The Private Equity Pivot: 4 Ways Private Equity Will Reset in 2011

The private equity industry appears to be in rough times. Investment returns have not rebounded to pre-2007 levels and they look to remain stagnant, as cheap and plentiful debt is scarce, valuations are subdued and economic jitters plague confidence globally. These conditions are negatively impacting the sector’s ability to raise capital and successfully exit investments with good multiples. The industry has other challenges too, including rising costs, bad press, and market maturity – many large institutional investors have already maxed out their PE investments within their asset allocation mixes.

If PE is going to regain yearly historical returns of 20% or more, the traditional model built on financial engineering (taking on debt, waiting on rising valuations, etc) and one-time cost reduction (headcount and capacity cuts, etc) must evolve. For one thing, few firms can continue to stand out from their peers based on their corporate finance capabilities. Furthermore, valuations remain stubbornly low (post write downs) despite fat trimming within the portfolio companies.

Reigniting historical returns is possible. PE managers should begin focusing on organic revenue growth in their portfolio. This is not a novel strategy. Some firms like Bain Capital have been doing this for years to generate industry-leading returns. This formula moves beyond slash and burn cost cutting and swapping management; it is about working with existing managers to tap new markets, foster product innovation, and leverage existing technology and operations into new revenue-generation activities. This new PE value creation model is also about developing internal sales, marketing, and product management skills, leveraging their Rolodex (or LinkedIn account), and rolling up their sleeves as interim hands-on managers and consultants. Four examples of this new approach:

Add and Deploy Experts

Some firms like TPG, KKR and Bain Capital have internal consulting groups whose mandates are to drive portfolio growth by improving revenue generation and operational performance in key areas such as sales force effectiveness, “lean” management, and pricing optimization. In some cases, this support is in the form of advisory services. In other cases, it’s about embedding expert PE management at the portfolio company. PE firms are well suited to add value, fast. They can bring a bias-free approach, implement cross-industry best practices, and deploy expert management quickly. Those PE firms lacking TPG’s scale or Bain’s pedigree should form strategic alliances with industry leaders and consultants.

Reframe Earnings Generation

Focusing more on growth will require PE firms to adopt a different paradigm when looking at market potential. One proven approach for mature markets is to focus on the available market “headroom” – the market share a firm does not have minus the share it will never get. Headroom-focused PE firms concentrate their efforts and capital solely on how many potential customer switchers are available, what their needs are, and what is missing in the existing product offering. Adopting a headroom-based organic growth strategy will increase marketing effectiveness and efficiency, thereby boosting earnings faster, improving resource allocation and conserving scarce capital – in many cases generating self-financed growth.

A Win-Win…

Having demonstrable growth competencies will ultimately help PE firms in their two core missions. First, fund raising efforts will be aided by improving a firm’s industry differentiation through offering an alternative value creation model. Second, PE managers can improve deal making win rates by leveraging enhanced risk management and analytical capabilities.

…If You Can Execute

Unfortunately for many firms, becoming an organic growth multiplier won’t be trivial. Today, most PE firms lack internal expertise and experience as well as operational mindset. Moreover, PE managers will inevitably discover what their investee managers learned eons ago: execution is not easy. Nonetheless, every PE firm will have to adapt to new market and business realities. Focusing on organically growing portfolio companies will be an attractive option for many firms.

This featured guest post is written by Mitchell Osak, Managing Director at Quanta Consulting. Mitchell is a management consultant with 20+ years of consulting and senior operational experience in a variety of Fortune 1000 firms. Mitchell can be reached at [email protected] or mitchellosak.wordpress.com.