Article

Private equity firms need a new blueprint

Leverage, multiples and GDP growth are no longer enough to propel returns.

Di Tim O'Connor, Andrew Tymms and Catherine Lemire

First published on gennaio 04, 2010
Tempo di lettura min.


The past year's economic upheaval ended private equity's long "golden age" of debt-fueled mega-deals and big returns. In the benign period that preceded the downturn, private equity firms did not have to put much muscle into generating attractive returns. A Bain & Company analysis of investment conditions between 2002 and 2007 found that the benefits of leverage, expanding price-earnings multiples in a rising equities market and GDP growth accounted for nearly all of their returns. Clearly, some industry leaders did create value in their portfolio companies, and their active ownership was rewarded with superior returns. However, there is little evidence that private equity owners, overall, added value during this period. Turbulent times-as private equity firms are facing now-create once-in-a-career experiences fraught with extraordinary opportunities and risks. Bain & Co. research has found that companies make more dramatic gains or losses from the actions their executives commit to during downturns than at any other time, and those results are more likely to be sustained through the next boom cycle. Recognizing this, many private equity firms are aggressively maneuvering to tap potential new sources of growth. But piecemeal moves that are dictated by expediency usually lack a strong strategic rationale and end up being poorly executed. Instead, private equity firms need to apply to themselves the same disciplines the most successful firms use to create sustainable value in their portfolio companies-namely, to define a clear strategy for competing effectively in their markets and put in place a focused blueprint for delivering it. The private equity firms that emerge with strategies that set them apart from their peers will be able to answer five questions: 1. Where should we play in order to win? The private equity universe has expanded over the past decade, and firms face a complex new set of investment decisions. Beyond traditional buyouts, opportunities now extend to a wide range of asset classes-from debt, mezzanine, and bridge financing to real estate, infrastructure, and natural resources-with broader geographic reach. More than half of the biggest private equity firms over the last five years are now active across multiple asset classes, and more than 80 percent invest in regions beyond their home base. But diversification produces ambiguous results. Indeed, our analysis has found little correlation between the number of asset classes or geographies in which a firm invests and its overall performance. Purported synergies across asset classes are limited in terms of the capabilities the firm requires, the networks it can tap, and the costs that can be shared. And interviews Bain & Co. conducted recently with limited partners reveal that most do not place a premium on firms that bridge several asset classes or geographies. Rather, they evaluate each fund opportunity on its own merit. Successful firms make diversification work by taking a disciplined approach. They evaluate each opportunity's economic attractiveness and its competitive intensity. In parallel, they weigh their firm's ability to leverage its strengths, such as an in-depth knowledge of select industry sectors, a productive network of relationships, and distinctive investment capabilities. Then, for each asset class and region they choose to participate in, they carefully define their investment "sweet spot"—in other words, the types of deals they prefer to do based on dimensions such as industry sector, size, degree of control and investment thesis. Recognizing the increasing importance of focus in their strategies, many leading firms are making the shift from generalist investors to intelligent risk-takers by specializing in just a handful of industry sectors. 2. What's our unique proposition to investors that will enable us to raise new funds? In recent surveys, some 90 percent of pension funds, endowments, financial institutions and other traditional private equity investors said they plan to maintain or increase their target allocation to private equity funds over the coming year. But firms that aim to tap new capital from familiar sources will need to reckon with significant new realities. For one thing, the industry faces a huge capital overhang-some $1 trillion in uncalled commitments from earlier funding rounds. That will severely test firms' ability to attract new funds from investors who are pressed to meet prior pledges at a time when private equity distributions from investments already made, but not yet monetized, are sparse. In addition, the challenging private equity environment has led LPs to insist on better governance, greater transparency about fees, and closer alignment of interests with general partners. As power tips to LPs, fund-raisers need to sharpen their differentiation from their competitors. Research has found that, by choosing the basis of comparison that most favors them, more than two-thirds of private equity funds are able to produce numbers showing they generate top-quartile results for their investors. But LPs will no longer fall for creative math that masks poor returns. More of them are applying a common set of metrics to evaluate the general partners' performance on a consistent basis. To