The Financial Times

Private equity must skill up for the upturn

It's time to supplement financial engineering skills with industry expertise.

Par Graham Elton and Hugh MacArthur

First published on juillet 19, 2009
min


Even before the recession started to bite early last year, private equity firms were feeling the full effects of contracting credit and declining asset values. New deal activity ground to a standstill, long-planned initial public offerings were put on hold, and highly leveraged portfolio companies began to strain against lending covenants. Private equity investors often serve as harbingers of big swings in business cycles and the recovery from this downturn should be no exception. As of March 2009, private equity firms were sitting on $517bn (£317bn, 370bn euro) in undeployed capital, earmarked for buy-outs but sidelined until market conditions improve. When the upswing arrives, however, private equity firms will be operating by new rules where lenders are more circumspect, limited partners supplying investment capital are more demanding, and competition for the best targets is more intense. In this new climate, deft financial engineering skills will not be enough to salvage value from beaten-down portfolios. Instead, leading firms have started to recognise they need stronger teams and deeper industry expertise. Many expect to focus on specific industry sectors. How well they execute this shift will be important not only to the private equity industry but the global financial system. The move toward sector specialisation has gained momentum because its benefits will be powerful. In deal generation, it will mark a buy-out firm as a serious player, increasing the volume and quality of deal flow. In due diligence, it can speed a firm's ability to identify good deals and bring to bear proprietary insights that provide an edge in auctions. Following acquisition, it will help the firm set strategic direction, improve performance and build value. When the time is ripe to sell, the firm can better identify potential buyers and present the sale in the most compelling light. Firms that specialise around sectors begin by identifying high potential sectors in play, defining them clearly but keeping them broad enough to ensure they will yield a healthy stream of investment opportunities within a reasonable timeframe. Private equity firms will select sectors by weighing their ease of entry, competitive dynamics, and availability of acquisition targets. Building these sector skills will be especially challenging for European private equity firms that operate across national boundaries. As firms start to increase their activity, they will pick their spots carefully. Instead of trying to land deals across a wide range of companies and industries, they will zero in on attractive industry sub-sectors, to get an early read on potential deals. Some firms work from sector "heat maps" to help identify the most promising segments and regions where they can add value. They also mobilise sector teams to gather unbiased information from the field by interviewing customers, suppliers, competitors and creditors who help to identify impending shifts in relative market share, earnings volatility, profit pools and other industry-shaping trends. They use this intelligence to develop concrete, and sometimes counter-intuitive, investment theses. In this new environment, powerful analytical skills will remain important, but they will not be sufficient by themselves. Look for the managing directors of sector-oriented firms to be more visible in the industry segments they cover. Instead of waiting for bankers to pitch deals, activist directors will spend more of their time cultivating relationships with industry insiders. Most importantly, they will work to earn the trust of management teams at companies that are high on their target lists. That is not new to private equity, but the added objective is to become so deeply in tune with the sector's business metabolism that private equity firms will be ready to jump when deal opportunities mature. Private equity firms that use the downturn to identify and build relationships with sector-leading companies should be well positioned to pull away from their rivals coming out of the downturn. Our analysis has found that an acquirer can typically purchase a sector leader for a lower price relative to its competitors just before a cyclical rebound. As they help lead the economy out of recession, private equity firms wielding well-tuned sector expertise will be holding a trump card. Graham Elton and Hugh MacArthur are partners at Bain & Company.

Even before the recession started to bite early last year, private equity firms were feeling the full effects of contracting credit and declining asset values. New deal activity ground to a standstill, long-planned initial public offerings were put on hold, and highly leveraged portfolio companies began to strain against lending covenants.

Private equity investors often serve as harbingers of big swings in business cycles and the recovery from this downturn should be no exception. As of March 2009, private equity firms were sitting on $517bn (£317bn, 370bn euro) in undeployed capital, earmarked for buy-outs but sidelined until market conditions improve.

When the upswing arrives, however, private equity firms will be operating by new rules where lenders are more circumspect, limited partners supplying investment capital are more demanding, and competition for the best targets is more intense. In this new climate, deft financial engineering skills will not be enough to salvage value from beaten-down portfolios.

Instead, leading firms have started to recognise they need stronger teams and deeper industry expertise. Many expect to focus on specific industry sectors. How well they execute this shift will be important not only to the private equity industry but the global financial system.

The move toward sector specialisation has gained momentum because its benefits will be powerful. In deal generation, it will mark a buy-out firm as a serious player, increasing the volume and quality of deal flow. In due diligence, it can speed a firm's ability to identify good deals and bring to bear proprietary insights that provide an edge in auctions. Following acquisition, it will help the firm set strategic direction, improve performance and build value.

When the time is ripe to sell, the firm can better identify potential buyers and present the sale in the most compelling light.

Firms that specialise around sectors begin by identifying high potential sectors in play, defining them clearly but keeping them broad enough to ensure they will yield a healthy stream of investment opportunities within a reasonable timeframe. Private equity firms will select sectors by weighing their ease of entry, competitive dynamics, and availability of acquisition targets.

Building these sector skills will be especially challenging for European private equity firms that operate across national boundaries.

As firms start to increase their activity, they will pick their spots carefully. Instead of trying to land deals across a wide range of companies and industries, they will zero in on attractive industry sub-sectors, to get an early read on potential deals.

Some firms work from sector "heat maps" to help identify the most promising segments and regions where they can add value. They also mobilise sector teams to gather unbiased information from the field by interviewing customers, suppliers, competitors and creditors who help to identify impending shifts in relative market share, earnings volatility, profit pools and other industry-shaping trends. They use this intelligence to develop concrete, and sometimes counter-intuitive, investment theses.

In this new environment, powerful analytical skills will remain important, but they will not be sufficient by themselves. Look for the managing directors of sector-oriented firms to be more visible in the industry segments they cover. Instead of waiting for bankers to pitch deals, activist directors will spend more of their time cultivating relationships with industry insiders.

Most importantly, they will work to earn the trust of management teams at companies that are high on their target lists. That is not new to private equity, but the added objective is to become so deeply in tune with the sector's business metabolism that private equity firms will be ready to jump when deal opportunities mature.

Private equity firms that use the downturn to identify and build relationships with sector-leading companies should be well positioned to pull away from their rivals coming out of the downturn. Our analysis has found that an acquirer can typically purchase a sector leader for a lower price relative to its competitors just before a cyclical rebound. As they help lead the economy out of recession, private equity firms wielding well-tuned sector expertise will be holding a trump card.

Graham Elton and Hugh MacArthur are partners at Bain & Company.