Private Equity Active Management:  Using Outside Operations Support to Complement Inside Leadership

For several decades now, as financial engineering opportunities fade and assets under management have grown, private equity firms have increasingly focused on active management to deliver the double-digit returns expected by investors. Even in the heady years leading up to the Recession, McKinsey research found that operational investments in portfolio companies generated superior earnings and value.

With a focus on both revenue generation and cost reduction initiatives, PE firms generally rely on a mix of outside expertise, operating partners and internal operations groups. The structure, responsibilities and day-to-day of involvement of these operating groups expands and contracts over the life of a fund. Determining what capabilities to develop in-house and when to hire outside help is always a complex and multi-dimensional decision.

In addition to availability, focus and ownership, having operations expertise in-house sends a signal to portfolio companies and investors that the PE firm is actively managing its investments. As is often the case, appearances don’t always translate into results.

Here are five instances when it makes strategic sense to complement in-house operational leadership with outside support.

  1. Capacity and Speed

    Following the Recession, the average time that PE firms held onto buyout investments rose steadily to almost six years, well outside the typical three- to five-year holding period. While that expansion was driven by a poor exit environment, and the holding period has declined recently, outside help makes it possible to implement operational efficiencies faster and realize earnings gains sooner.

  2. Independence and Focus

    Because they are contracted to perform specific work, like due diligence, external advisors are less beholden to making a deal and less likely to be subject to any in-house cross functional conflict. They can focus 100% on the merits and weaknesses of a particular deal without being pulled in multiple directions, as in-house resources often are.

  3. Clear Cost Allocation

    In recent years, the SEC has collected multi-million dollar penalties from PE firms that allegedly misallocated expenses. It’s more transparent to allocate the costs of a contracted 1099 resource to a deal and portfolio company.

  4. Industry & Operational Expertise

    As a fund’s investments grow, the portfolio companies will naturally become more diverse. Internal operations teams often lack the specific industry experience that can drive change and generate value quickly. Take the automotive sector as an example. Even if an operating partner has some industry experience, and understands OEMs’ stringent demands, automotive suppliers are so diverse it’s unlikely that he or she will have the optimal technology and production expertise.

  5. Back-loading Expenses

    Prior to the due diligence phase, a trusted outside partner can provide valuable advice while minimizing a PE firm’s costs before a letter of intent is signed. Trusted partners will often execute these pre-LOI reviews at a minimal expense. Such exploratory work can be executed by smaller teams that expand as needed when a deal is more thoroughly vetted.

Those are just five occasions when outside operational expertise can help PE firms evaluate potential deals and improve the performance of portfolio companies faster. As we like to say at TBM, speed always wins with operational due diligence. In the case of PE company holdings, as noted above, the faster that the targeted operational improvements are realized, the sooner the primary focus can turn toward revenue and earnings growth.