Boston Consulting Group: Engaging for growth


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The name of the game in private equity is no longer leverage or multiple arbitrage. The key to delivering superior returns is operational value creation. What’s more, bottom-line improvements won’t be enough. Success will depend on a firm’s ability to grow its portfolio companies and improve the top line.

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Boston Consulting Group: Engaging for growth

  1. 1. RT  P-E R Private Equity Engaging for Growth
  2. 2. The Boston Consulting Group (BCG) is a global managementconsulting firm and the world’s leading advisor on business strategy.We partner with clients from the private, public, and not-for-profitsectors in all regions to identify their highest-value opportunities,address their most critical challenges, and transform their enterprises.Our customized approach combines deep insight into the dynamics ofcompanies and markets with close collaboration at all levels of theclient organization. This ensures that our clients achieve sustainablecompetitive advantage, build more capable organizations, and securelasting results. Founded in 1963, BCG is a private company with74 offices in 42 countries. For more information, please visit
  4. 4. CONTENTS  EXECUTIVE SUMMARY  THE TREND TOWARD OPERATIONAL VALUE CREATION  PRIVATE EQUITY’S GROWTH CHALLENGE  A SPECTRUM OF OPERATING MODELS No Operating Capabilities A Network of External Advisors Generalist Operating Partners Functional Operating Partners Small In-House Operating Team Large In-House Operating Team  THE PARADOX OF STANDARDIZATION Standardization of the Deal Process Standardization of Operational Value-Creation Initiatives  THE IMPERATIVE OF PROFESSIONALIZATION Professional Development Communication, Decision Making, and Teaming A New Partnership  FOR FURTHER READING  NOTE TO THE READER | P E
  5. 5. EXECUTIVE SUMMARYP  E: E  G addresses the challenges facing private-equity firms in a period when creating operational valuefrom top-line growth will be increasingly central to competitive success.Market conditions are accelerating the trend toward operationalvalue as the primary source of value created by private equity.• Although debt has become more readily available since the 2008 financial crisis, the total amount is unlikely to return to precrisis levels.• The premiums that private-equity firms are paying for companies are rising, suggesting that it will become even more challenging to realize multiple-driven returns in the future.Private equity’s ability to generate operational value will increas-ingly depend on a firm’s ability to develop and grow the businessand improve the top line of its portfolio companies.• The relentless focus on cost cutting in response to the Great Recession by companies throughout the economy means that there will be fewer “quick wins” available for bottom-line opera- tional improvement.• The Boston Consulting Group estimates that in order for a private- equity firm to generate an internal rate of return (IRR) of 25 percent in the current market environment, it will have to deliver an average annual growth in earnings before interest, taxes, depreciation, and amortization (EBITDA) of 11 percent.Private-equity firms have been experimenting with a varietyof models for operational value creation, each defined bythe internal operational-value infrastructure created by thefirms. T B C G | 
  6. 6. • Some do without internal operating capabilities altogether or prefer to rely solely on external advisors. • Others have been hiring industry generalists and functional specialists at the partner level. • Still others have created full-fledged operating teams with staff at multiple levels below that of partner. Increasing standardization of operational-improvement initia- tives will be a key success factor—irrespective of the operating model a private-equity firm chooses. • Firms are developing explicit, replicable proprietary processes for creating operational value—along the investment life cycle and within the specific initiatives they undertake at their portfolio companies. • While many firms are using standardized approaches on the cost side—in particular, for financial optimization and bottom-line improvement—relatively few have developed standardized approaches for the top-line initiatives, which will be critical to creating operational value in the future. As their staffs become larger and more complex in response to the needs of their portfolio companies, private-equity firms will also need to professionalize their management processes. • They should put into place comprehensive review, remuneration, and professional-development processes for many different kinds of talent (beyond the traditional dealmakers) and define appropri- ate new metrics for recruiting, nurturing, and rewarding these diverse groups of individuals. • They need to fully integrate expertise in top-line operational value creation into the firm’s business model. Improving a private-equity firm’s capacity to create operational value will require a new kind of partnership. • Deal teams, operating teams, and portfolio company management all need to work together to ensure top performance. • Interactions should be encouraged among deal teams, operating personnel, and portfolio companies; and a culture should be created in which all three groups feel like equal, value-adding contributors to the private-equity enterprise. • The strength and quality of that three-way partnership will be the key determinant of a firm’s competitive advantage in the years ahead. | P E
  7. 7. THE TREND TOWARD OPERATIONAL VALUE CREATIONF    , the private-equity industry has been focused on operationalvalue creation—that is, increases in funda- means that there will be fewer “quick wins” available for operational improvement through cost cutting. In the future, privatemental value at a firm’s portfolio companies. equity’s ability to generate operational valueThe days when private-equity firms could will depend less on bottom-line improve-create value primarily through leverage are ments and more on a firm’s ability to developlong over. Nor can the industry count on and grow the business and improve the topdelivering superior returns through multiple line of its portfolio companies.arbitrage. As a result, operational improve-ment—on both the cost and revenue sides Given the poor prognosis for economicof a business—remains the chief source of growth in the developed world, this task rep-value delivered by private-equity firms resents a stiff challenge. We estimate that intoday. order for a private-equity firm to generate an internal rate of return (IRR) of 25 percent in the current market environment, it will haveOperational improvement to deliver an average annual growth in earn- ings before interest, taxes, depreciation, andis private equity’s chief amortization (EBITDA, a proxy for funda- mental value) of 11 percent.source of value. In order to learn how private-equity firms are organizing to deliver that degree of opera-We believe this trend will only become tional value, BCG recently interviewed morestronger in the future. Although debt has be- than 25 general partners, operating partners,come more readily available since the 2008 and associated portfolio-company CEOs at 15financial crisis, the total amount is unlikely to private-equity firms in the United States andreturn to precrisis levels. Meanwhile, the pre- Europe. (See Exhibit 1.) We identified threemiums that private-equity firms are paying major developments in the industry:for companies are rising, suggesting that mul-tiple arbitrage will become even more chal- • Private-equity firms have been experi-lenging in the future than it has been in the menting with a range of models forpast. What’s more, the relentless focus on delivering operational value, reflectingcost cutting in response to the Great Reces- different organization structures andsion by companies throughout the economy divergent understandings of the funda- T B C G | 