secure new investment, private equity firms will need both a well-honed strategy and solid evidence to back it up. 3. How do we elevate our investment and ownership capabilities? No longer able to rely on favorable credit-market conditions to do their heavy lifting, private equity firms need to differentiate themselves, by building skills that enable them to add value across the entire investment cycle from deal sourcing to exit. Sector specialization, mentioned earlier, enables firms to mobilize proprietary insights about sector trends and tap networks of industry insiders to give them an edge in sourcing and screening good deals and winning the best ones. Following an acquisition, sector insights also enable private equity owners to set strategic direction, improve performance and build value. Most private equity firms pay only lip service to the notion of hands-on value creation after transactions are closed. They may impose a "100-day plan" on their new portfolio companies, but frequently these are long "to do" lists for CEOs to satisfy the new owners and police performance, rather than guidance that fundamentally redirects operational and resource-allocation priorities. Private equity leaders, by contrast, flex their muscle as activist owners with a robust, repeatable engagement model. Immediately following an acquisition, they develop a blueprint that defines the business's full potential, prioritizes three to five critical initiatives to reach its target equity value, and specifies milestones for hitting it. Meeting regularly with management, they track key metrics to ensure the program is on course, use an early-warning system to alert them when targets are missed, and intervene quickly. 4. What role does the center need to play to support the firm's strategy? The business of running a private equity firm has never been more complex. New legal and compliance issues are making the firm's administrative roles more demanding. Fundraising challenges and more discriminating LPs have ramped up the need for more sophisticated investor communications. Helping their investment teams operate across asset classes, regions and sectors adds new dimensions of responsibility for strategic planning and for managing the firm's brand, talent and knowledge. Thoughtful firms are beginning to recast their administrative centers to perform a role we call "strategic architect." Instead of adopting a hands-off approach to serving largely autonomous investment teams or concentrating control of all major functions in the center, strategic architects serve as strategy enablers. They coordinate overall direction setting, recruit and train top talent, foster the sharing of insights across investment teams and take the lead in fundraising and managing investor relations. At the same time, strategic architects are careful to take on only support services they can perform effectively and efficiently. They periodically reassess whether the activities the center performs are necessary, would be better delegated to the business units, reengineered or outsourced. When one leading private equity firm ran more than 60 central support services through this assessment filter, it found opportunities to cut costs, upgrade, delegate or contract out more than half of them. 5. How do we become a high-performance organization? Private equity firms have long fixated on hiring top talent and building strong organizations in their portfolio companies, but too often they seemed willing to tolerate convoluted reporting structures, ambiguous career paths and ad hoc decision-making processes in their own operations. Today, however, private equity firms' senior partners are too stretched to micromanage teams deployed across many more asset classes, regions and sectors. Inattention to strengthening the firm's organization and culture can be a fatal shortcoming in the challenging period ahead. LPs tell us that, second only to a firm's performance, their most important criterion in selecting a firm with which they will invest is the cohesiveness of its teams. Through our work with leading organizations, Bain & Co. has found that the high performers have fast, effective decision-making skills at their core and share four key operational traits. First, they set clear priorities for creating value and communicate these consistently to the organization. Second, they put the right people in the right jobs and focus them on the right objectives through incentives that reward performance. Third, they adhere to formal decision rules and assign specific roles. Finally, they link robust decision-making procedures to well-tuned business processes for effective execution. Together, these qualities forge a unique organizational identity that is externally focused and made up of people who think like owners, prize teamwork, and are wired to win. Top private equity firms are resourceful at adjusting to new conditions, and today's challenges will test that resilience. Leading firms already know how to create winning results in their portfolio companies. They, and other firms that would emulate them, now need to apply these skills to themselves and etch a blueprint for success in the new environment. Tim O'Connor and Andrew Tymms are partners with Bain & Company and are members of the firm's Private Equity Group. They are based in Bain & Co.'s Boston and London offices, respectively. Based in Toronto, Catherine Lemire is a senior director and practice manager of Bain & Co.'s Private Equity Group.

