Why is Active Management the Most Important Trend in Private Equity?
The way to achieve above-average results without excessive risks is through firmly controlling your assets’ business vision. If you are not ready to give your private equity investment a new impetus and to navigate it successfully from acquisition to divestment on a daily basis, you needlessly waste the profits of yourself and your co-investors.
The Case for Active Management
As a partner in a private equity company, I have helped breathe new life into twenty-five industrial enterprises in twenty years, arriving at a more than three times cash-on-cash multiple. Our primary objective over the years has hardly been shocking: to achieve high returns without excessive risks. Surprisingly, the path we have paved to accomplish this is not as widespread among private equity professionals as I would have expected. With the good reputation of the whole private equity sector in mind, I would like to argue for a more active approach towards assets’ management. Here are my thoughts on why the “hands-on” daily management of your portfolio companies is the right way to maximise your profits and gain the trust of external investors.
You do not achieve high returns by running a factory from the comfort of your computer in a warm office
Passive management leads to increased risks and lower ROI
The control you can exercise over your acquisitions is one of the greatest added values of private equity investing as opposed to investing in stocks and bonds. So why is it that I so often see private equity firms stepping into the role of a broker, investing solely in the incumbent management? The lesson I have learnt through my career is quite a straightforward one: you do not achieve high returns by running a factory from the comfort of your computer in a warm office. It takes much more than just being a financial expert. As an experienced investor, you have to influence the risk associated with the investment purposefully. Your task is to design a long-term vision, to make sure it is being implemented, and most importantly, to confront your vision with reality and the opportunities or threats on the market. Every day. In my experience, that is the only way to increase the intrinsic value of an acquisition. So, how do we do it?
Prepare to do the dirty work yourself
When we acquired one of the largest suppliers to the freight railways industry in Europe, we let the management do their job as best as they could, but we were far from being idle ourselves. We focused heavily on R&D. We were aware of the high fees railway operators had to pay to the national railway provider for every kilogram transported, so the idea suggested itself: if we managed to develop lightweight bumpers, we could sell a product with high added value and shift the position of the whole company on the market up. This idea would not have been born without an active approach and fresh outlook on our side, coupled with cooperation and communication with the incumbent management.
Succinctly put, our approach to private equity goes like this:
My colleagues and I actively manage each company we buy. Our team has experts on strategic, tactical, and crisis management, and often with extensive experience from the industry. That is why we only buy companies in sectors we genuinely understand, and each purchase decision is backed by a lengthy decision-making process and detailed due diligence. In acquired companies, we replace ineffective management and provide the impetus to move businesses in new directions. Moreover, we seek to build robust platforms in specific industries, taking advantage of synergies within our portfolio, while selling off unproductive assets.
Money Is the Best Incentive
Furthermore – and this is important – the remuneration of a project director is entirely dependent upon the success of his or her projects (the plural here means no more than a couple as none of the project managers on our team is allowed to handle more than two projects so as not to distract his or her focus). This ensures that every one of us gives all we’ve got. Last but not least, we have yet another stake in seeing that our factories achieve the best possible results. In our private equity funds, we own 10 - 40% share. We are motivated to achieve the highest possible returns for our investors. I dare say this is why successful businesspeople and managers trust us, repeatedly, with their money.
The Incumbent Dilemma and the Praise of Fresh Outlook
To make it clear, I am not arguing against cooperation of the private equity investor and the management of the company. Quite the opposite. The tighter it is, the better. There is no one else who understands running the business and dealing with the employees better than the hard-core matadors, who have often tied their lives to the prosperity of your new acquisition. However, being so intimately acquainted with the daily operations inevitably brings about creative blindness. That is where you step in. A good project manager knows almost everything about the firm, down to the substantial detail, but has the privilege of not being concerned with the practical running of the company. His mind is free to wander, to consider new paths, to imagine what is unimaginable for the management, simply because they lack time to do so - and when the time comes, to predict crises and changes on the market in order to allocate or reduce investments more effectively.
A good project manager knows almost everything about the firm but has the privilege of not being concerned with the practical running of the company. His mind is free to wander.
Thinking Out of the Box: The Example of Carbon Fabrics
We knew right from the beginning that the 70 years’ know-how of one of our acquisitions, a leading manufacturer of technical fabrics, was strong enough to keep the company on top of its industry sector. However, we also suspected that such potential was meant to be used as a fuel for change. After assessing the business risks, we embarked on a brand-new path to produce carbon fabrics – a product the current management had heard of but was not entirely keen on producing. It took a lot of convincing but the outcomes more than paid off. In a few years, we had not only a fully capable production line up and running, but we also achieved, through acquiring another company, the integration of an entire production chain from manufacturing textiles through to their impregnation, and then to the production of final components. Embracing a bold idea all those years ago led us to the production of state-of-the-art, hi-tech materials for the automotive and aircraft industries.
10 Things We Do Differently from Other Private Equity Firms
I have titled this article “a blueprint”, and I intend to honour this pledge. I will leave you with a list of managerial approaches that differentiate us from other private equity companies. Feel free to use it as a set of clues on how you may or may not change your own practice.
Investgment Focus and Return Profile
The focus of investment in terms of its stages, types and industries often tends to be too broad or too tight and in return brings either a too low or too high risk/return profile. We have discovered that a mixture of buy-outs, growth, late-stage venture and rescue/turnaround projects ultimately deliver better return due to the balance of regular and growth paybacks.
We find short-term, passive management of investments is quite badly suited to support value creation. Instead, long-term strategies leading to a repositioning of investments, like buy & build-up, hands-on-growth, business roll-out, platform consolidation, spin-off or restructuring, have proved to be the most efficient in value creation.
A scattered portfolio reduces risks but does not necessarily translate into above average results. On the other hand, controlled investment strategies that contribute to the development of diversified industrial platforms deliver an attractive return, with a low-risk profile.
By focusing on a short-term horizon (up to 5 years) and quick exits, you might miss a lot of growth and return opportunities. In 8-10 years, you can open the window of opportunity for value initiatives wider, and you might be rewarded with stronger growth and higher return.
Concentrating solely on the financial performance of your investment without active management minimises your ability to adapt to market challenges, which in turn increases the risk. Taking full responsibility for active, hands-on management of your portfolio companies facilitates flexible and proficient decision-making, which reflects market challenges and prevents crises.
Being experienced in M&A and Finance is often not enough. If your goal is a sustainable, competitive business, you might want to build your team with experts on strategic, operational, restructuring and crisis management. Never forget that the team members with direct experiences in the industry you invest in are your most valuable asset.
Abandon the idea that one manager can handle more than two projects. Every project requires professional decision-making based on in-depth knowledge. No project manager is a Superman, and an overambitious workload will almost certainly jeopardise his or her ability to make the right decision or come up with an interesting idea at the right time.
Set rules for success fees smartly. Distinguish between the remunerations for the representatives of the companies in your portfolio and those for your project managers. Do not forget that their respective goals are achievable in different terms (long-term and mid-term).
A strong team is your most significant advantage. Leave approaching external advisers as a last resort. Focus on building your investment company’s vision hand in hand with the internal capabilities of portfolio companies.
Why not use service providers wisely? Share them across your portfolio to control the costs and support business opportunities.