What tools do private equity firms use to create value?
There aren't many proprietary tools that private equity groups can use to create value. Business management, sales, and marketing strategy have been well researched and published in which the best practices are in the public domain. Thus there are no secrets in the ways to create value and build a great business. Out of plenty of related books, "Good to Great" by Peter Drucker is one of the best books to read.
The key to having a private equity group create value in a business is investing in the company in areas where the business owner has historically not been willing to invest. The reason is that most business owners run a business to maximize their after-tax cash flow on an annual basis, which means that they want to maximize the legitimate expenses in the business without spending money on those that they perceive as invaluable to maximize their annual income.
It is their prerogative when facing a decision of bringing in a new CFO that can help improve the reporting, the systems, and the analysis around the business. They need to make sure that the business is running as lean as possible and that just enough resources are available to generate adequate financial reports. For example, a business owner may see that, by spending $200,000 or even $250,000 a year, there is no added value in the systems and reporting, and it is not helping the after-tax cash flows; in fact, it is hurting the cash flow by the investment in a CFO.
The change is when a partnership is consummated and the business owner is able to harvest the value that they built in the business and disconnected their personal banking account from the one of the company. Since they invest before the equity value of their company, the private equity groups are not investing by pulling money out of the business on an annual basis as the business owners do. The private equity groups are interested in making the investments in people, in systems, in technologies and in sales teams where they need to grow the value of the business. This is the fundamental difference in which private equity groups are able to create value due to the fact that they are willing to reinvest in the business where entrepreneurs are unwilling.
The private equity team may have some relationships and some experiences to better handle particular situations, and they can be very helpful to what the company is doing, but the basics of building a great business is well-known at this point. There may be a small difference in industry type and business model, but it is all about the execution and willingness to reinvest in the company.
More Q&As from our experts
- What are typical fee structures for portfolio companies by private equity groups?
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- What are some of the key differences between a financial buyer and strategic buyer?
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