The past year's economic upheaval ended private equity's long "golden age" of debt-fueled mega-deals and big returns.

In the benign period that preceded the downturn, private equity firms did not have to put much muscle into generating attractive returns. A Bain & Company analysis of investment conditions between 2002 and 2007 found that the benefits of leverage, expanding price-earnings multiples in a rising equities market and GDP growth accounted for nearly all of their returns. Clearly, some industry leaders did create value in their portfolio companies, and their active ownership was rewarded with superior returns. However, there is little evidence that private equity owners, overall, added value during this period.

Turbulent times-as private equity firms are facing now-create once-in-a-career experiences fraught with extraordinary opportunities and risks. Bain & Co. research has found that companies make more dramatic gains or losses from the actions their executives commit to during downturns than at any other time, and those results are more likely to be sustained through the next boom cycle. Recognizing this, many private equity firms are aggressively maneuvering to tap potential new sources of growth. But piecemeal moves that are dictated by expediency usually lack a strong strategic rationale and end up being poorly executed.

Instead, private equity firms need to apply to themselves the same disciplines the most successful firms use to create sustainable value in their portfolio companies-namely, to define a clear strategy for competing effectively in their markets and put in place a focused blueprint for delivering it. The private equity firms that emerge with strategies that set them apart from their peers will be able to answer five questions:

1. Where should we play in order to win?

The private equity universe has expanded over the past decade, and firms face a complex new set of investment decisions. Beyond traditional buyouts, opportunities now extend to a wide range of asset classes-from debt, mezzanine, and bridge financing to real estate, infrastructure, and natural resources-with broader geographic reach. More than half of the biggest private equity firms over the last five years are now active across multiple asset classes, and more than 80 percent invest in regions beyond their home base.

But diversification produces ambiguous results. Indeed, our analysis has found little correlation between the number of asset classes or geographies in which a firm invests and its overall performance. Purported synergies across asset classes are limited in terms of the capabilities the firm requires, the networks it can tap, and the costs that can be shared. And interviews Bain & Co. conducted recently with limited partners reveal that most do not place a premium on firms that bridge several asset classes or geographies. Rather, they evaluate each fund opportunity on its own merit.

Successful firms make diversification work by taking a disciplined approach. They evaluate each opportunity's economic attractiveness and its competitive intensity. In parallel, they weigh their firm's ability to leverage its strengths, such as an in-depth knowledge of select industry sectors, a productive network of relationships, and distinctive investment capabilities.

Then, for each asset class and region they choose to participate in, they carefully define their investment "sweet spot"—in other words, the types of deals they prefer to do based on dimensions such as industry sector, size, degree of control and investment thesis. Recognizing the increasing importance of focus in their strategies, many leading firms are making the shift from generalist investors to intelligent risk-takers by specializing in just a handful of industry sectors.

2. What's our unique proposition to investors that will enable us to raise new funds?

In recent surveys, some 90 percent of pension funds, endowments, financial institutions and other traditional private equity investors said they plan to maintain or increase their target allocation to private equity funds over the coming year. But firms that aim to tap new capital from familiar sources will need to reckon with significant new realities.

For one thing, the industry faces a huge capital overhang-some $1 trillion in uncalled commitments from earlier funding rounds. That will severely test firms' ability to attract new funds from investors who are pressed to meet prior pledges at a time when private equity distributions from investments already made, but not yet monetized, are sparse. In addition, the challenging private equity environment has led LPs to insist on better governance, greater transparency about fees, and closer alignment of interests with general partners.

As power tips to LPs, fund-raisers need to sharpen their differentiation from their competitors. Research has found that, by choosing the basis of comparison that most favors them, more than two-thirds of private equity funds are able to produce numbers showing they generate top-quartile results for their investors. But LPs will no longer fall for creative math that masks poor returns. More of them are applying a common set of metrics to evaluate the general partners' performance on a consistent basis. To secure new investment, private equity firms will need both a well-honed strategy and solid evidence to back it up.

