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Added value - from cliché to critical success factor

Private equity is becoming increasingly littered with catch phrases, such as ‘upper quartile' and ‘added value'. John Hartz of Inflexion argues that the latter of these two has grown in importance as investors focus their attention on it. No longer just a cliché but a critical factor behind a firm's success.

Up there with ‘top quartile', ‘added value' is surely vying for the number one slot of tired private equity clichés. The snag however, is that ‘adding value' to private equity portfolios is starting to become a bit of a burden for some groups, now that it is increasingly a focus of investor attention.

Traditionally, discussions about adding value in private equity is a discussion about how to work with portfolio companies, with the tacit assumption that multiple arbitrage is a market phenomenon that cannot be influenced. Undoubtedly if you buy and sell at ‘market' price through tightly run auction processes, the scope for adding value is pretty limited. However, not all segments in the private equity market are like that. Where Inflexion is focused, the lower end of the UK mid-market, directly negotiated transactions are the norm and so opportunity for adding value in the acquisition and disposal process is actually quite high.

With financial engineering skills commoditised and the opportunity for multiple expansion generally limited, the remaining major driver of private equity returns is the fundamental profits growth of the portfolio companies. It is the role of the private equity manager in assisting this growth that forms the core of the debate surrounding ‘added value'.

Monitoring

This debate is far from a new one. McKinsey has reported to EVCA a number of times on this subject and KPMG / Manchester Business School (MBS) have also recently published a study. One of the most interesting features of the KPMG/MBS study was the frequency with which UK private equity managers used the word ‘monitoring' when discussing their dealings with investee companies. In an era when returns came from multiple expansion, this ‘monitoring' became a relatively passive, reactive process focused on historic, financial information.

Despite the best efforts of the accounting profession, financial information can be manipulated to mask unsatisfactory short-term performance or trends. Most important things going on in a business eventually appear in the management accounts, but by then the damage has been done. It is therefore not surprising that another theme from the KPMG/MBS study was that private equity managers did ‘too little too late', i.e. they did not find out about problems early enough. (Another striking admission was that some felt they did not understand the business that they had invested in). One can only conclude that some houses have some way to go to turn their ‘monitoring' activities into something that can add value to their investee companies.

Asset Management

Private equity is after all a branch of asset management - something the industry would do well to take more literally. Asset management is about optimising performance of one's chosen investments over the holding period. Optimisation requires use of the whole toolkit - of being able to react to non-financial and financial indicators and to take action in changing market conditions. A key skill is to be able to manage change and not just manage it but to take advantage of change too.

One solution is to deploy a team consisting of both financially skilled, private equity executives and proven business operators. Whilst rare in our market segment, it is by no means a unique approach, having been adopted by groups such as Apax Partners and Permira more than a decade ago.

Getting beneath the numbers, to the key strategic and operational issues or opportunities facing investee companies, is where genuine value can be added. Experienced and respected business operators are best placed to do this and to work with management on relevant performance indicators for both management and the private equity firm to use to assess performance. Aside from this, there are also potential benefits for the private equity firm from multiple access points into an investee company, providing it, inter alia, with early warning of issues.

Other strategies adopted by private equity firms include setting up separate units of internal consultants to work with investee companies on their strategies. However you approach it, there is benefit in having a formal structure to direct one's efforts with the portfolio. Otherwise the temptation is for business operators employed in private equity firms to move from their areas of expertise into becoming private equity deal leaders - a metamorphosis that history suggests is not always filled with success.

No doubt the debate on how best to ‘add value' to portfolio companies will run and run. Certainly few private equity firms will raise much money on the back of claims that financial engineering and multiple expansion will again be the key drivers of their returns in the coming decade.

So, in a decade when ‘rational caution' is more likely to prevail than ‘irrational exuberance', being able to demonstrate that you can add value and help your investee companies generate earnings growth will be a key skill for private equity firms. Sounds like ‘added value' is becoming a critical success factor rather than a cliché.

Copyright © 2002 Inflexion

Inflexion Private Equity is a private equity investor focused on smaller UK mid-market buyouts.  Its management team combines both operational expertise as well as extensive private equity experience. For more information please visit www.inflexion.com