Value-creation in Middle Market Private Equity

John A. Lanier

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9781472444455
• eBook ISBN: 9781317002734
• Topic: Business
• Subtopic: Business General
• Index: Business

Value-creation in Middle Market Private Equity by John A. Lanier holistically examines the ecosystem relationships between middle market private equity firms and their portfolio companies. Small business is the job creating engine in the US economy, and consequently is a prime target market for private equity investment. Indeed, private equity backs over six of each 100 private sector jobs. Both the small businesses in which private equity firms invest, and the private equity firms making the investments, face inter- and intra-company fiduciary leadership challenges while implementing formulated strategy. The architecture of each private equity firm-portfolio company relationship must be uniquely crafted to capitalize on the projected return on investment that is memorialized in the investment thesis. Given the leveraged capital structure of portfolio companies, the cost of a misstep is problematic. Individual private equity professionals are typically members of multiple investment teams for the firm. Not only may each investment team have its own unique leadership style, but its diverse members have to assimilate styles for each team in which they participate relative to a specific portfolio company. Acquisitions and their subsequent integrations add exponential complexity for both private equity investment and portfolio company leadership teams; indeed, cultural integration ranks among the most chronic acquisition obstacles. Accordingly, the stakeholders of private equity transactions do well to embrace leadership best practices in applying value-creation toolbox best practices. The perspectives of both the private equity investment team and the portfolio company leadership team are within the scope of these chapters.

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Chapter 1

Introduction

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The only true wisdom is in knowing you know nothing.¹

Small business is the job creating engine in the US economy. Private equity investment is a significant source of small business capital. Both the small businesses in which private equity firms invest, and the private equity firms making the investments, face intra-company leadership challenges as they grow. Moreover, there are inter-company leadership challenges. The fiduciary responsibilities of the private equity firm necessitate an activist board role. This posture carries over into the portfolio company’s daily operations.

The complexities continue. Individual private equity professionals are typically members of multiple investment teams for the firm. The teams may be characterized by mixed membership, as the investment teams may not be identical across the portfolio companies they support. Not only may each investment team have its own unique leadership style, but its diverse members have to assimilate styles for each team they support relative to a specific portfolio company.

Finally, acquisitions are high probability scenarios for portfolio companies during the investment hold period. Acquisition integration poses yet another leadership challenge as the acquiree must be integrated into the acquiring company. Cultural integration ranks among the most chronic acquisition obstacles. Given the leveraged (debt-heavy) capital structure of portfolio companies, the cost of a misstep is painful. Accordingly, the stakeholders of private equity transactions do well to embrace leadership best practices in their value-creation toolbox, especially with regard to the more chronic challenges of value-creation in the middle market.

The objective of this book is imparting holistic value-creation best practices gleaned from working with both private equity investment professionals and their portfolio companies. Each stakeholder encampment possesses accretive core competencies. However, both have room for improvement in how they: (i) perceive each other; and (ii) collaborate with each other to realize the shared objective of value-creation. As with many solutions to puzzles, the essence of a challenge must be distilled to its fundamental elements before root causes are clear and viable solutions are embraced by constituents. This odyssey fares better when complexity is displaced with simplicity. Such is the aim of this book.

What is Private Equity?

The most important single about a free market is that no exchange takes place unless both parties benefit.²

The objective of this section is to provide a basic explanation of private equity to non-investment professionals. Beginning in the Clinton administration, the term “investor class” was brandished to explain that the majority of households own public equities. This tends to be in the form of their workplace 401k or some similar vehicle. These 401K investment options include a menu of various mutual funds. For example, Fidelity Magellan is one of the most renowned mutual funds. Individuals and corporations may contribute to the fund. Professional investors manage the fund. Funds have different investment personalities. For example, Morningstar, a popular fund rating medium, classifies funds as domestic stock, international stock, municipal bond, and taxable bond.³

Private equity mirrors a similar model to mutual funds—but predominantly “privately,” that is to say, not on a traded exchange. This means that access to this option is not open to the general public. Private equity and venture capital investors are different. Whereas private equity investments tend to be with established companies with appetizing growth prospects, venture capital investors pursue start-ups or early-stage businesses.⁴

Private equity firm organizational structure may be more easily defined in legal terms than in managerial terms.⁵ The mechanics are as follows:⁶

• A private equity firm tends to have a legal status as general partner of a limited partnership that manages a fund on behalf of investors.