3. How do we elevate our investment and ownership capabilities?

No longer able to rely on favorable credit-market conditions to do their heavy lifting, private equity firms need to differentiate themselves, by building skills that enable them to add value across the entire investment cycle from deal sourcing to exit. Sector specialization, mentioned earlier, enables firms to mobilize proprietary insights about sector trends and tap networks of industry insiders to give them an edge in sourcing and screening good deals and winning the best ones. Following an acquisition, sector insights also enable private equity owners to set strategic direction, improve performance and build value.

Most private equity firms pay only lip service to the notion of hands-on value creation after transactions are closed. They may impose a "100-day plan" on their new portfolio companies, but frequently these are long "to do" lists for CEOs to satisfy the new owners and police performance, rather than guidance that fundamentally redirects operational and resource-allocation priorities. Private equity leaders, by contrast, flex their muscle as activist owners with a robust, repeatable engagement model. Immediately following an acquisition, they develop a blueprint that defines the business's full potential, prioritizes three to five critical initiatives to reach its target equity value, and specifies milestones for hitting it. Meeting regularly with management, they track key metrics to ensure the program is on course, use an early-warning system to alert them when targets are missed, and intervene quickly.

4. What role does the center need to play to support the firm's strategy?

The business of running a private equity firm has never been more complex. New legal and compliance issues are making the firm's administrative roles more demanding. Fundraising challenges and more discriminating LPs have ramped up the need for more sophisticated investor communications. Helping their investment teams operate across asset classes, regions and sectors adds new dimensions of responsibility for strategic planning and for managing the firm's brand, talent and knowledge.

Thoughtful firms are beginning to recast their administrative centers to perform a role we call "strategic architect." Instead of adopting a hands-off approach to serving largely autonomous investment teams or concentrating control of all major functions in the center, strategic architects serve as strategy enablers. They coordinate overall direction setting, recruit and train top talent, foster the sharing of insights across investment teams and take the lead in fundraising and managing investor relations.

At the same time, strategic architects are careful to take on only support services they can perform effectively and efficiently. They periodically reassess whether the activities the center performs are necessary, would be better delegated to the business units, reengineered or outsourced. When one leading private equity firm ran more than 60 central support services through this assessment filter, it found opportunities to cut costs, upgrade, delegate or contract out more than half of them.

5. How do we become a high-performance organization?

Private equity firms have long fixated on hiring top talent and building strong organizations in their portfolio companies, but too often they seemed willing to tolerate convoluted reporting structures, ambiguous career paths and ad hoc decision-making processes in their own operations. Today, however, private equity firms' senior partners are too stretched to micromanage teams deployed across many more asset classes, regions and sectors. Inattention to strengthening the firm's organization and culture can be a fatal shortcoming in the challenging period ahead. LPs tell us that, second only to a firm's performance, their most important criterion in selecting a firm with which they will invest is the cohesiveness of its teams.

Through our work with leading organizations, Bain & Co. has found that the high performers have fast, effective decision-making skills at their core and share four key operational traits. First, they set clear priorities for creating value and communicate these consistently to the organization. Second, they put the right people in the right jobs and focus them on the right objectives through incentives that reward performance. Third, they adhere to formal decision rules and assign specific roles. Finally, they link robust decision-making procedures to well-tuned business processes for effective execution. Together, these qualities forge a unique organizational identity that is externally focused and made up of people who think like owners, prize teamwork, and are wired to win.

Top private equity firms are resourceful at adjusting to new conditions, and today's challenges will test that resilience. Leading firms already know how to create winning results in their portfolio companies. They, and other firms that would emulate them, now need to apply these skills to themselves and etch a blueprint for success in the new environment.

Tim O'Connor and Andrew Tymms are partners with Bain & Company and are members of the firm's Private Equity Group. They are based in Bain & Co.'s Boston and London offices, respectively. Based in Toronto, Catherine Lemire is a senior director and practice manager of Bain & Co.'s Private Equity Group.