  8. 8. E  | BCG Interviewed Personnel at 15 Private-Equity Firms Interview subjects (%) 100 >61 Large in-house operating >$50 billion team 80 General 46-60 Small in-house partner operating team 60 $30 billion – $50 billion Functional 31-45 operating $10 billion – partners 40 $30 billion Generalist Operating 16-30 $5 billion – operating 20 partner $10 billion partners External <15 <$5 billion advisors 0 CEO Role in Number of Assets under Operating private-equity firm portfolio companies management model Source: BCG analysis. Note: The sample consists of 29 interview subjects at 15 private-equity firms. mental relationship between the private- personnel, and portfolio company CEOs. equity firm and its portfolio companies. That partnership will involve new ways of teaming, with more explicitly defined roles • Irrespective of the operating model, there and responsibilities. And it will require the is a growing standardization of operation- professionalization of key management al-improvement practices at some private- processes at private-equity firms. In- equity firms. That standardization, creased professionalization is critical to however, is limited mainly to initiatives the long-term sustainability of the private- that improve the bottom line at portfolio equity business model. companies. When it comes to business- building activities that grow the top line In this report, we describe private equity’s and are critical for the future, most growth challenge, discuss the strengths and private-equity firms are still struggling to weaknesses of the various operating models develop a replicable approach. currently found in the industry, and make the case for why even more standardization • Successfully creating operational value and professionalization are in the industry’s will require a new kind of partnership future. between general partners (also commonly known as deal partners), operating | P E
  9. 9. PRIVATE EQUITY’S GROWTH CHALLENGEF   , BCG identified a shi in the private-equity industry away fromleverage and toward operational improve- axis and orange line) and the change in that multiple at the time the firms exited the deals (the left-hand vertical axis and green line).ment as the primary source of value creation. This analysis demonstrates that the deals(See The Advantage of Persistence: How the Best with the highest absolute EBITDA growthPrivate-Equity Firms “Beat the Fade,” BCG were also those for which private-equity firmsreport, February 2008.) Since then, private- paid the highest multiples—suggesting thatequity firms have been experimenting with a the firms already had a clear idea before thevariety of operating models in order to deal about how they would improve the tar-increase their capacity to create value by get company’s EBITDA, how much EBITDAimproving the operations of their portfolio growth they were likely to generate, andcompanies. therefore what a “fair” premium would be, on the basis of the target’s EBITDA growthSo far, their efforts have been extraordinarily potential. Because of the relatively high aver-successful. We recently analyzed the opera- age premium, the median deal in this grouptional performance of 89 U.S. and European created no value through multiple expansion.private-equity deals that were closed between1998 and 2008 and exited between 2005 and We believe that market conditions are accel-2011. This sample represents all deals with a erating this trend toward making operationalminimum enterprise value of €500 million value the primary source of value created by(approximately $670 million) at exit and for private-equity firms. Exhibit 3 portrays threewhich data were available from entry to exit. key trends in the private-equity market. First,We found that more than two-thirds of these premiums paid by firms are rising. This trenddeals (70 percent) generated an absolute in- is driven in part by all the “dry powder” thatcrease in annual EBITDA of at least 20 per- has built up in private-equity funds duringcent—and nearly half the deals generated an- the global crisis and that is competing for anual EBITDA growth of 50 percent or more. relatively small number of deals. Only about 13 percent of the money raised in vintageExhibit 2 clusters these 89 deals into eight year 2010 funds—and just 1 percent of vin-groups on the basis of the change in the tage year 2011 funds—has been invested soamount of annual EBITDA each deal generat- far. Second, when one combines these unin-ed and shows both the average multiple the vested funds with the trillions of dollars thatprivate-equity firms paid to acquire the com- public companies have accumulated on theirpanies in each group (the right-hand vertical balance sheets and that are also available for T B C G | 
  10. 10. E  | Firms Pay Higher Multiples When They Expect Strong EBITDA Growth Change in multiple Average from entry to exit (%) entry multiple 300 15 250 12 200 150 9 100 6 50 3 0 –50 0 Less than Between Between Between Between Between Between More –50% –50% and –20% and –10% and 0% and 10% and 20% and than 50% –20% –10% 0% 10% 20% 50% Change in EBITDA from entry to exit Percentage of all deals 4.5 4.5 3.4 6.7 1.1 9.0 22.5 48.3 Median Entry multiple Sources: Thompson One; BCG analysis. Note: The sample consists of 89 U.S. and European private-equity deals that were closed between 1998 and 2008 and exited between 2005 and 2011. E  | Shiing Market Conditions Make Operational Value Creation Important Total fund size (%)1 Not invested Invested 100 1 5 10 14 37 52 Recent funds 70 Increased competition 50 99 95 90 87 99 for deals causes purchase hold substantial 86 uninvested capital 63 48 multiples to rise 30 13 0 1 2003 2004 2005 2006 2007 2008 2009 2010 2011 Vintage year Purchase multiples2 10 Purchase 8.4 8.4 9.7 9.1 8.5 8.5 multiples 7.1 7.3 7.7 Long-term multiple 5 are increasing expansion is unlikely 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Debt-to-EBITDA ratio3 10 Debt is still 5.4 6.2 well below 4.6 4.8 5.3 4.9 4.7 4.9 Using leverage to 5 4.0 create value recent peak levels is not an option 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sources: Prequin; Morgan Stanley; S&P LCD; Factiva; BCG analysis. Note: Values for total fund size for 2011 are as of August 4; values for purchase multiples and debt-to-EBITDA ratio for 2011 are as of June 30. 1 Buyout and balanced funds only. 2 Purchase price to EBITDA where purchase price includes senior debt, subordinated debt, equity, and other financing. 3 Average debt multiples of corporate leveraged-buyout loans with an EBITDA of greater than $50 million, including first lien debt, second lien debt, other senior debt, and subordinated debt. | P E
