levels, interest and tax rates, and capital expenditure), BCG reckons that for private equity firms to achieve an internal rate of return of 25 percent in the current climate, its portfolio needs to be seeing average yearly EBITDA growth of 11 percent.
That’s a big number. At the larger end of the market – i.e. for the kind of businesses that typically interest the mega-funds – this kind of annual growth would be exceptional. And even for the majority of smaller, growing firms, it would still represent an impressive rate.
“Asking a business to deliver double-digit year-on-year EBITDA growth is a big ask even at the best of times,” admits Zwillenberg. “It’s even more difficult when the economy is growing at low single-digit rates and inflation is higher than we’ve been used to.”
Nonetheless, the good news is that he believes operational value creation does provide private equity with the ability to deliver numbers like this. The key, he suggests, is for GPs to leave no stone unturned in their efforts to drive growth – and once they find approaches that work, to make sure these get embedded and replicated throughout the portfolio.
“Today private equity firms need to look at a broader range of actions they can take – or their portfolio companies can take – to deliver their target returns. They need to understand all the levers they can pull, develop standard approaches and make sure they have the right resources to deliver – either in-house or through external partners.”
This last point is also important. Another of BCG’s areas of professional interest is the way that private equity firms operate internally – which, you might think, would leave it ideally placed to identify the best operating set-up. Is it better for firms to use external operating partners, or in-house operating teams, or both? Or something else altogether?
Happily, Zwillenberg reckons that all these approaches can work. “There’s no silver bullet in terms of how a private equity firm organises itself to deliver top and bottom line growth in its portfolio companies. There’s no best or perfect model; different models will suit different funds of different sizes and structures. A lot of it has to do with how effective you are at implementing the model that works best for you.”
In other words: it’s less about the what, and more about the how.