As recently as the last decade, a focus on value creation was the exception across much of private equity, and actually ran counter to the financial-engineering strategies employed by many of the industry's biggest names. Fast forward to 2017, and there are few, if any, firms that don't claim to focus on improving portfolio company operations. Yet few of these firms have managed to successfully support the operating partners and investment teams that are counted on to drive this growth.
While this may sting, research suggests these operational efforts remain inconsistent from firm to firm. For instance, Bain & Company, in its 2016 Global Private Equity Report, conducted a survey in which one in three operating partners polled said they do not have the full backing of their investment team. Three out of every five also claimed that the value-creation functions within their firms were not yet fully staffed or even focusing on the right priorities.
In many ways, these half-hearted efforts don't do justice to the immense impact operating partners can and do have – both at the partnership and within portfolio companies. Success on this front requires that the financial interests of an operations team are aligned with the fund – not just the deals they work on – and that these former executives and CEOs are considered true 'partners'.
Many assume the role of operating partners is to 'parachute in' during periods of stress or that they are merely there to fulfil a governance function. Even those who understand how closely operating partners work with portfolio companies still assume there is some kind of hand-off that occurs, post-close, in which the deal team passes the baton to the operators. This may be true for some, but this approach doesn't maximise the value available through a more integrated model. In a market in which assets are being priced to perfection, the active contribution of executives can be instrumental when it comes to winning deals in the first place.
At the very outset, operating partners can inform and refine the investment thesis that supports a bid. For instance, if a firm is exploring a retail investment, there are questions that only a former executive would know to ask. Does the company have competitive advantages that will survive evolving consumer patterns? Does it compete with Amazon or does the potential exist that it someday will? How much white space is available to accommodate new-store growth and at what point does saturation start hitting returns? With this colour, the deal team can either be more aggressive with their valuations or can save investors from being exposed to transformational market shifts.
Operating partners are also vital in building relationships. Having participated in buyouts from each side of the table, the credibility imparted can make the difference when all else is equal and even on occasions when it isn't.
In the Bain & Company report, the consultant also highlighted the most common factors that sabotage value-creation plans. Among the top four were the skillset of management teams, shifting industry dynamics, macroeconomic headwinds and overly ambitious growth plans. Each of these factors also underscores the critical role operating partners play following an investment, whether it's setting realistic strategies, supporting management with resources or helping companies correct course amid change.
Beyond helping companies manage the unexpected, operating partners also instill the conviction necessary to make bold, calculated bets – driving the kind of initiatives that showcase the value of patient capital. We acquired Mattress Firm in 2007 and a year later the entire economy was hobbled by the financial crisis. Consumers deferred big-ticket purchases and same-store sales nosedived. Amid this uncertainty, when most retailers were scaling back and closing stores, our operating partner Bill Watts made the case to accelerate real-estate development to take advantage of leases as much as 50 percent below market. The investment yielded a substantial return, but it could have been a total loss without trusted guidance and leadership.
Often, the value of an integrated model will take the form of small insights that collectively have a tremendous impact on each company's bottom line and, ultimately, fund performance.
Some have taken issue with the idea that GPs refer to operating professionals as 'partners' in the first place. Former Securities and Exchange Commission director Andrew Bowden observed at the PEI Private Fund Compliance Forum in 2014 that while they “may walk, talk, act and look” like representatives of the firm, most operating partners “are not usually treated as employees or affiliates of the manager”.
In our experience, this characterisation couldn't be further from the truth. Our operating partners, as full partners in our funds, have as much at stake as our investment team and reap the same rewards on every successful investment, even those outside of their domain. On the deals they're involved with, the operating partners make incremental investments – on top of their fund commitments – to further buttress the incentive structure and provide a final measure of conviction ahead of closing.
As such, our operating partners have a hand in everything from pre-screening investments and due diligence to creating and executing the strategic plan that informs and drives our investment theses. It's a model that fosters alignment, not only between the investment team and our operating partners, but also between our portfolio companies and our LPs.
Adam Suttin co-founded JW Childs Associates in 1995 after working at Thomas H Lee Company.