  11. 11. use in the M&A market, it is unlikely that pre- Using these relatively conservative assump-miums will come down anytime soon. Third, tions, a firm would have to generate a com-while leverage levels (measured as a ratio of pound annual EBITDA growth rate in its port-debt to EBITDA) have recovered from their folio companies of 11 percent over a five-yearpostcrisis lows, the market remains challeng- period. To understand just how challenging aing at the end of 2011. hurdle that figure is, consider that the only times in recent history that the earnings ofLow levels of debt and ever higher acquisi- either the S&P 500 or London’s FTSE indextion premiums mean that private-equity firms surpassed this five-year compound annualwill be unable to count on leverage or multi- growth rate were in the five-year periods end-ple expansion as major sources of value in ing in 2006 and 2007 (for the S&P 500) andthe immediate future. Thus, improvements in 2006 through 2008 (for FTSE), during the bub-fundamental value, as reflected in growth in ble that preceded the 2008 global financialEBITDA, are the only sure source of value cre- crisis. Given the likelihood that the globalation. What’s more, the wave of cost cutting economy (and, in particular, the developedat companies in response to the Great Reces- world) has entered an extended period of be-sion has led to a paucity of opportunities in low-average economic growth, this hurdle rep-which fundamental value can be generated resents a substantial challenge to the private-rapidly by cutting costs. Thus, a successful equity industry.private-equity firm will increasingly have togenerate EBITDA growth by growing its port- The limited partners who invest in private-folio businesses. equity funds realize that the operational capabilities of individual private-equity firms will be critical in meeting this goal—and theFirms’ capabilities are firms themselves realize that these capabili- ties are under increasingly intense scrutiny.under increasingly intensescrutiny.How much EBITDA growth? We developeda simple model to estimate the amount ofEBITDA growth that would be necessary inthe current market environment for private-equity firms to realize an IRR of 25 percent.We assumed an entry multiple of 8.5 timesEBITDA (the average of reported deals inthe first half of 2011) and assumed that thatmultiple would remain unchanged at exit,a practice that is typical in private-equity in-vestment plans. We also assumed a debt mul-tiple of 4.5 times EBITDA and an interest rateon that debt of 400 basis points over the Lon-don interbank offered rate (LIBOR). We as-sumed capital expenditures of 2.5 percent ofnet revenue. Finally, for simplicity’s sake, weassumed an all-cash tax rate of 26 percent ofincome, and no additional investment inworking-capital productivity. T B C G | 
  12. 12. A SPECTRUM OF OPERATINGMODELS O    - partners and portfolio company CEOs identified six different “operating models” for well—or poorly. Which model is appropriate for a particular private-equity firm depends on two factors. operational value creation. (See Exhibit 4.) It is useful to think of these operating models The first is the private-equity firm’s preferred in terms of three clusters, each defined by the style for engaging and working with its port- degree of internal operational-value infra- folio companies. For example, is the philoso- structure the firms have created. phy of a firm’s general partners to hire high- quality managers, provide them with the • Firms in the first cluster have not invested right incentives, and then play only an over- at all in building an internal capability for sight role? Or do the general partners tend to improving operations at their portfolio get more involved in the day-to-day manage- companies. Either they function like a ment of the company, playing more of a traditional private-equity firm with no hands-on role? operating capabilities. Or they rely on a network of external advisors. The second is the private-equity firm’s basic organization structure, culture, and design. • Firms in the second cluster have built an For instance, are the firm’s funds large or internal capability at the partner level. small? Does it have many portfolio compa- They have hired either generalist operating nies or just a few? Does it primarily target partners or functional operating partners, or healthy companies or distressed businesses some combination of the two. that have a high potential for turnaround? Does it focus on a specific set of industries or • Firms in the third cluster have invested is it present in many sectors? Does it have op- significantly in the creation of operational erations in one country or in several? Do its teams at multiple levels of the organization deal teams consist mainly of people with below that of partner. Some firms rely on a financial backgrounds or do these teams relatively small in-house operating team; include people with consulting or industry- others, however, have built a large in-house specific expertise? operating team that can rival the number of members on the deal team itself. To understand how these two factors interact with the different operating models and what None of these operating models is necessarily constitutes best practice for each model, let’s better than the others; each can be executed explore each of them in turn. | P E
  13. 13. E  | Our Interviews Identified Six Operating Models No internal capability Operating partners In-house operating teams Model None Advisors Generalist Functional Small Large Neither internal External net- Single layer of Single layer of Multilevel group Multilevel group operating work of senior executives on executives on of operating of operating capabilities nor advisors with private-equity- private-equity- professionals on professionals on external advi- equity stake in private-equity- private-equity- sors the portfolio with generalist with functional Description company or expertise (for expertise; fund example, sector they do not nec- knowledge); essarily have an they do not nec- equity stake essarily have an equity stake Not applicable Former CEOs Former senior Former Operating team Operating team and CFOs executives; executives and as large as high-level gen- consultants smaller than deal team, with eral managers with expertise deal team, with comparable compensation functional area of compensation (for example, procurement, sales, or IT) Deal teams in- Serve on port- Will work on Will work on Will work on Will work on teract with port- folio company more than one more than one one portfolio one portfolio folio company board, usually portfolio com- portfolio com- company at a company at a through board; in the role of pany at a time pany at a time time throughout time throughout Activities no project man- chair; may as- entire invest- entire invest- agement role; sist in diligence ment process; ment process; no involvement phase to build will stay on site will stay on site in day-to-day value creation for up to one for up to one operations plans year year Source: BCG analysis.No Operating Capabilities In a world in which operational value cre-Despite the growing importance of operation- ation is becoming more important, we be-al value creation, some private-equity firms lieve that this traditional private-equity mod-have chosen not to develop internal operat- el will likely struggle to perform. But thereing capabilities and to rely only selectively on are a few exceptions in which firms are stillexternal providers with operating expertise. making it work. A private-equity firm with no operating capabilities can still be successful,Firms in this category tend to influence their but only if it has other differentiating charac-portfolio companies primarily through gover- teristics in its business model that make it annance mechanisms such as the appointment attractive partner—for example, privilegedof top management, the design of incentives, access to deals or a network advantage uponand ongoing involvement on the company exit. In such cases, a firm can partner withboard. Typically, they target relatively healthy other private-equity firms, but only in a mi-companies that can operate without major nority role.hands-on intervention. And they focus care-fully on building a strong managementteam—whether by giving existing managers a A Network of External Advisorsstake in the business or by bringing in an en- Other private-equity firms avoid building antirely new team. “We change management in internal operational infrastructure by choos-nearly half the cases at the beginning of our ing to rely on a network of external advi-ownership,” a general partner at one such sors—typically former CEOs and CFOs—tofirm said. provide leadership on operational value cre- T B C G | 
