Value Creation in Direct Private Equity

Before the holidays, Institutional Investor published a good interview with BlackRock’s Colm Lanigan, Co-Founder, Managing Director and Senior Investor, Long Term Private Capital, discussing value creation in direct private equity:

When investors look at public markets today, many see high current valuations, low expected returns and a likelihood of increased volatility. Against this backdrop, it’s little surprise that more than a few are increasing their focus on private markets, and on private equity specifically. Their interest is amplified by a shift in the public-private balance of company ownership. With more companies going private or staying private for longer, allocators who want to be invested in growth over the next decade have even more reason to consider private equity.

There are several ways for institutional investors to access private equity today, including the traditional route of being invested in GP/LP structures; co-investments alongside those structures; and secondary markets. As private equity matures and investors’ needs evolve, the need for innovation increases — setting the stage for a direct, flexible-hold strategy, aimed at better alignment among GPs, LPs, and portfolio companies to maximize value and capital appreciation.

This II interview with BlackRock’s Colm Lanigan, Co-Founder, Managing Director and Senior Investor, Long Term Private Capital, focuses on value creation in such a strategy, and is one of a three-part series on creating persistent alpha in private equity.

You are a founding partner of a flexible-hold private equity strategy. There’s a perception among some people that such a strategy is a form of hands-off, passive private equity ownership. Do you see it that way?

Not at all. There’s almost nothing passive about private equity. In the private markets there is much greater disparity across both scale and quality, so the whole screening process is, itself, active. In addition, fees are not the differentiator between alpha and beta in private equity. They’re part of it, but a much bigger part of alpha generation is the active management of the business, active governance, and value creation — regardless of the time frame, shorter or longer.

There have been approaches to longer-term investing in private equity that focused on asset selection as the number one indicator of earnings over a longer period, and then used the long holding periods to achieve something resembling private equity multiples, though not alpha. But those approaches have focused on assets that are infrastructure-like or on asset-intensive businesses with stable earnings, as opposed to businesses that can drive private equity IRR and multiples over long periods of time. There’s a big difference between the two, and the key to the latter is still active management of the business and active governance to drive return on invested capital (ROIC) and growth.

You’re an advocate of the importance of persistent private equity returns. What are the keys to achieving them?

I think what we’ve learned is that good companies often remain good companies as long as they are effectively managed. The business model matters – do they have a slightly better mouse trap? – as do other things, such as having better gross margins than their competitors. But it really comes down to superb management teams who think and act like company founders, and who unfailingly and unwaveringly focus on execution of the plan and the strategy that they know makes their companies successful. And part of that founder mindset is rigor around capital allocation. Favorable market positioning from differentiated business models, durable economics, and seasoned management teams with disciplined strategy execution are what drive ROIC, and those companies succeed for longer periods of time. Sponsors covet those types of companies because they know they have the potential to make them even more successful.

What do you see as the most important aspects of a value-creation plan?

Developing a value-creation plan begins with identifying the fundamental variables that drive the business’ success. You’re looking for no more than five such points that allow you to focus management practices and create continuing value. For example, operational excellence is one, and it’s a must-have for every successful business. Drivers of scale are another. Which elements of the business are on the right side of pervasive disruption is another, so you can focus your efforts on the greatest opportunities for growth. A final one should be your digital strategy — it’s imperative that it supports your day-to-day analytics so you can make the right decisions in an environment that’s moving faster, and is tougher to navigate, than ever.

When you focus on those few things that matter the most, you don’t overstretch your organization, and you can match capabilities with goals and incentives. People’s behaviors are shaped by incentives and associated performance metrics. If employees know that you are focused on — and measuring — the right things, and that’s how they’re going to be compensated from top to bottom in the organization, you have all the ingredients of success.

Are there any special considerations that come into play in a late-cycle climate?

Having managed through a couple of cycles, I would mention several.

You need to be careful about leverage, which instead of adding to your returns can very easily subtract from them when the cycle turns. And you have to be wary of deals that have a lot of execution risk — for example, from moving plants or expanding margins. If you haven’t built in a recession scenario, you’re probably playing with a little bit more risk than you anticipated. Looking left on the return curve — thinking about what could go wrong and factoring that into your due diligence and underwriting — is probably even more important right now than looking to the right.

In good times, extra volume through a business can hide a lot of inefficiencies and problems. It has been a little easier to take lower-confidence bets when you’ve had margin expansion due to 12 years of economic prosperity and growth that’s higher than trend. Multiple expansion has been a major driver of returns in the deals done since 2010. You’d be on shaky ground if you relied on that continuing. It may, but it’s less likely than before.

If it looks like the business will be tested by an economic trough, it is key to focus on the fundamental business variables that generate lasting value and to position for growth. That can help generate a couple of quick wins to build confidence throughout the organization and put you in a slightly better position going into what could be a tougher period.

A robust capital structure is a big plus. Private equity is a long option, and if you have a capital structure that can withstand some of the hiccups, you’ll come through the other side. I would focus a little more on the balance sheet in this environment, too. If you have enough capital available, you’re in position to be the consolidator of your weaker competitors over time.

