Part 5: The Private Equity Spectrum

As mentioned early on, private equity’s inner workings have always seemed to be somewhat of a black box. In speaking to executives day in and day out over the past 13 years, it became apparent to me that lifting the curtain would be beneficial - both to help executives learn more about it for their own career path, and to attract a whole new universe of high caliber talent to the private equity space. So far in this Thrive Blog Series, I’ve covered a lot of private equity ground (links to the entire series are included below) - an introduction to private equity, the secret sauce that gives firms their returns, how they target acquisitions and their primary measuring stick (EBITDA). I’d like to dig in a little deeper on the differences between private equity firms this week.

Financial vs. Operational

I look at private equity as a spectrum where on the one end you have purely financial investors and the other end you have heavily operational investors. Purely financial investors are looking for companies to buy as a vehicle to invest their LPs’ money. They choose carefully and they always either back, or work with firms like Thrive to install, professional management teams to run these companies. They tend not to get involved in day to day operational management. They give their leadership teams the targets to achieve and they expect them to do their job. We see these firms get involved in a more micro fashion when one of their companies is not doing well and starts missing its targets. But more often than not, instead of taking over themselves, they simply call us to bring in a new CEO, or management team, who will be more successful for them.

On the other end of the spectrum, you have operational investors. These firms are heavily involved in the day to day running of their owned companies and many of them come from industry executive positions themselves. They believe they can help their portfolio companies achieve greater success by tapping into their own experience, resources, knowledge and relationships. They are often in the trenches with the management teams, sharing in the glory and the agony.

The majority of PE firms fall somewhere in the middle of the spectrum and incorporate a bit of both approaches. They may stay involved in decision-making but not in the hands-on running of things. Or they may leverage Operating Partners, a very common approach in today’s private equity market. While the title can mean extremely different things at different firms, typically an Operating Partner is from industry and works closely with the portfolio companies under his/her purview. A common model is for an Operating Partner to have anywhere from 3+ portfolio companies that they are responsible for, much of the time, as Chairman of the Board or a member of the board at the least. Their day to day responsibilities vary depending on the firm. In some firms, the Operating Partner steps in as an interim executive, or is at least deeply involved in daily decisions and strategies. In other cases, they are simply monitoring their companies ensuring they are staying on the straight and narrow. Bigger private equity firms investing in bigger portfolio companies often use the latter model while many smaller and middle market private equity firms take the more active approach.

Culture

Culture is certainly worth mentioning. Again, it’s a broad spectrum - you have everything from white shoe highly formal firms to tech-like relaxed cultures. You can see and feel the differences when you walk in the door or join a Zoom call. Culture also affects communication and interaction with the portfolio companies. Some prefer highly formal communication processes, others talk to their companies multiple times a day. I always tell our executives (and target companies) to find firms where they relate well to the culture to ensure there will be a strong fit. Are you a formal executive or do you prefer no hierarchy? In my opinion, private equity in general is pretty conservative by nature. That said, we are definitely seeing more and more of a shift toward the increasingly relaxed culture of today with hybrid and remote work. In order to attract the next generation, companies have to be somewhat malleable on their approach here. I find that the tech and healthcare focused private equity firms already tend to be more relaxed and less conservative. It’ll be interesting to watch as it permeates through to the more conservative manufacturing, energy and transportation focused firms among others.

Formula vs. Emotion

Formula versus emotion is a theme throughout this series. Private equity firms are 150% formulaic in nature, they are not emotional entities. I’m not talking about the individuals that make up each firm, I’m talking about the collective decision-making body. In my experience, there is nothing emotional that goes into making a decision about what to buy, where to invest or who to hire. It is ALL data and formula related. The proprietary strategy that each firm leverages is the objective measure by which almost all decisions regarding where to spend their time and money are made. We are all emotional beings - some more so than others, but still, most of us have strong opinions and get swayed in our day to day lives by who and what we like and what we think. Private equity firms are not. The good ones anyway. They collectively, with their LPs, define what it is they are after, and they hone their experience until they are able to measure a company’s worth by their formula in their sleep. Sometimes Company Founders let emotions get in the way when selling their companies to private equity firms which is only natural. Similar to selling our own homes, this is why we have real estate agents. We are too close and emotionally attached to our own homes to value them objectively. Founders are better served listening to their investment bankers and being as objective as possible about the current market they are selling into. They should take their bankers’ advice about prepping and staging their companies for sale to fetch the highest price. They won’t be successful trying to convince a PE firm to see the intrinsic value that they hold dear. The PE’s job, on behalf of it’s Limited Partners, is to make sure they stay 100% true to their mission and adhere to their guardrails. The sooner in a process that a company recognizes that it cannot pitch on emotion, the better job they will do in selling themselves on their underlying value. Understanding and being prepared to sell on data, measurable value and results will give them a leg up on the other entrepreneurs and companies that still think they can sell their “goodwill” or that they can make the PE understand (and value) their softer assets. Since PE partners are people, they can individually get wrapped up in their own biases, but if they are worth their weight in salt, they will look at it as per their fiduciary duty and always come back to the firm’s proprietary formula for investing.

Leverage

Leverage strategies are also fundamentally different. Pre-2008 crash, available credit was everywhere and many firms jumped into private equity. We saw lots of hedge funds trying to change up private equity by offering a more attractive liquidity profile by investing in companies and exiting within a year. They were convinced they had found a new way to outperform traditional buy and hold models. There was also a lot of financial engineering going on in those days. Essentially, firms would buy asset-rich companies that they could load with lots of debt. They would then go and acquire numerous other companies to grow the balance sheet, using the cash to pay down their debt and voila, they generated a great return on investment. That all came crashing down when the markets literally stopped providing credit. A lot of firms lost a lot of money doing this. But it seemed to me the markets ended up stronger as a result. The firms who shouldn’t have been doing private equity were wiped off the private equity map and those left were the ones truly creating value.

It also reset the barometer for the industry and we started to see a fundamental shift to value creation, including more of an emphasis on the revenue generation side versus just cost cutting and streamlining to generate returns. There was a new focus on growth - companies today are expected to enter new markets, develop introduce new products and technologies, expand internationally etc. Acquisitions are still very important, but it became and still is more about buying value, not just scale or cash rich balance sheets. Leverage also remains an important part of private equity, but we don’t see crazy leverage as often these days as was quite common pre-2008. Today, while there are innumerable variations on this, most private equity firms are looking to buy companies where they can add real value through both institutionalizing/professionalizing the operations as well as rapidly growing the business.

Stay tuned for my favorite topic coming up soon - All About Talent.

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Click Below to Catch up on our Blog Series: Private Equity is Not a Black Box

PART 1 - Introduction to Private Equity

https://www.thriveresources.com/news/2022/4/19/private-equity-is-not-a-black-box

PART 2 - The “Secret Sauce” of Private Equity

https://www.thriveresources.com/news/2022/4/6/thrive-resources-blog-series-private-equity-is-not-a-black-box

PART 3 - The Down and Dirty on PE Acquisition Targeting

https://www.thriveresources.com/news/2022/5/18/part-3-how-pes-target-acquisitions

PART 4 - EBITDA - The BAEA (Be All End All)

https://www.thriveresources.com/news/2022/5/31/part-4-the-baea-be-all-end-all-ebitda

Susanna MaddenJune 7, 2022Comment