  14. 14. ation. These advisors, who may have func- Generalist Operating Partners tional or sector-specific expertise, typically In this model, former senior executives with have an equity stake in the private-equity sector-specific experience join the private- firm’s fund or in one or more of the firm’s equity firm as general partners. Like deal portfolio companies. However, they are not partners, these generalist operating partners on the firm’s payroll. are typically compensated through some combination of fixed salary, annual bonus, and carried interest (carry), which is a share Portfolio companies in the profits that the private-equity firm makes on its investments. They may also re- should not view advisors ceive options in the portfolio companies they work with, and they sometimes are required as CEOs-in-waiting. to coinvest as a limited partner in the private- equity firm’s fund. External advisors typically fill two roles. In Much like external advisors, generalist oper- some cases, they identify potential deals. But ating partners are usually former CEOs or more often they function as a coach to the CFOs with enough experience in the private- CEO and, sometimes, an intermediary be- equity firm’s target industries to have cred- tween the CEO and the private-equity firm— ibility with portfolio company CEOs. They act for example, by serving as chair of the portfo- as key interlocutors with those CEOs in the lio company’s board. Although advisors are development of company strategy and gener- usually not involved in the day-to-day run- ally serve as coaches and “sparring partners” ning of the business, their degree of engage- on a whole range of issues on the CEO agen- ment with the portfolio company can range da. Another important role is to be the pri- from working closely with the CEO and sen- vate-equity firm’s primary overseer of opera- ior management to being available for the tional-improvement programs at portfolio occasional meeting as needed. companies. They do not, however, get deeply involved in the day-to-day running of the The most important success factor for this business. model is to develop strong relationships with genuinely high-caliber former CEOs or CFOs One of the attractions of this model, com- who are industry veterans in the sectors the pared with the external-advisor model, is that private-equity firm targets. This is easier said it brings substantial industry and operational than done. Although there may be many for- expertise directly into the private-equity firm mer executives who have held the title of and therefore offers the opportunity to inte- CEO or CFO, relatively few have the skills grate this expertise more fully into both pre- and the flexibility to adapt to the private- deal due diligence and postdeal work at the equity environment and to make a material portfolio companies. But for the model to contribution to the businesses they are work, it is critical that the generalist partners involved in. be fully accepted by the deal team. If general- ist operating partners are simply imposed on Once a firm has found the right advisors, it the deal team by the firm’s management or must also empower them so that they can have backgrounds so different from those of play a meaningful role in portfolio companies the deal team that the two sides never really and in the fund—for instance, by involving connect, the model tends to break down. them fully in the front end of the deal proc- Therefore, it is critical to hire operating part- ess in order to draw on their deep industry ners who already have or can develop the expertise. right mindset for work in private equity. Tra- ditional “command and control” executives Finally, the role of the senior advisor must be typically do poorly in this role. clearly defined so that he or she is not per- ceived as a CEO-in-waiting by the portfolio Even more than senior advisors, a generalist company’s management team. operating partner runs the risk of being per- | P E
  15. 15. ceived as a CEO-in-waiting by management at be systematically rolled out across the entirethe firm’s portfolio companies. “Our experi- portfolio in a relatively standardized manner.ence is that it is difficult to bring in general- The model also seems more appropriate forists,” one general partner told us. “The CEO primary rather than secondary investments,immediately starts worrying, ‘Is this guy going because companies that are already ownedto be my replacement?’” This risk can be mit- by another private-equity firm tend to haveigated by linking the incentives of generalist far fewer opportunities left for cost cuttingoperating partners to overall fund perfor- and other standard improvement activities.mance, which gives a clear sign that they willbe staying in their roles at the private-equity To ensure that functional initiatives are ap-firm for the long term. plied systematically across the portfolio, it is critical for the private-equity firms that followA key limitation of this model is that it is not this model to develop mechanisms thateasily scalable. Generalist operating partners embed the functional partner’s expertisecan engage with, at most, about five portfolio deeply within the firm. Functional operatingcompanies during the same time period. partners need to have strong incentives toWhen they try to cover more, their involve- contribute to the success of the fund and itsment is usually restricted to board-level inter- portfolio companies. In our experience, it isactions, where their ability to impact the busi- generally more effective to link incentives, atness is relatively limited. In a typical midsize least in part, to predefined targets in the dif-private-equity firm using this model, there ferent portfolio companies rather than to themight be at most a handful of generalist oper- overall success of an entire fund.ating partners, which can make it difficult tohave the necessary breadth of sector experi-ence to support a multi-industry investmentstrategy. Some firms have devel- oped a full in-houseFunctional Operating Partners operating capability.Another approach at the partner level is tohire executives with expertise in functionalareas such as procurement or sales force The primary limitation of the functional-effectiveness. Typically, functional operating operating-partner model is that it is focusedpartners are not as senior as generalist oper- mainly on well-defined, bottom-line opera-ating partners. They rarely serve on the tional-improvement initiatives. If there areboards of portfolio companies. Rather, they unexpected discontinuities in a company’sfunction more like consultants to portfolio business, requiring fresh thinking about strat-company CEOs, working on specific opera- egy and top-line growth, that thinking is un-tional-improvement initiatives and moving likely to come from functional operating part-from one initiative to the next as each is com- ners. The private-equity firm will have to findpleted (a fact that tends to make them more it elsewhere.easily accepted by a portfolio company CEO).Functional operating partners receive asalary but, depending on the private-equity Small In-House Operating Teamfirm, do not always participate in the carry. The third and final level of operational-valueIt is also common for these specialists to re- infrastructure concerns those private-equityceive a success fee that is based on the results firms that have developed a full in-house op-of the specific operational-improvement erating capability. This capability takes theprojects that they lead. form of a multitier team of operating profes- sionals (below the partner level) who lever-This operating model works best when a pri- age the work of the operating partner.vate-equity firm has a large and frequentlychanging number of portfolio companies, so Owing to the high cost of maintaining such athat functional value-creation initiatives can team, this option is appropriate primarily for T B C G | 