Of course, human capital is perhaps the most important element of all. To achieve long-lasting success, there is no substitute for having the right people and forging the right partnerships.

Indeed, human capital is the most important element and quite worryingly, I just read an II article today on how private equity firms are struggling to recruit and retain young talent:

Private equity executives at firms of all sizes are trying to figure out how to better attract and retain younger staff, resorting to tactics such as offering free lunches and relaxing their dress codes.

Sixty percent of private equity CFOs surveyed by EY said it was at least somewhat difficult to recruit millennial and Generation Z employees — and an even greater proportion found it challenging to retain such talent. The largest private equity firms, those with at least $15 billion in assets, appear to be struggling the most to keep younger employees around, with 82 percent reporting some level of difficulty in retention.

Given these challenges, the vast majority of surveyed executives told EY that they were taking action to better appeal to millennial and Gen-Z talent.

“With an aging workforce, advances in technology, and a constantly changing world, a strategic CFO has to be focused on attracting and retaining younger generation talent,” EY said in its report on the findings.

More than two-thirds of survey respondents said that they had improved their in-office amenities, offering for example free lunches or gym access. Other tactics employed by a majority of respondents included relaxing the office dress code, giving employees flexibility to work from home, and implementing health and wellness reimbursement programs. Meanwhile 45 percent said their firms were offering mentors or career coaching, and 36 percent had instituted formal career road maps or progression targets for employees.

“For smaller funds, which may not have the ability to make significant investments in amenities, more than 70 percent are providing their employees with the flexibility to work from home,” EY reported.

Beyond focusing on young talent, private equity firms have also prioritized diversity and inclusion, according to the EY report. Executives cited increasing gender representation as their top objective in talent management, followed by the goals of creating a more inclusive culture and increasing ethnic minority representation, the survey showed.

Among the surveyed firms, 88 percent said women held less than a third of their front-office positions. “This challenge is even more glaring among the mid-sized and largest firms, where fewer than 10 percent of firms report that they have more than 30 percent of their investment professional roles filled by women,” the report stated.

The back office had higher female representation, with women accounting for more than half of traditional finance function roles at 41 percent of the surveyed firms. However, that figure dropped to 27 percent at firms with assets above $15 billion.

Just under half of executives polled by EY said their firms had set targets for gender diversity, while another 10 percent planned to implement targets. A similar proportion of firms had either set targets or planned to target improvements in ethnic diversity, with the largest funds placing the most emphasis on hiring minorities.

Surveyed executives said they planned to increase the diversity of their firms by recruiting from a broader group of colleges and universities and establishing or increasing family planning policies such as parental leave. Other tactics included establishing diversity groups and adding or increasing health and wellness policies.

Quite shockingly, times are not changing fast enough at private equity firms, it's still an old white man's industry. That may have worked fine 40 years ago, but in 2020, if you don't change attitudes, culture and focus on diversity and more importantly, inclusion, you're ensuring the slow extinction of your firm.

That observation goes for all industries but finance is especially slow to embrace change.

You need more women, more ethnic representation, hire people from different backgrounds and with their unique perspectives, fight group think every step of the way.

Then you need to mentor this young talent as many young workers have never experienced a full economic cycle, haven't lived through a bear market and severe recession (scary but true).

Today's young generation are luckier than they can imagine. Formal career roadmaps? Back in the early 80s, you'd be lucky to find a job in finance, let alone find a mentor who will take you under their wings.

But I have to hand it to the younger generation, they're rewriting the old rules and implementing some much needed changes to ensure a better work-life balance.

Now, back to creating value in direct private equity. I like what BlackRock’s Colm Lanigan stated above, he's absolutely right on so many levels.

I want to hone in on this passage:

Developing a value-creation plan begins with identifying the fundamental variables that drive the business’ success. You’re looking for no more than five such points that allow you to focus management practices and create continuing value. For example, operational excellence is one, and it’s a must-have for every successful business. Drivers of scale are another. Which elements of the business are on the right side of pervasive disruption is another, so you can focus your efforts on the greatest opportunities for growth. A final one should be your digital strategy — it’s imperative that it supports your day-to-day analytics so you can make the right decisions in an environment that’s moving faster, and is tougher to navigate, than ever.

If you're working at Canada's large pensions, you're going to hear a lot about "value-creation plans" for every investment in private markets.

By the way, private equity firms also have value-creation plans. We are buying a business for X, improving operational efficiency, its digital strategy, etc. and hopefully we can sell it down the road for Y at multiples of what we bought it for.

Notice I am not talking about leverage although private equity firms still engage in leveraged buyouts, pack a company with debt and extract a pound of flesh.

That model worked well in the past but in a low-rate, low-return world where multiples are stretched, you need a specific skill set to roll your sleeves and execute on a value-creation plan.

This is especially true for Canada's large pensions which have a much longer investment horizon than private equity funds and need to hire talent that can execute on a long-term value creation plan.

