Resetting private equity in 2011

The private equity industry is in a funk, and for good reason.  Investment returns have not rebounded to pre-2007 levels and look to remain stagnant in the near term as cheap and plentiful debt remains scare, valuations continue to be subdued and global economic jitters plague confidence everywhere.  Importantly, these conditions are negatively impacting the sector’s ability to raise capital and successfully exit investments with good multiples.  At the same time, the industry is plagued by a host of other challenges including rising costs, bad press and market maturity – many of the large institutional investors have already maxed out their PE investments within their asset allocation mix.

The times they are a changin’

If PE is going to regain yearly historical returns of 20% or more, the traditional model built around financial engineering  (piling on debt, waiting on rising valuations etc) and one-time cost reduction (headcount and capacity cuts etc) will have to evolve. For one thing, few firms can continue to stand out from their peers based on their  corporate finance capabilities.  Furthermore, valuations remain stubbornly low (post write downs) despite fat trimming within the portfolio companies.     

Reigniting historical returns is possible. One way is for PE managers to begin focusing on organic revenue growth in their portfolio. This is not a novel strategy.  Some firms like Bain Capital have been doing this for years generating industry-leading returns. This formula moves beyond slash and burn cost cutting and swapping management;  it is about working with existing managers to tap new markets, foster product innovation, and leverage existing technology and operations into new revenue-generation activities.  This new PE value creation model is also about them developing internal sales, marketing and product management skills, leveraging their Rolodexes and rolling up their sleeves as interim hands-on managers and consultants.  

Examples of this new approach include:   

Adding and deploying expert bench strength

Some firms like TPG, KKR and Bain Capital have internal consulting groups whose mandate is to drive portfolio growth by improving revenue generation and operational performance in key areas such as sales force effectiveness, “lean” management and pricing optimization.  In some cases, this support is in the form of advisory services; in other cases, it is about embedding expert PE management at the portfolio company.  PE firms are well suited to add value, fast.  They can: bring a bias-free approach; implement cross-industry best practices and; deploy expert management quickly. Those PE firms lacking TPG’s scale or Bain’s pedigree can form strategic alliances with industry leaders and consultants.

Reframing earnings generation

Focusing more on growth will require PE firms to adopt a different paradigm when looking at market potential.  One proven approach for mature markets is to focus on the available market “headroom” – the market share a firm does not have minus the share it will never get. Headroom-focused PE firms concentrate their efforts and capital solely on how many potential customer switchers are available, what their needs are and what is missing in the existing product offering. Adopting a headroom-based organic growth strategy will increase marketing effectiveness and efficiency, thereby boosting earnings faster, improving resource allocation and conserving scare capital – in many cases generating self-financed growth. 

A win-win…

Having demonstrable growth competencies will also help PE firms in their two core missions.  Fund raising efforts will be aided by improving a firm’s industry differentiation through offering an alternative value creation model.  Additionally, PE managers can improve deal making win rates by leveraging enhanced risk management and analytical capabilities.

…if you can execute

Unfortunately for many firms, becoming an organic growth multiplier won’t be easy.  Today, most PE firms lack internal expertise & experience as well as an operational mindset.  Moreover, PE managers will inevitably discover what their investee managers learned eons ago:  execution is not easy.

Going forward, every PE firm will have to adapt to new market and business realities.  Focusing on organically growing their portfolio companies will be an attractive option for many firms.

For more information on our services and work, please visit the Quanta Consulting Inc. web site.

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