  16. 16. the largest private-equity firms with opera- insular and losing its best people. An in- tions in multiple markets and regions. These house operating team can also be perceived firms tend to have a minimum of 40 compa- negatively by a firm’s portfolio companies, nies in their portfolio at any one time, with especially if they are forced to use—and pay companies regularly moving into and out of for—it (as opposed to solving problems them- their ownership. “Scale is absolutely critical for selves or going outside for help). this model to work,” one general partner said. In some of the firms we studied, the in-house Large In-House Operating Team operating team is quite small in comparison At some of the largest private-equity firms we with the deal team, and it mainly plays a sup- studied, the in-house operating team has porting role. Board-level engagement is re- reached such a critical mass of people and ex- stricted to deal team partners, who manage pertise that it plays a considerably more cen- the deal from predeal through closing and, tral role than do typical small in-house oper- eventually, exit. The operating-team partners ating teams. In these firms, the operating focus on specific management-level projects team is so large that in any particular trans- with the CEO, which the operating team then action, it functions more as an equal partner helps the company implement. In effect, the to the firm’s deal team. In some situations, operating team functions as an in-house con- deal management is a shared responsibility, sultant that the private-equity firm can de- with deal team partners taking the lead until ploy as needed across its portfolio companies. closing and operating-team partners taking the lead during implementation of the value creation plan. Building an in-house team What we have observed is that once an in- expands the universe of house operating team reaches critical mass in terms of numbers, depth, and breadth of ex- potential targets. pertise, there is a subtle but significant shift in the private-equity firm’s culture. Operat- ing-team members acquire more influence. The singular advantage of having an in-house The operating team’s organization structure team is that the private-equity firm develops and career paths increasingly mirror those of a comprehensive understanding of the team’s the deal team. And operating-team partners’ capabilities and can deliver a consistent ap- compensation is structured in the same way proach to operational improvement at its as that of deal team partners. “Operating portfolio companies. The existence of an in- teams need to be completely integrated,” said house operating team also expands the uni- an operating partner at one such firm. “We verse of potential targets for a private-equity have a clear and agreed-upon role to play at firm. Specifically, it allows a firm to consider each step of the deal process.” distressed assets with high turnaround poten- tial that require intensive hands-on involve- It should be clear from the above descrip- ment and a level of attention that firms with- tions that these models are not all necessarily out an in-house capability cannot offer. mutually exclusive. Indeed, a number of the firms we interviewed appeared to be in a A major challenge with this model, however, state of flux about the evolution of their own is continuously refreshing the knowledge model, and some have embraced creative base and approaches of the team so that it combinations of different elements of these keeps current with the latest best practice in models. For example, one private-equity firm operational value creation. Unless the pri- has invested in building a large in-house vate-equity firm invests in creating a sustain- operating team. But it also regularly calls on able learning environment (including clear an external network of world-class functional career paths for associates to become operat- experts who are brought in as needed (as ing partners themselves at some point), an independent contractors) to solve specific in-house team runs the risk of becoming too problems at the firm’s portfolio companies. | P E
  17. 17. THE PARADOX OF STANDARDIZATIONO     a trend that is increasingly shaping the industryand that we believe will be central to its We identified three standardized approaches to postclose planning:future evolution—irrespective of the specific • The postclose strategy day, in which theoperating model that a private-equity firm private-equity firm’s deal team and (ifchooses. That trend is increasing standardi- present) operations team meet withzation. company management to reach agree- ment on the company’s general strategicBy “standardization,” we mean the develop- direction and identify a limited set ofment of explicit, easily replicable proprietary critical strategic initiatives (without goingprocesses for creating operational value. Driv- too deeply into how those initiatives willen by the maturing of the private-equity in- be implemented).dustry, standardization is taking place bothalong the private-equity value chain—that is, • The 100-day program, in which the private-the general process by which private-equity equity firm and company managementfirms identify, acquire, improve, and then exit develop a detailed action plan for opera-their portfolio companies—and within the tional improvements to be implementedspecific initiatives that private-equity firms in the first three months aer the dealdeploy to create operational value at those closes (sometimes with the help of ancompanies. external consulting company). • The value creation road map, which is aStandardization of the Deal comprehensive long-term action plan forProcess realizing the company’s strategic agenda—When it comes to the deal process, standard- complete with critical milestones, aization is taking place in three areas: post- timeline, designated responsibilities, keyclose planning, performance monitoring performance indicators (KPIs), and links toduring the holding period, and professional the company’s budget and business plan.development of the portfolio company man-agement team. While nearly all the firms we In our experience, most private-equity firmsanalyzed are standardizing these three proc- use at least one of these three mechanismsesses to some extent, there is broad variation for postclose planning. But, of course, thesein the degree of standardization and its over- approaches are not mutually exclusive. Eachall robustness. has a different time horizon and each tends T B C G | 
  18. 18. to go progressively deeper into the nuts and and stock levels in the automotive industry). bolts of operational value creation in the In the future, we expect to see comprehen- portfolio company. One key trend in the stan- sive standardized monitoring of portfolio dardization of postclose planning will be to companies, including automated monthly re- integrate each of these approaches into a porting, standardized cross-portfolio metrics, more comprehensive planning process. In this and company-specific leading indicators. integrated approach, the strategy day focuses on aligning the key players around the long- The professional development of the man- term strategic direction, the 100-day program agement cadre at a private-equity firm’s port- focuses as much (or more) on figuring out folio companies is probably the area in which how to implement the initiatives necessary to there is the least amount of standardization execute the strategy as it does on achieving today. Most firms do an initial assessment of quick savings, and the value creation road management during the due diligence proc- map guides the company’s activities through- ess or, if they choose to go outside for man- out the holding period. agement, before they hire a new team. Many complement this initial assessment with on- In today’s highly volatile economic environ- going performance reviews of the CEO. But ment, however, firms need to