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Operations: more than a buzz-word?

Institutional investors are placing increasing emphasis on ‘operational experience' when analysing private equity fund managers. About time, say some industry observers. But is there a danger that the phrase becomes little more than a mantra with scant substance behind it?

Time was when life was relatively straightforward for the average European buy-out firm. They raised funds from a small group of loyal investors, they bought low, monitored their portfolio companies, made changes where necessary and then sold a few years later at a decent multiple. They were happy and their investors were happy.

OK, so it's a simplistic view and one that doesn't take account of some of the hard graft done by many of buy-out firms in the 1980s and early to mid-1990s. But it's often how that time period is characterised by investors and privately by some fund managers. So why the nostalgia? In main part it's because life has become much harder for buy-out groups, particularly in the UK, but also on mainland Europe.

One cause of this is that the low-inflation, low-growth environment we are experiencing has made it harder for firms to rely on financial engineering strategies. But it's more than that. Private equity as an industry has matured and become more competitive along the way. And for their part, sellers of buy-out target companies have become much wiser to the ways of private equity firms and have either opted to put their businesses out to auction or have become much tougher in negotiation processes.

It's a development that Rod Selkirk has seen first hand. He worked at 3i for nine years, was at Bridgepoint Capital from 1990 and then joined Hermes Pensions Management as head of private equity last year. ‘The environment in which private equity firms are operating now is very different from that of the 1990s,' he says. ‘A lot of people say that most firms made money back then through financial engineering, but I don't think that's true on the whole. I think that what has changed is that the environment has become much more competitive. Firms are now competing with trade buyers and they are dealing with much more sophisticated sellers. As a result, they are paying higher prices and they are now having to add much more value to generate returns.'

New emphasis
The realisation that adding value to portfolio companies has become increasingly important has led many buy-out firms, particularly those in the UK, to reassess the skills make-up and structure of their teams. Some, for example, have restructured their organisations to create separate portfolio management teams whose main responsibility is to monitor and guide investee companies, providing advice where necessary, helping implement new strategies and positioning them for exit. These teams are often thought of as providing corporate financier-type services within the firm.

But possibly the most significant development in the push to demonstrate that they add value has been firms' increased emphasis on access to operational experience. ‘We are definitely seeing a move towards creating more balanced teams among buy-out houses,' says Catherine Lewis of fund of funds Proventure. ‘In the 1980s, especially in the UK, teams were mainly made up of accountants and bankers. In the 1990s, we saw a shift towards taking on consultants in-house. Now we're seeing the next stage in the development of the industry and more and more firms are taking on operational people.'

But it's not just firms that are placing more emphasis on adding value, and more particularly on operational experience. Many investors also now believe that this is one of the more important ingredients for the future success of a fund. In a forthcoming survey of institutional investors conducted by AltAssets, 74 per cent of respondents rated operational experience as critical to their investment decisions. In a similar study conducted last year, only 40 per cent mentioned operational experience in this context. The views of the Danish Investment Fund's Martin Hansen reflect this increased emphasis. ‘Operational experience is important to us,' he says. ‘A lot of people talk about this; we feel strongly about it. We like to see people who have taken companies public within the same industry for which they are raising a fund because they understand the nuts and bolts involved in the company creation process.'

But the ways in which firms gain access to this experience vary almost from buy-out house to buy-out house. Many of the mega-funds, for example, have opted to bring the skills in-house. Terra Firma, for example, has made a point of hiring people with company management experience. Veteran firm Bain Capital also makes a play of the mix of skills in its team, saying that most of its 165 investment professionals have strategic consulting and direct operating experience. And Nordic Capital, which recently closed its fifth fund on E1.5bn, can name a handful of former business managers among its executive team of 21.

From the outside, this appears to be the simplest way of ensuring that a firm has operational talent on tap. And, if the organisation is large enough, it may actually be the best way of securing the use of these skills. In fact, some investors prefer to see operational experience in-house before they will commit. ‘I think it's good to see operational experience in a buy-out team, especially in a larger firm,' says one investor. ‘These people bring with them an understanding of change management. They know that it is usually difficult and time-consuming to implement new strategies and to restructure a company. And it's this experience of implementation that many more financially oriented private equity managers don't have.'

But this approach is not without its problems. The most important of these is cultural fit. ‘There are potential problems when you try and bring operational people together with corporate finance or investment banking people because of the different ways that they tend to work,' says Hansen. ‘Investment bankers, for example, tend to celebrate individual achievements and they are not focused on mutual success; operational people are very much more team-oriented. To be successful a firm will need to be able to develop an approach that incorporates both ways of working.'

A question of integration
The problem of cultural fit is especially pertinent in firms with relatively small teams. It's often hard enough to integrate one or two people into a team of, say, ten to 15 people when they are from similar backgrounds. Add to this the difference in approach and way of working between deal-oriented people and those used to managing large teams of people and you have the potential for a bumpy ride.

This is an issue that Duke Street Capital grappled with when it looked at boosting its operational capability in the late 1990s. ‘We thought about bringing in one operations person full-time on the team,' says managing director Peter Taylor. ‘But we decided it wouldn't work for us on a number of levels. One of these is that private equity is a very different environment from an operating environment. We tend to look at 100 deals before we will go ahead with one, for example; operational people tend to work much more on projects that are actually going to happen. They are just not used to the way that we work and I don't think that we would be able to give them what they would want out of a career.'

Instead, Duke Street opted to employ the services of a handful of operating partners. These are not people who come into the office every day and they are not retained as such by Duke Street. They are best thought of as a pool of talent that the firm can call on when necessary. They also sometimes take positions on portfolio company boards alongside one of the investment professionals. ‘Their involvement is on a deal-by-deal basis,' explains Taylor. ‘That way we can call on people who have the right experience and contacts. We also feel that our operating partners work better as free spirits.'

