“Learn to Grow”
Applied Research on Sales, Marketing, and Customer Experience
State of the Private Equity Industry
Private equity firms have been enjoying an unprecedented run of fundraising success over the past five years with over $3T raised, capped by nearly $700B in 2017. Pitchbook’s most recent data suggests things have cooled slightly through 2018 and interestingly, Europe has commanded a greater share of the money raised vs. the U.S. (i.e., 50% vs. 40%) in 2018, a major reversal over 2017, when the U.S. raised 65% to Europe’s 25%.
Firms, therefore, are not suffering for lack of funds – if anything there may be too much dry powder available. As capital inflows have increased, EBITDA multiples have been rising steadily since 2010, reaching an average of 10.6X in 2017. At the same time, overall deal flow in the U.S. has been flat since 2014, which suggests an increasing scarcity of attractive, affordable targets.
Figure 1: Comparing US M&A EBITDA Multiples vs. Number of Deals Completed
The inflow of money is not the only thing making deals more expensive: competition is getting increasingly fierce, with traditional and non-traditional players entering the space. The bulge bracket PE firms are heading downstream, large corporations are looking to accelerate growth and enter niche markets with more aggressive M&A, fundless sponsors are doing more and more one-off deals, and family offices are bypassing PE firms to invest directly.
To prevail in a market where more money is chasing fewer deals with an increased number of competitors, PE firms will need to re-think and modify their own go-to-market strategies, models and ways of deploying not only capital, but talent and expertise, to create value. Because PE is, if anything, a resilient industry we have every confidence in its staying power for strategic and institutional investors, both in the U.S. and globally. Our thesis is that growth, underscored by commercial excellence, will be essential to PE’s continued success.
Reshaping the Value Creation Playbook
This is far from the first time PE firms have had to adjust their approach. In fact, the model and playbook for PE has evolved multiple times over the past 30 years. In the 80’s, it was about leveraging large amounts of debt with high cash flow companies. When cheap credit and junk bonds went away in the late 90’s and 00’s, value engineering and cost reduction dominated the playbook. Shifting to today, there are a set of factors we think will characterize the next wave of success within the PE industry:
- Deep Specialization: PE will create exceptional value by focusing on distinct, leverageable knowledge of industry sectors and sub-sectors, market and customer insights, and regulatory environments to build defensible strategies and business models.
- Integration Capabilities: There is a push towards acquisitions of platforms, or lower middle market companies upon which multiple add-ins create synergies, accelerate growth and result in more defensible, valuable businesses. However, being able to effectively integrate these businesses will become a critical capability to realize the forecasted returns associated with these types of deals.
- Preemptive Disruption: True innovation is increasingly rare and expensive. Companies led by those who are restively curious, and can help their product teams “see around corners” to uncover ways to do things in fundamentally better ways (vs. simply cheaper or faster), will win the day.
- Superior Talent: Most PE backed companies neither require nor can afford A-players in every seat, and therefore they must map-out the functions and roles for which “difference makers” provide asymmetric advantage to their companies.
- Commercial Excellence: Beginning with due diligence, continuing into the first 100 days post-deal (i.e., the formative period in the PE-portfolio company relationship), and throughout the holding period, a clear strategy, playbook, and set of capabilities for delivering above-average revenue growth will be critical.
HGP‘s primary focus is on commercial excellence and top-line performance, so naturally we’re biased towards growth as a means to create enterprise value. We are not dogmatic in this viewpoint, rather we believe bottom-line/EBITDA improvements and top-line growth are complementary, essential components to a winning strategy and playbook. From the standpoint of application, we see commercial excellence through two distinct lenses: 1) Pre-investment – Commercial Due Diligence and 2) Post-investment – Dynamic Portfolio Management.
Commercial Due Diligence: Hockey Stick vs. Reality
Perfect is the enemy of good and very good, especially in a world where the average mid-size firm evaluates between 800 and 1,000 potential deals per year. Few firms can afford – and very few deals justify – the investment of time and resource to address every aspect of a target company’s commercial-revenue performance vs. future potential.
Below is HGP’s playbook for commercial excellence; not a “codex,” rather an integrative, practical framework any firm can apply:
Dynamic Portfolio Management
Investment theses can differ substantially by portfolio company, each possessing different risk-return profiles and upside potential based on a number of criteria and factors, including the company’s maturity model. Our perspective is that commercial evaluations should occur naturally as part of investment committee reviews, intensively each year, and substantively at least once per quarter.
This framework helps both to objectively determine the condition and performance of portfolio companies, and to make smart decisions around deploying time, talent and resources:
It would be unusual, and quite troubling, if a majority of a firm’s portfolio companies were re-builds. Similarly, it would be fortuitous but improbable for these companies to need only tune-ups. Rather, within a representative portfolio of 10-15 companies, we would expect no more than 2-3 rebuilds and 4-5 tune-ups, with the majority being modifications.
The ultimate goal of this process would be to provide an “early warning system” to firms, particularly when paired with a combination of financial and operational metrics that don’t simply tell the top-line numbers but rather portend more granular success signals that demonstrate whether a portfolio company’s “growth engine” is working and sustainable.
Success in the Next Era of PE Will Hinge upon Commercial Excellence
PE firms have experts that rip apart company financials and understand the different levers they have to pull from a financing perspective; likewise, they also often have operating partners who are skilled at cost optimization and improvement. These capabilities, combined with a tremendous will to win, are elemental to the DNA of PE.
In our experience, commercial/revenue-side expertise is both under-developed and under-utilized across PE, especially within pre-investment. And, this is a mistake. Whether to stress test (and validate or refute) the “hockey stick” slide seen in every investor deck, or to enable investment committees to make informed decisions on exiting or increasing their positions, the value greatly outweighs the investment.