Where Does the Operating Partner in Private Equity Begin?
The operating partner in private equity has developed into a critical person (and group) for the PE firm and for the investments they become involved in.
What Is an Operating Partner?
Initially viewed as a career senior executive with deep experience and a good Rolodex, these executives provide operational credibility and periodic or situational involvement in the companies. They have, however, evolved into a firm asset and are critical to the culture and strategy. In a period where finding actionable deals is hard and accelerating growth is challenging, operating partners provide human capital and additional deal flow. Today these people are integrated into thesis validation on investments, diligence, and part of the deal execution and 100 day teams.
How much can operating partners ultimately drive in performance at the company level and fit in at the private equity firm, and where do they begin?
Numbers Don't Lie
A bit of background and perspective:
- Returns in private equity from 2008 to 2013 were just under 10%. Ten-year returns were closer to 15%.
- Competition for deals to deploy capital has driven valuation on both good and also semi-broken companies (some company characteristics still solid and some with financial and human capital needs) to high levels.
- Modeling in most scenarios to offer 8X EBITDA valuations require consideration of dangerous leverage levels (5-6X EBITDA as total debt structure) to approach even sub 18% IRR.
- With more investments held in excess of five years, those returns will suffer even on companies that have improved in performance.
The compressed process of "IOI (or EOI) to LOI to close" does not provide adequate executive profiling or evaluation of current strategic plans in a diligence. A new plan must ultimately be developed by your team and hopefully blend in elements of what is in the company currently. It also gives some insight into how the executive team works under time pressures, addressing and debriefing in a variety of areas. This adds up to a daunting proposition to assure driving rapid value with a team unproven to new ownership.
The strategy needs to accelerate a five- to six-year hold and growth story into a three-and-a-half to four-and-a-half-year hold, in order to enhance IRR and limited partner returns. Market conditions and demand will ultimately allow for an accelerated growth and an early sale, though it would be nice to be in that situation and have the choice of an early exit. Growth and EBITDA enhancement will come from a premium priced product/service in new markets, and carefully choosing and exploiting niche and segment opportunities. Add-ons need to be rapid and done correctly with an eye for attracting the inquisitive strategic buyer. The 60 days to close through the first year requires executive team development and aligning with the possible three-and-a-half to four-and-a-half-year growth and sale strategy.
Making the Team
Operating partners play a role to vet, develop and organize the strategic plan with the internal (or external) CEO candidate. The operating partner will facilitate relationships that augment the team early on with consultants, other executive candidates and mentoring and deploying tool kits with management. Another key aspect in this early stage is to identify B players who can become A players and middle and senior management that have the capacity and drive to take the next step up.