I’m very novice when it comes to Private Equity (PE) world. I am learning as much as possible in a short amount of time; luckily I am currently associated with one of the best PE firms in Asia called Mekong Capital that has started a major shift in its value creation towards Operational Value Creation under an umbrella called Vision Driven Investingframework.
Operational value creation goes far beyond slashing costs or implementing a land-grab for revenue growth. A sustainable operating model should be established to execute on the corporate strategy, but without jeopardizing efficiency or flexibility. Over the last 15 years, the private equity (PE) fund model has become a mainstay in the portfolios of the world’s largest institutional investors. As PE assets under management increased five-fold during that time, the industry has rapidly matured and prospered through a series of business cycles and extreme market dislocations. Although the illiquidity of PE investment often restricts fund allocations to single-digit percentages, repeated findings in academic and for-profit research citing the industry’s outperformance relative to public equity markets underscores its importance in a balanced portfolio. But what has produced this outperformance? And, more broadly, how do successful PE fund managers (general partners, or GPs) consistently and repeatedly generate value for investors (limited partners, or LPs) over time? Skeptics have long pointed to a combination of job cuts and “financial engineering” — i.e. the aggressive use of leverage — as private equity’s secret sauce. GPs, on the other hand, have increasingly of late pointed to operating teams and operational value creation as the key driver of value creation in PE. INSEAD has a very good article on this topic.
As such, many PE firms are evolving the skillsets of their teams and opting to establish in-house operational specialists, in addition to deal makers and portfolio managers. The extent of a PE firm’s operational involvement in the portfolio companies can vary from being a silent partner, active monitor, or owner and operator. In fact, most opt to install entire leadership structures into portfolio companies and implement big-scale performance improvement projects. Or as Bain & Company says: we have outlined four archetypal approaches to creating value at portfolio companies (Figure 2):
The adviser-led model. PE firms that adopt an adviser-led approach typically take a less interventionist approach to their portfolio companies. They will selectively lean in on particular investments to help shape the management team’s goals and supply resources to help deliver on those goals. Adviser-led value creators typically eschew dedicated portfolio teams and instead assemble a network of external experts who can address specific needs.
The functional playbook model. Some activists take a more hands-on prescriptive approach to creating value in portfolio companies. PE funds that adopt the functional approach typically employ full-time experts who implement a dedicated playbook with initiatives that improve business processes, reduce costs or deliver other operational improvements by digital transformation.
The maestro model. This model places considerable emphasis on early, high-level and continuous engagement with portfolio management, but is well suited for PE funds that lack the resources or the desire to staff expensive in-house operating teams. PE funds that adopt the maestro approach typically designate a seasoned leader within the firm to coordinate a flexible team comprising deal team members and external resources to develop and implement value-creation plans.
The general-activist model. Some larger PE funds build portfolio activism into their DNA. Their multidisciplinary operating teams bring a high level of engagement to each investment. These dedicated multidisciplinary portfolio groups work closely with the newly acquired companies to provide deep strategic analysis, support the development of value-creation blueprints and help management teams put them into operation.
EY’s analysis reveals that approximately half of the operational value created is generally attributable to sales growth, with the remainder coming from margin and free cash flow improvements. When assessing how best to extract value from operations, some typical considerations include:
- Sales growth: Establish an appropriate management reporting framework to expose underperforming components of the business (i.e., products or markets), and complete market studies to develop a route-to-market that will improve price, volume, and product mix.
- Direct cost value creation: Improve the efficiency of facilities and enhance asset utilization. This would typically include footprint consolidation, supply chain management, labor productivity assessment, and improving network efficiency.
- Leveraged sourcing: Spend analytics and sourcing solutions to drive cost savings across portfolio companies. Components of this include portfolio spend classification, and spend data analysis to examine variances by segments such as category, supplier, or region.
- Indirect cost value creation: Transform general and administrative functions to drive margin improvement. This may include headcount consolidation, such as increasing span of control, combining roles, reducing layers of management, and increasing usage of low-cost staff; outsourcing; facility rationalization; establishing shared services; customer service productivity improvements; and lean R&D and engineering.
- Information technology value creation: Short- to medium-term implementable solutions to improve performance across all business processes. This may include application rationalization; infrastructure consolidation; cyber security; emerging technology such as digital, advanced analytics, big data, digital marketing, mobile app development, design thinking, customer experience; and enterprise intelligence.
- Processes and performance: Design process improvements and operational excellence to sustain competitiveness. Are there processes that could be automated or standardized? Are there activities that are undertaken that are no longer valid or adding value? Are there activities for which the frequency could be reduced?
- Free cash flow: Improve cash flow forecasting and implement tighter working capital management in order to reduce cash requirements and increase future free cash flow.
Well, that is what I do when I am working at Mekong Capital which is challenging but that is how we re-invent private equity together and achieve our 5x vision.