Asian GPs are building up their operational resources to support portfolio companies, but the true value of expertise is knowing when and where to make influence count.
A few years into an investment the deal executives at Pacific Equity Partners (PEP) are grilled by an internal operating committee on whether it is time to exit.
The Australian GP buys underperforming market leaders, hires an entrepreneurial CEO and agrees a value-driven strategy to turn these companies around.
But a mature business – often carved out from a conglomerate – can't be expected to deliver exponential growth indefinitely.
“You've changed the CEO, launched some new products, you are optimized on the efficiency front, but there is just no more gas in the tank and it's time to get out and move on,” David Grayce, a managing director at PEP, told the AVCJ Forum in November. “The opportunity cost of our resources is very high so if there are no more dollars to be had the IRR clock is ticking, take the medicine and move it on.”
It is a judgment call; one that can be rationalized through raw data yet also requires gut instinct. An investment that is on course for a 3x return could achieve 5x if more resources are tilted in its direction. A second portfolio company might have already reached its full potential at 3x while a third has underperformed and the time and money required to turn it around is best deployed elsewhere.
PE firms in Asia are increasingly taking a more active role in their portfolio companies, assembling in-house operations teams or at least showing a greater willingness to bring in third-party expertise. It is in part a function of the asset class maturing and in part a function of longer holding periods. According to Bain & Company, the average investment period in Asia was 4.6 years in 2012, compared to 2.3 years in 2007.
Operational expertise is also being pushed up the agenda by LPs. In Asia, where returns in growth markets have historically relied on multiples arbitrage, there is now a sense that GPs must offer something more. Operational experience – if it hasn't already delivered sufficient returns to secure an LP commitment – is a powerful differentiating factor.
The challenge for GPs is knowing when and how to bring their expertise to bear.
“Especially when you have a dedicated operations team there is a tendency to think this is fantasy land, that you can play out all your ideas, that you have a bunch of hammers and everything is a nail,” said Venkatesh Srinivasan, managing director at India and Southeast Asia-focused Everstone Capital. “But in fact the most important task our operations team has is continually evaluating whether an intervention is required at all, and if it is required, what is the best way to allocate resources.”
Once a capable management team – whose interests are aligned with those of the investor – is in place, value-add can take many different forms: in-house professionals who work at ground level; industry veterans who brought in to exert influence at board level; or partnerships with consultancy firms that are hired across the portfolio as and when necessary.
“The two ends of the spectrum I see are instinct and data,” said Marcus Thompson, CEO of Headland Capital Partners. “The data is the service provider that will do some market research and gather information and the instinct is the industry guru. Clearly, you need a mixture of both to be effective.”
Headland's approach is primarily to rely on outsourcing, recognizing that it is difficult to assemble an in-house team with capabilities that cover the broad range of consumer-related businesses it invests in across China, South Korea and Southeast Asia. KKR, with significantly more resources at its disposal, is at the other end of the scale, having set out to hire local professionals for each market in which it operates in the region.
Others fall somewhere in between or even occupy niches of their own. PEP's CEO-centric model is suited to the kind of companies it targets. The same could be said of Lunar Capital, which focuses exclusively on mid-market buyouts in China's branded consumer products space. The GP brings in experienced industry executives as sector partners to participate in due diligence and then appoints them as CEO or COO of the resulting portfolio companies.
Regardless of the strategy, discipline is required not only due of the high opportunity cost to the GP but also because operational value-add must ultimately translate into better returns for LPs. It is easy for investment or operations professionals who work closely with a company to lose sight of the bigger picture and focus on initiatives that have little or no impact on the balance sheet.
“You want to make the company stronger, you want to be proud of the work you've done but working deep on the third generation of an HR enhancement program to give employees some kind of Saturday benefit in the park does not,” said Scott Bookmyer, Asia head of Capstone, KKR's operations unit. “I have seen ops teams spend time on that because they get too nativist about how they work.”
The counterargument is paying attention to employee satisfaction might deliver disproportionately larger increase in productivity – just not in every case. This is where value-add becomes more art than science, being able to identify situations that might be the exception rather than the rule.
In this context, the tracking of operational improvements that may not have an immediate or direct impact on near-term performance is very important.
A private equity firm that invests in a quick service restaurant chain can work on processes that are immediately realized in additional billing per cover – a single set of numeric values show whether the effort put in justifies the performance that comes out. An initiative that is more complex and takes longer to bear fruit is harder to track.
