A common refrain was echoed time and time again at a recent dinner with several PE deal partners, “There are too many PE firms today chasing the same number of deals as in the past and our returns are suffering because of the required purchase price multiple.” The only way Private Equity professionals can continue to generate risk-related returns greater than those in the stock market is by partnering with operating executives earlier in the deal process.
As the Private Equity market has transitioned from a cottage industry to a more mature asset class, it has become harder and harder to generate the returns needed to consistently outpace the more traditional equity markets. According to Preqin, a London-based research house, there were 24 Private Equity firms in 1980. In 2015 there were 6,628, of which 620 were founded in 2015 alone and approximately 50% of all these funds are located in the United States. Even simple supply and demand theory would suggest that there are too many funds chasing a finite number of investment opportunities and that returns (and Limited Partners) will bear the brunt of this evolution.
This scarcity of differentiated deal flow combined with the fact that most private equity professionals have learned to generate returns through a healthy dose of financial engineering taught at top business schools, creates an added problem of using a similar playbook – even if you are lucky enough to win an auction… How can one PE firm differentiate themselves from another in this difficult environment and gain the conviction needed to pay a market clearing multiple?
The answer is operating expertise. As fun and exciting as it is to build financial models, they are almost always wrong at the end of an investment period because predicting the future is impossible and models are static. If you take two companies of similar size and in a similar sub-sector of the economy – the financial models will often produce a similar outcome. In reality, one company ends us tripling in value and the other hardly grows at all – why? The regression analysis suggests it is all about the executives and their ability to pivot and transition the company during that ownership period to generate differentiated alpha and this comes through operations and not pure financial engineering. In fact, most of the time, the right decision for Private Equity professionals is not to buy the asset they are reviewing (for hundreds of reasons in addition to price) and the right executive can help deepen the conviction to both buy and pass on opportunities.
So, if it is all about the differentiated alpha and all about the executives that can drive this through operating expertise, how does an executive break into the world of Private Equity to monetize his or her expertise in driving value and how do private equity firms discern which executives are actually best in class and able to generate top decile returns?
The answer is finding those professionals that believe they are in a privileged position to work with the top executives around the world, who take the time to learn more than just what an executive’s resume highlights as historic accomplishments, and appreciate how they have been successful – their personal and professional style.
Many deal partners themselves spend time with operating executives because of this fact but the ebbs and flows of closing deals often causes this effort to be disjointed and inconsistent. Another way this has evolved is through Operating Partners within the PE firm that are hired to help bring this type of insight to the investing professionals. This role has grown substantially over the past 15 years and these Operating Partners can get carry (share in the equity and upside of deals) in both deals they work on and in the fund itself. There are also firms where this insight into generating alpha through operational expertise is married with the knowledge gained through working with the most successful PE firms over the past 20+ years and the specific PE partners at these shops to put the right operators with the right investors based on their collective style and operating expertise. In short, the more conversations an operator can have with PE firms before they are looking for their next role, the greater the chances he or she can find the right fit, for the right asset, at the right price. This all translates to maximizing the returns for both the PE firm and the executives in their collective quest to drive differentiated alpha.