be prepared for relatively few have instituted standard re- the fact that portfolio companies may have to views of C-suite employees across all their adapt their strategy multiple times through- portfolio companies. out the holding period. As a result, postclose planning will increasingly extend until exit, As operational value creation becomes more with the value creation road map being revis- central, private-equity firms will need to take ited at multiple points as changing business a much more active approach to encouraging conditions require. This iterative planning the professional development not only of the process will conclude with the ever more im- top teams at portfolio companies but also of portant task of exit preparation—that is, re- the broader management ranks. That will be viewing the business plan and key value driv- a big challenge because private equity has ers 12 to 18 months prior to a planned exit in had something of a blind spot when it comes order to test whether the company is attrac- to talent management. When value mainly tively positioned for likely buyers. came through leverage and holding periods were relatively short, the development of tal- When it comes to performance monitoring, ent seemed like an investment that firms we also found a range of standardized ap- could safely avoid. proaches. While nearly every firm we looked at has some standardized approach to track- But as top-line growth becomes more impor- ing KPIs at their portfolio companies, the tant and holding periods grow longer, build- comprehensiveness of those KPIs varies ing a strong management bench even down greatly. Most firms track financial reporting, a into the middle ranks of portfolio companies process that in some cases has become com- will be core to successful value creation. pletely automated. But only some regularly Systematic professional development will track operational KPIs (for instance, operat- help to ensure that firms are getting the most ing income or industry-specific indicators out of the people at their portfolio compa- such as same-store sales in retail), which are nies. What’s more, we believe that standard- absolutely critical for monitoring ongoing op- ized approaches to people development will erational value creation. Finally, relatively eventually cover all employees at portfolio few firms have taken the additional step of companies. (See the sidebar “Bridging the systematically tracking leading indicators that Talent Gap.”) For example, one large private- would allow them to identify problems in the equity firm we studied has a proprietary business before those problems start showing professional-development process that in- up in downward-trending operational KPIs. cludes an employee-training program and on- Leading indicators might include macroeco- line surveys to gauge employee satisfaction at nomic factors (such as inflation rates) or in- portfolio companies, the results of which are dustry-specific factors (such as order intake integrated into the firm’s reporting system. | P E
  19. 19. BRIDGING THE TALENT GAPPrivate-equity firms need to think more objectives. By asking where the company isseriously about how they develop a strong now and where it wants to be in the future,bench of talent at their portfolio compa- executives can identify the current gaps innies. Consider the demographics. Talent is talent quantity and quality and map a pathalready in short supply for many positions. forward on the basis of its business plan andIn a 2010 BCG worldwide survey, 56 resulting talent requirements.percent of responding companies cited acritical talent gap for senior managers’ Leadership Models. Leadership modelssuccessors—in part because their internal also need to be grounded in the broadertalent pools were too shallow. business context. Today’s volatile competi- tive environments call for adaptive leadersDespite slow economic growth in the who embrace uncertainty and experimen-developed nations, most companies are tation, and who manage through influencehard-pressed to find high-performing, and empathy more than through commandhigh-potential individuals who will serve as and control.tomorrow’s middle managers and seniorleaders. In high-growth emerging nations, Talent Sourcing and Diversity. Competitivethe challenge is to find sufficient numbers markets are now characterized by global-of skilled workers. The shortage of skilled ization and increasingly distinct andpeople will worsen over the next decade, demanding customer segments. Compa-making it more difficult for organizations to nies staffed exclusively with similar-lookingpenetrate new markets and compete and similar-thinking employees lack theeffectively in volatile markets. broad range of insight and experience needed to meet the challenges of aThe new reality is that companies face a globalizing world. As companies diversifyseller’s labor market, with highly talented their employee base, they will also need toindividuals having more job choices than modify their value proposition in order toever before and desperate companies meet more diverse expectations.engaging in “talent wars” that only bid upthe price of talent, oen far beyond an Talent Development Acceleration. Today’sindividual’s capabilities. In such an envi- young talent demands a steady stream ofronment, it is more sustainable to build developmental opportunities. A careertalent internally. Doing so preempts the trellis offering multiple options, as distinctneed to expand expensive and time-con- from a single-track, vertically orientedsuming recruiting processes, and it rein- career ladder, can help address that need.forces the company’s value proposition to To more quickly build employees’ compe-employees and potential recruits. On the tencies and accelerate the pace of theirbasis of our survey, high-performing business experience, companies cancompanies (as defined by revenue growth immerse their talent in unfamiliar markets,and profitability) fill 60 percent of senior- temporarily assign them to external groups,manager positions internally, as compared or provide limited-authority opportunitieswith 13 percent at low-performing compa- such as joint ventures. These initiativesnies. High performers have realized the help raise levels of engagement, reduceneed to have a holistic talent strategy in unwanted attrition, and ensure a continualplace to leverage this most valuable asset. flow of talent.That strategy has six building blocks. Talent Engagement and Affiliation.Talent Strategy and Returns Tracking. The Nothing derails construction of a robustfoundation of a solid talent strategy must be talent pipeline faster than unwanteda company’s business strategy and growth attrition. And nothing reduces attrition as T B C G | 