Now, last week, I discussed how OMERS wants to double its private equity exposure by 2030 and stated that to do this, they need to focus their attention on fund investments and co-investments.

The folks at OMERS were quick to point out to me that OMERS Private Equity employs a professional dedicated PE team deployed around the world that sources deals and directly manages the OMERS PE portfolio.

Actually, following my initial comment, a PE expert from outside OMERS sent me this:

I am not current on the scope of OMERS investments where they are the sole investor, and sourced in the marketplace but I do know they did at least a few transactions like that, perhaps they have ramped up this activity considerably, probably by making a few very large investments.

I suspect it is quite likely this true direct activity is larger than you might expect, probably now the most significant of the large pensions. Whether successful of course takes some time and cyclicalities to know. But for example, I believe one of their disclosed US investments Caliber Collision was acquired from ONCAP, and has done quite well so far under the OMERS ownership.

It is not impossible to compete with the more intrusive ownership approach of the main buyout firms. You can just pay more, and combined with a lighter touch some companies will prefer an OMERS. Their teams headcount and backgrounds look suitable for direct investing of all flavors.

What this tells me is if OMERS does compete for deals head on with large private equity funds, it typically will pay higher prices but can keep these investments in its books for longer, thus implementing a value-creation plan over time.

Another approach to direct private equity, one that most of Canada's large pensions have adopted, is to invest in top-decile private equity funds and co-invest alongside them on bigger transactions to reduce the fee drag (pay no fees on co-investments but to gain access to them, need to invest in the funds where you pay fees).

CPPIB's CEO Mark Machin even spoke about it earlier this week in Davos when he sounded the alarm on private market assets.

The reason why CPPIB has invested 24% of its gargantuan assets into private equity is because it has developed an excellent fund investment/ co-investment program. BCI, which is also ramping up its direct private equity, has implemented the same approach and so have most others.

A third way Canada's large pensions gain direct exposure to private equity is by bidding on companies when a private equity fund they invested in is winding down (after four or five years).

Typically, senior directors working at these pensions sit on the boards of these companies, know management well and if they really like it, they will bid directly on it and keep it longer on their books (avoiding churning that goes on when private equity funds sell winners to other private equity funds when winding down a fund).

This is what BlackRock's Long Term Private Capital is doing, keeping investments longer in its book as it executes its value-creation plan on companies they are acquiring (learn more here).

Lastly, whether it's a private equity fund or a large Canadian pension, value creation in direct private equity often requires an additional skill set which typically resides in large accounting firms.

I saw one such team at KPMG last year when I briefly worked with the advisory group based in Toronto and headed by Benjie Thomas. I met a guy called Tim Prince who leads Canada’s Operations M&A practice and is the Service Line Co-Lead of Transactions Services in Canada.

Tim's expertise is in "post-merger integration," a fancy way of saying he specializes in improving operational efficiency when a company acquires another company, and he and his team are really busy.

His background is interesting, having come from Deloitte London where they specialize in value creation services for private equity funds:

Deloitte London offers value creation services across the deal cycle: acquisition pre-deal support, performance improvement and exit support:

I'm sharing this with you so you gain a full appreciation of what exactly goes into value creation in direct private equity. It's not easy and requires a specialized skill set.

Below, a great 2018 Milken Institute panel discussion on creating value against increased competition featuring Virginie Morgon CEO, Eurazeo; Jonathan Rotolo Head of Private Equity and Real Assets, Barings; Scott Sperling Co-President and Co-Chairman, Thomas H. Lee Partners; David Wasserman Partner, Clayton, Dubilier & Rice Limited (CD&R) and Andrew Weinberg Founder and Managing Partner, Brightstar Capital Partners.

Also, the the time to watch an interesting discussion on private equity featuring BlackRock's Colm Lanigan which is available here.Unfortunately, BlackRock doesn't post these clips on YouTube so I can't embed it below.

Third, I embedded a clip by Simon-Kucher on taking value creation to the next level. A lot of firms offer these services and it's important to find ones where the principals have deep experience.

Fourth, Carlyle Group Co-Chief Executive Officer Glenn Youngkin discusses asset prices, investment returns and risk appetite. He talks with Bloomberg’s Tom Keene and Jonathan Ferro at the World Economic Forum’s annual meeting in Davos, Switzerland on "Bloomberg Surveillance" and states "prices are high and will stay high."

Lastly, David Rubenstein, Carlyle Group co-founder and co-chairman, discusses the changes in the private equity space and the impeachment trial of President Donald Trump with Bloomberg’s Tom Keene and Jonathan Ferro at the World Economic Forum’s annual meeting in Davos, Switzerland on "Bloomberg Surveillance."

Rubenstein is the host of the "David Rubenstein Show: Peer-to-Peer Conversations," which airs on Bloomberg Television. Interestingly, Marc Benioff, founder, chairman and co-chief executive officer of Salesforce, told Rubenstein that "Facebook is the new cigarettes." He said the company needs to do more to make sure things are accurate on the site. I completely agree with him.