• “Fund raising” entails a targeted amount of money for a specific fund, e.g., $400 million. The private equity firm solicits potential limited partners whose individual commitments total the size of the fund. The commitment lasts upwards of 10 years, i.e., the life of the fund. The typical private equity portfolio company investment lasts about five years.

• Private equity firms typically manage several funds whose lives overlap.

• The limited partners tend to be institutional investors and wealthy individuals.

• The private equity general partner, on behalf of the fund limited partnership, pursues investments in attractive opportunities. The investments may be controlling or minority.

• Size of prospect and industry vertical are other common distinguishing characteristics. The term “industry vertical” regards the preferred industry in which a particular private equity firm specializes and prefers for investment. Private equity firms tend to invest in more than one industry vertical.

• The true focus for investment professionals is EBITDA (earnings before interest, taxes, depreciation, and amortization) as a measure of cash flow.⁷ Private equity transactions are sometimes described as leveraged buyouts (LBOs) because of the substantial amount of associated indebtedness. Free cash flow is a key variable in determining the amount of debt the company can support in the capital structure. Accordingly, the private equity firm would much prefer a smaller sales volume with a strong EBITDA margin than a large sales volume with a modest EBITDA margin.

• Firms earn a modest maintenance fee on the fund; however, this is not how the firm makes the bulk of their income. Rather, the firm participates in the gain—when the investment is sold—after the limited partners experience a minimum return threshold. The maintenance fee is reimbursed to the limited partners from the firm’s share of capital gains.

• An “investment thesis” encapsulates the private equity firm’s objective for the portfolio company investment.⁸ “Investment thesis” and “strategy” are functionally interchangeable terms.

Private equity may be considered among the poster children of agency theory. The firm investment professionals may accomplish significant economic rewards for producing attractive financial returns for the fund limited partners. These returns commonly eclipse the returns of blue chip stocks traded on the New York Stock Exchange. However, the investment professionals’ agency may be considered holistically beyond financial engineering. Keen focus is applied to fiduciary responsibilities. Private equity firms manage investments by proxy through their portfolio company leadership teams. This is one of the things that make private equity so fascinating. Not only does the firm have to execute its business model functions effectively, but the firm’s ultimate success is predominantly reliant on its influence over the leadership of the portfolio companies creating the enterprise value for the fund’s (and its limited partners’) benefit. Therefore, a Sword of Damocles scenario looms omnipresent. Private equity firms are only as good as their last fund’s performance. Thus, the pressure to produce results never subsides.

A sample of salient statistics substantiate the economic impact of private equity:

• Private equity firms manage an estimated global asset value of $2 trillion.⁹ Prequin defines “assets under management” as “the uncalled capital commitments (dry powder) plus the unrealized value of portfolio assets.”¹⁰

• In 2013, private equity firms consummated 2410 transactions. Fifty three percent of these were add-on acquisitions to existing private equity portfolio companies.¹¹ Using the “middle market” definition of $5–$25 million of EBITDA rationalized later in this chapter, and applying Bain & Company’s average transaction valuation EBITDA multiple of 4.7,¹² this corresponds to approximately half of all 2013 private equity investment transactions.

• At the end of 2013, 2797 US private equity firms comprised $426 billion in equity investment across 17,744 companies employing 7.5 million people.¹³

• The 2797 firms referenced above are in excess of half the 5200 estimated active global private equity investors.¹⁴

• Private equity portfolio companies employ approximately 6.5 percent of the 115.5 million 2013 year-ending private sector workforce.¹⁵

• “Through 2012, private equity funds worldwide have distributed more than $1.4 trillion to limited partner investors.”¹⁶

• “As of September 2013, private equity outperformed the S&P 500 Index by 1.0 percentage points and 6.6 percentage points for the five- and ten-year periods.”¹⁷

• In 2011, approximately 150 public employee pension funds invested about $220 billion, or 11 percent of their assets in private equity. The pension funds actually increased their relative holdings from 8.6 percent.¹⁸

• “The biggest investors in private equity include public and private pension funds, endowments and foundations, which account for 64 percent of all investment in private equity in 2012.”¹⁹ The rationale i...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Dedication
• Contents
• List of Figures
• List of Tables
• Foreword
• Preface
• 1 Introduction
• 2 Primary Diligence Issues: The Trifecta of Oversight
• 3 The Private Equity “Operating Partner”
• 4 The DNA of Packs
• 5 The Importance of Strategy
• 6 Innovation and Value-creation
• 7 Marketing versus Selling
• 8 Leadership Choices and Organizational Design
• 9 Change-management Competencies: A Competitive Ace
• 10 The Legacy Effect
• 11 Wrapping It Up
• Index