  20. 20. BRIDGING THE TALENT GAP (continued) effectively as an organization that recog- A Talent Magnet Culture. Building an nizes and responds to the impact of employer brand in sync with the varied emotional drivers on employees’ discre- priorities of a multigenerational workforce tionary effort. Compensation matters, but is essential to ensuring that a company has only as one factor among several. A high- the right talent to achieve its growth plans. caliber management is more effective than In addition to executive time and attention, a monthly paycheck at binding employees it takes resources and infrastructure, such to a company. And more engaged employ- as talent management processes that cut ees are more productive, reducing the need across functions, business units, and for additional staff. Leaders play a big role countries. here, by establishing norms and expecta- tions about what constitutes exceptional For a fuller treatment of this subject, see performance and by being accountable “Make Talent, Not War: From Serendipity for the development and engagement of to Strategy,” BCG article, December 2011, their staff. from which this sidebar is excerpted. Standardization of Operational sion. And more than 70 percent said that Value-Creation Initiatives their firms also focus on sales force effective- The other area in which standardization is ness and pricing. The bad news, however, is taking place is in the range of initiatives that that despite these exceptions, the majority of can create operational value at a private- top-line initiatives bring up the bottom of the equity firm’s portfolio companies. Exhibit 5 list. For example, less than 30 percent of the presents a typology of 25 ways that a compa- firms systematically focus on product bun- ny can create operational value. Some in- dling and cross-selling, less than 20 percent volve optimizing the company’s financial consider account management, and none fo- structure—for example, its working-capital cus on channel management. productivity, capital expenditures, or policies for the use of surplus cash. Others focus on Of course, just because a firm says that it uses creating efficiencies that improve the compa- any one of these mechanisms does not neces- ny’s bottom line—reducing overhead costs, sarily mean that it has developed a robust, delayering the organization chart, or reengi- replicable, standardized capability. In our ex- neering key functions such as sourcing, logis- perience, the areas in which firms are using tics, and procurement. Still others focus on fully standardized approaches the most are improving the top line—whether by fine-tun- financial optimization and bottom-line im- ing the core business or by expanding into provements. Relatively few have developed new channels, regions, or whole new busi- standardized approaches to the top-line ini- nesses. tiatives increasingly critical to creating opera- tional value. “We’ve become good at taking We asked the private-equity executives whom cost out and standardizing our approach,” we interviewed which of these initiatives they said one operating partner. “We are less ex- regularly use at their portfolio companies. perienced with the revenue growth levers.” Their answers are portrayed in Exhibit 6. In Although it is true that some top-line areas an environment in which operational value seem inherently difficult to standardize— will increasingly come from improving the business model development, for instance, or top line, the good news is that nearly all of brand strategy—we believe that best-practice the firms are using at least some of the top- models do exist for many of them. (See the line initiatives. More than 80 percent of re- sidebars “A Standardized Process for Pricing spondents said that their firms systematically Improvement” and “A Standardized Aproach focus on two: M&A and geographic expan- to Product Innovation.”) | P E
  21. 21. E  | Companies Can Create Operational Value in Four Broad Areas Top line Top line Financial structure Bottom line (core business) (expansion) Working-capital optimization Sourcing Sales force effectiveness Channel strategy 1 Inventory, receivables, 6 Outsourcing, offshoring, 12 Incentives tied to margin 19 Expansion into new and payables management insourcing and growth channels Fixed-asset optimization Procurement Account management Product innovation 2 Capacity, leasing, financing, 7 Cost savings and 13 Strategic accounts and 20 New-product and utilization supplier base end customer development Capital expenditure Logistics Marketing 3 optimization Order handling, planning Promotion effectiveness, Postpone or avoid 8 and stocks, warehousing, 14 21 M&A brand management investments and distribution Surplus cash policies Operation, production, Pricing 4 Dividends, share buybacks, 9 and manufacturing 15 Strategy, levels and 22 Brand strategy and debt repayments efficiencies structure, execution Restructuring or Overhead cost reduction Product line development 5 10 Value- and activity-based 16 Continuous improvements 23 Geographic expansion divestment cost reduction to existing products 11 Delayering 17 Product bundling Business model and cross-selling 24 development Channel management Service 18 Channel merchandising, 25 Model, organization,Source: BCG analysis. sales aspects of logistics and processesE  | Private-Equity Firms Do Not Routinely Use Top-Line Initiatives Initiatives M&A 91 Geographic expansion 82 Sourcing 82 Overhead cost reduction 82 Procurement 73 Sales force effectiveness 73 Pricing 73 Working-capital optimization 64 Capital expenditure optimization 45 Surplus cash policies 45 Fixed-asset optimization 36 Logistics 36Operation, production, and manufacturing efficiencies 36 Delayering 36 Restructuring or divestment 27 Product bundling and cross-selling 27 Channel strategy 27 Product innovation 27 Business model development 27 Account management 18 Marketing 18 Product line development 18 Brand strategy 18 Service 9 Channel management 0 0 20 40 60 80 100 Percentage of firms that systematically use this initiative Financial structure Bottom line Top line (core business) Top line (expansion)Source: BCG analysis.Note: The sample consists of 29 interview subjects at 15 private-equity firms. T B C G | 
  22. 22. How do the various operating models differ cally have a balanced mix between bottom- in their use of standardized approaches to line and top-line initiatives, although they operational value creation? On the basis of tend not to be as comprehensive in address- our research, firms that use external advisors ing bottom-line opportunities—owing mainly show no consistent pattern. In fact, the initia- to lack of time. Firms with functional part- tives they employ seem largely dependent ners have a clear focus on standardized ap- on the experience of the particular advisor. proaches to bottom-line improvement, but to Firms with generalist operating partners typi- the degree that they do address top-line A STANDARDIZED PROCESS FOR PRICING IMPROVEMENT A standardized process for pricing improve- time of day). These types of changes ment focuses on two clear goals: improving require managers to carefully segment a company’s pricing model through better their customers and opportunities. Piloting policies on how prices are set and improv- and testing are crucial before pricing ing the pricing platform used to implement schemes are rolled out; therefore, imple- those policies throughout the organization. mentation takes longer than for other, less complex moves. There are three ways to improve a com- pany’s pricing model. The easiest is Improving the pricing platform is a more through quick, no-risk fixes for pricing cyclical effort in which the company policies and anomalies—for instance, reviews its progress and redesigns its tightening the terms of payment, setting processes when necessary. The process strict guardrails (such as minimum includes redefining the roles and responsi- profitability levels), increasing prices on bilities of key stakeholders; establishing a products or product features that have low clear process for collecting, analyzing, and visibility, and monetizing giveaways. Such interpreting market data; integrating initiatives can be decided upon quickly and pricing into key business processes; rolled out for immediate impact. investing in tools and technology to support stakeholders in pricing; and Other changes are more strategic—for designing incentives for general managers example, shiing price levels on key items and sales teams that incorporate explicit by changing list prices or redefining the price-realization targets. terms of trade promotion. Such moves are not to be taken lightly. It is critical to Given the complexity of pricing improve- analyze carefully how both customers and ment, it is best for these initiatives to be competitors are likely to react to the implemented in phases. Start by sizing the changes. Exploring the impact of such prize and developing a road map for pricing changes takes some time, but once a improvements. Then optimize price levels decision is made, implementation is in the pricing model and redesign process- fast—and so are results. es in order to improve the pricing platform. In the final two phases, return to the The third, and most comprehensive, way to pricing model to reshape the pricing improve a company’s pricing model is by structure (a new product lineup and new creatively rethinking its overall pricing pricing schemes, for example) and hardwire structure. For example, a company could the new pricing platform. decide to overhaul its product lineup or completely rebuild its discount structure. For additional information on pricing It might also consider innovations such improvement, see “Pricing Fluency: A as pricing for performance, subscription Program for Pricing Excellence,” BCG pricing, or dynamic pricing (which is article, December 2009, from which this pegged to an external variable, such as sidebar is excerpted. | P E