“You have to be honest and disciplined about how you have actually added value because quite often those are the things that don't give you better performance right away but are crucial to getting a better multiple or bolting on other engines of growth to the story,” said Everstone's Srinivasan.
When Everstone acquired a financing business for one of its portfolio companies, the private equity firm's operational role was clear: obtain the appropriate licenses; bring in a management team; set up project milestones in 30-day increments to ensure the process stayed on schedule; and then carry out a formal review 12 months on and establish whether the efforts have contributed to increased EBITDA.
Srinivasan contrasted this with working on a portfolio company's marketing capabilities where the effects may not be felt until eight years down the line and a raft of different measures must be considered.
Most PE firms with a degree of operational capability have well established post-investment processes for putting in place appropriate key performance indicators (KPIs) and reporting systems. Consultants note that when they are brought into a situation the investor is often well past drawing up a 100-day plan and has identified specific areas that require work.
However, Peter Liddell, a partner at KPMG, argued that some firms face challenges when trying to measure the effectiveness of longer-term operational initiatives. Measurement frameworks are introduced but they function at too high a level and fail to demonstrate the impact of change. This in turn undermines efforts to add value to portfolio companies above and beyond synergies, optimization and efficiency.
“When the fund has made its investment or made additional acquisitions there is a need to uplift capability, whether that is the people, resources or systems. We see it as equally important but it can be less of a priority,” Liddell said. “If you look at how you create sustainable value, you look at the operating model. Quite often these models have been set up several years ago and worked quite effectively but they are tired and lack innovation.”
The other key consideration in deploying operational resources is the impact it will have on management. First, the incumbent CEO and executive team might feel their positions are being undermined. This is especially important where the private equity firm is a minority investor and the company founder still plays an active executive role, but it applies to control situations as well – even an appointed CEO would resent any notion of an operations team treading on his toes.
The solution is to be supportive, flexible and, when in minority positions, up front as to where value can be added. According to Bookmyer, KKR has become more transparent with founder-entrepreneurs during initial negotiations. Areas in which the PE firm believes its expertise can be brought to bear are presented as a value-added capital proposition. If it appears that creating an alignment of interest with the founder on these issues is going to be difficult, KKR might think twice about doing a deal at all.
In situations where an investment is not going according to plan and the private equity firm is unable to switch around management, it is a case of pulling every lever to secure realignment. This might involve bringing in a different person to serve as the primary interface with the founder or leaning on other executives and board members.
Second, there is always a risk that implementing multiple operational initiatives at the same time might overwhelm the management team.
“Even if you have a very experienced CEO, if you put a full plate of requests to him then he's got a new team and trying to do 200 things at the same time. That is where the art comes in,” said Y.R. Cheng, a partner at Lunar. “It is a very dynamic process that has to be managed very carefully.”
The development plan a private equity firm devises for a portfolio company may take 2-3 years to execute; only the most pressing issues need to be addressed in the first 30 days and these are often quite rudimentary.
Lunar's typical targets are medium-sized enterprises run by septuagenarian founders that are willing to give up control to a third-party investors because their offspring don't want to assume leadership of the business or because they are finding increasingly difficult to cope in a climate of moderating macro growth, rising costs and intensifying competition. They don't have professional management skills and so standard financial reporting procedures, plus the accompanying IT infrastructure, isn't in place.
As such, the first step in the value process is not product customization and marketing initiatives, but securing operational transparency and getting good information. Bookmyer added that KKR spends a disproportionate amount of time in its growth investments conducting infrastructure diagnostics, establishing what needs to change in the first year so a portfolio company is able to meet its growth targets.
“Pushing too hard on growth when the company can't handle it or when the CEO has 25 direct reports and refuses to set a regional structure up, and because of that you lose governance on what is happening in the northeast, is a big issue,” he said.
Back to basics
Operational improvement therefore starts with getting the simple things right – the processes, data and people – before moving on to more sophisticated projects. The particular needs of a portfolio company in this area guide a private equity firm's approach to the timing and nature of resource deployment.
While the general assumption is that investments in less developed economies require more attention, PEP's Grayce begs to differ. The GP recently completed a carve-out from a large conglomerate and found organization and information systems to be lacking, with the sales, finance and operations departments reporting to managers on three different continents. A little bit of surgery went a long way.
“All the KPIs were aligned around revenue growth, not profitability; the organization was completely functional as opposed to market facing,” Grayce said. “The first things we did when we go in there was put in place very simple systems to report KPIs that actually drive value. Then Christmas came and when we returned the company was 20% more profitable.”