Luck vs skill

Limited partners place a huge amount of value on a GP’s ability to create operational value in today’s environment – and although every manager trumpets their operating expertise these days, investors are increasingly confident that they can tell the difference between a genuinely integrated strategy and a glorified marketing exercise.

That was the message from investors speaking on the LP panel at Private Equity International’s Operating Partners Forum Europe in London in May.  All agreed that GPs tend to overstate their operational abilities, particularly if they have a fundraising round imminent. So LPs have to do their due diligence – visiting management teams, making reference calls, doing a full attribution analysis – to try and identify those firms for whom value creation is really part of the day-to-day strategy.

“What we’re looking for when we’re investing is a sustainable model that can be repeated again and again,” said Clearsight Investment partner James Roebuck. “We’re looking for luck and skill, and the difference between those two things.”

The panellists agreed that they expect to see some recognition of how the world has changed in this regard in their communication with GPs. However, a newly-minted operating partner will not in itself be enough to satisfy LPs.

“We see the operating partner model becoming more and more common, and them being increa-singly integrated as part of teams,” said Kaarina Suikkonen, head of private equity at FERI Group. “But from an LP point of view, you really have to understand the extent to which operating partners are able to add value. If there’s one partner and a number of portfolio companies, that’s questionable.”

“I’m quite cautious about changes,” added Alexandre Delos, a partner at Access Capital Partners. “I don’t think you can suddenly turn into a different firm, even if you change your team structure.” In this environment, it will be hard for these GPs to compete on the fundraising trail, he said.

So is it too late for GPs who have relied upon a financially-oriented model to reinvent themselves as operating experts? “I wouldn’t say categorically no,” said Mark Nicholson, a partner at SL Capital Partners. “It depends where the GPs is in its evolution. If it’s still led by the old guard, it’s very difficult for a leopard to change its spots. But if there’s been a generational change, and they’ve increasingly been persuaded of the importance of operational improvement, then absolutely the firm can evolve.

However, the best exponents today, he said, tend to be those for whom it has “always been part of their mindset” – either because their team combined people from financial and operating backgrounds, or just because they’ve done a very good job of utilising their operational networks.

The panel also pointed out there can be dangers in a very operationally-focused model. In Europe, for example (and particularly Germany, in light
of the new rules), very hands-on managers can sometimes fall foul of the rules about direct control of assets, according to Suikkonen. Delos added that scalability can be a problem for these managers, as can governance – because they’re not used to ensuring alignment of interests between GP and LP. And Nicholson suggested that GPs who feel they have a strong operational capability can sometimes “bite off more than they can chew”.

Ultimately, though, these LPs agreed that value creation is here to stay. As Delos put it: “I think operational excellence is at the heart of the private equity process. The very essence of private equity is not to buy, lever and sell; it’s to buy, improve and sell.”