  23. 23. A STANDARDIZED APPROACH TO PRODUCT INNOVATIONAer years of focusing on cost, quality, and over time. It runs from the very beginningproductivity, private-equity firms are of development until the point at which theincreasingly concerned with generating product or service is removed from thegrowth. As a result, they want more innova- market. (See the exhibit “A ‘Cash Curve’tion from their portfolio companies. But Offers a Window on Product Innovationthey oen admit that they don’t know how Initiatives.”)to put an innovation agenda into practice. By carefully modeling the impact ofA starting point is to realize that innovation different choices on the cash curve of anis an act, not an idea. Successful innova- innovation, managers have insight into thetion—which is to say profitable innovation— relative impact of key drivers of value. Thisdepends on the entire set of actions that approach also provides a mechanism forare required to turn an idea into cash raising important questions about risks andreturns. Combined, these actions are what for discussing possible interventions towe call the innovation-to-cash process. reduce the risk of failure.Because this process cuts across organiza-tional boundaries and presents many The financial analysis of innovations, which isdifficult choices, it must be explicitly and fairly common, combined with a dynamicthoughtfully managed. In particular, view of the cash curve, which is relatively rare,companies need a way to evaluate and blends strategy and execution. It can makemanage the inherent tradeoffs—consistent- the difference between developing anotherly and across a whole portfolio of different inconsequential product or service andinnovation efforts. winning big—because it gives the top management team a language for and anDespite the many uncertainties of innova- appreciation of interrelated financial, market,tion, it is possible to assess, at the outset, and technology risks. In the end, executivesthe likely impact of different approaches to have common ground to make bettermanaging the full innovation-to-cash tradeoffs and break current compromises.process. This is accomplished by examininga particular innovation’s “cash curve.” A For a fuller treatment of this subject, seecash curve depicts the cumulative cash “Making Innovation Pay,” BCG article, Mayinvestments and returns for an innovation 2004, from which this sidebar is excerpted. A “Cash Curve” Offers a Window on Product Innovation Initiatives Speed Scale (time to market) (time to volume)Cumulative cash Time Start-up Support (prelaunch (postlaunch investment) investment) Launch Idea generation Commercialization Realization Source: BCG analysis. T B C G | 
  24. 24. E  | Some Operating Models Rely More Heavily on Standardized Approaches No internal capability Operating partners In-house operating teams None Advisors Generalist Functional Small Large Are top-line initiatives standardized? Are bottom-line initiatives standardized? Not standardized Fully standardized 1 1 Geographic 1 1 1 M&A M&A 1 expansion M&A M&A M&A Most commonly Geographic Geographic 2 expansion 2 M&A 2 Sourcing 2 Sourcing 2 used initiatives expansion Sales force Working- Overhead 3 3 Pricing 3 capital 3 cost 3 Procurement effectiveness optimization reduction Source: BCG analysis. levers (which is rare), they often take a rela- dardization furthest and fastest will free up tively unsophisticated “plain vanilla” ap- their senior people to focus on activities proach. The profile of firms with operating that potentially can confer a long-term teams is similar to that of firms with func- competitive advantage—specifically, activi- tional partners, although the teams, of course, ties that do not lend themselves to standard- are significantly more involved in the actual ized approaches and that require a complex implementation. (See Exhibit 7.) mix of strategic and operational skills (for ex- ample, top-line expansion levers such as The trend toward increased standardization channel strategy, brand strategy, and business in private equity presents the industry with model development). a paradox. The more the industry embraces standardization—both in the deal process and across the spectrum of ways to create operational value—the less likely it is that either arena will become a source of differen- tiation. However, those firms that push stan- | P E
  25. 25. THE IMPERATIVE OF PROFESSIONALIZATIONT     value creation is creating one final challenge for theprivate-equity industry. As the staffs at forward. They did deals; if the deals were suc- cessful, they were promoted; the more suc- cessful the deals were, the more money theyprivate-equity firms become bigger—and would make.include people with backgrounds and disci-plines that go beyond the financial expertise Today, things have become more complicated.of the industry’s early years—these firms’ As private-equity firms grow bigger and in-organizations are becoming more complex. clude not only financial but also industry andThis complexity will force firms to profession- functional experts, questions of professionalalize their management processes. and career development come to the fore. And in a tougher economic environment, it isIn a sense, the private-equity industry faces a no longer enough to assume that outsized paysituation not so different from that of a suc- packages will attract the right kind of people.cessful start-up that has become a big compa- Much like their portfolio companies, firmsny. The ad hoc practices that worked well will have to define appropriate metrics for re-during its early years are no longer effective. cruiting, nurturing, and rewarding many dif-Instead, the company has to take a more ferent kinds of talent and put into place astructured approach to key internal issues. comprehensive review process that reinforcesSo, too, do private-equity firms today. those metrics.More professional management does not nec-essarily mean more bureaucracy; it can be Communication, Decision Making,achieved in ways that preserve the flexibility and Teamingand fast decision-making of the traditional Another key area in which practices need toprivate-equity organization. What it does be professionalized concerns interactions be-mean, however, is paying closer attention to tween a private-equity firm’s deal-team staffkey internal processes that govern how em- and operating personnel. Effecting change inployees are developed, how they are compen- this area is more a matter of organizationalsated, and how they work together. culture than formal processes. Probably the biggest obstacle to successful operational value creation in private equity today is theProfessional Development perception on the part of at least some oper-In the early days of private equity, the career ating personnel at some firms that they arepath for people in the industry was straight- not treated as equal partners in the private- T B C G | 