The firm currently has ten operating partners sourced through various networks and includes Remy Sautter, chairman and CEO of RTL Radio France, Peter Macielinski, formerly managing director of Geest, and John Rogers, formerly director of Unigate, Invergordon Distillers and David Lloyd Leisure. ‘We have been promoting the importance of operational experience for a long time,' says Taylor. ‘We have always modelled ourselves as being very hands-on. It was a natural progression for us to start bringing on operational partners - these are people who can be hands-on because they know how to be hands-on.'

Their value, says Taylor, is in complementing the in-house team's private equity experience. ‘Our operating partners add value most when it comes to appraising the management and to developing company strategy, although they can be involved in all stages of an investment. These are two areas where financially trained private equity professionals may not be that strong. Our operating partners help us plug that skills gap.'

Not so simple
It all sounds relatively easy, but even with this approach, the difficulty of cultural differences can be a problem. The key, says Taylor, is to choose the right people for the job - people who are prepared to roll their sleeves up and get involved and who get on well with the rest of the team. ‘One of the most important things in this is chemistry,' says Taylor. ‘A lot of ex-company managers or directors are used to delegating work to large numbers of people. They may also find this type of work lonely. There has to be the right chemistry between them and our team otherwise it won't work. Like most other private equity teams, we are pretty young - we're all in our mid to late 30s - and so our operating partners have to be comfortable with that. We're a bit irreverent compared to what many of them are used to. If they are the kind of people used to having people doff their caps at them, then it's not going to work.'

There is also the potential difficulty of accessibility. The decision Duke Street and other firms have made not to employ in-house operations people obviously saves money - they are not having to pay the large salaries that talented company managers might expect. In the case of Duke Street, operating partners are paid a salary by portfolio companies if they take a seat on the board. Many of them have also invested in Duke Street funds - a good way of aligning interests. But the flip side to this is that these partners are usually involved in a lot of other projects and so the time they can devote to portfolio companies can be limited. It's a difficulty that Taylor readily admits. ‘One of the disadvantages we have found with this approach is that we can't always get people exactly when we need them - sometimes they understandably have other commitments. But we are trying to bring our operating partners closer to the firm. We would like to try and knit them closer together with the team.'

More than contacts
Christophe Hemmerle of German mid-market firm Finatem has chosen a similar model for his firm. He has five operational partners drawn from previous portfolio companies and from people he and his team know well and have worked with in some capacity previously. Hemmerle believes that this type of personal, long-standing relationship is key to the success of bringing on operational talent. Many of the partners still have roles in other companies but, as with Duke Street, Finatem has managed to align their interests with those of the firm by having them invest in the fund. ‘I think there are two elements to making this work,' he says. ‘One is that you have to find the right people with the right experience - people who can implement change and who are able to take certain risks. These are rare. The other is that you have to have a good relationship with them. That is why we wanted to attract people we had worked with before and got on with because I think that it's more than a working relationship. You have to know that you can rely on each other and there has to be some element of friendship for that to happen.'

Roberto Pilotto of the fund investment arm of PPM Ventures has seen the problems that can arise when firms take on people that they may not know very well, especially at the smaller end. He agrees that having some kind of operating partner system or industry board can bring valuable skills to a firm. ‘I like to see this kind of arrangement, especially in mid-market firms. I think people with good business experience can help with deal flow and they can add a lot of value to companies.' But he believes that the skill lies in choosing the right people for your firm - and that doesn't always mean attracting big names. ‘At the lower end of the market you often see firms taking on important people in particular industries and paying them some form of retainer to gain access to advice and to open doors for them,' he says. ‘Unfortunately, the reality can often be quite different. If the people they take on are too busy or too important, they may appreciate the regular cheques they receive from the firm, but they won't have time to review investment papers or visit portfolio companies. In other words, they are often only able to help theoretically.'

The network approach
It's this type of problem that private equity giant 3i seeks to avoid in its Independent Director Programme. This is a different model from the operating partner approach: it is a network of over 600 business people from 15 countries who have experience of being a chairman, CEO or CFO and who no longer want to be an executive but wish to play an active role in a company. The idea is that the programme provides independent directors to 3i portfolio companies specifically chosen to meet their needs.

3i's Patrick Dunne says that the selection process is rigorous. ‘We will only take on people we believe to have the right experience, such as those who have successfully led a management buy-out or buy-in,' he says. ‘Sometimes they will be people who have run 3i-backed companies, for example. It's very difficult to get on the programme and we choose very carefully who gets accepted and we also review the group on a regular basis - we don't want people on there who haven't got the time to devote to our companies.'

3i does not pay the members of the programme, but encourages them to invest in the companies themselves and as a result, requires members to be financially independent. In return, 3i offers the opportunity to join company boards as an independent director and also arranges regular training and networking events. Dunne believes that the arrangement is a two-way street. ‘This is a long-term relationship on both sides,' he explains. ‘The idea is that we both get a lot of value out of that relationship. For us, we are able to tap highly experienced operational talent and the contacts those people bring to the table to ensure that we add as much value as possible to our portfolio companies; for the members, they gain access to a huge network and the ability to get involved with some really interesting companies.'

And the most valuable part of it from 3i's point of view? ‘We can call on people with appropriate skills and experience early on in a deal. In buy-outs especially, you have limited access to a business before you invest and so having someone you rate and trust going into the business and helping you assess it is very helpful. One great value they have is in guiding us where not to invest. They are not on investment committees, but their views are listened to.

‘The other area in which the members can be especially helpful is post-investment. No-one has a monopoly on wisdom. It can be invaluable to have someone challenge you on your thinking. These people are not poodles - they wouldn't be much help to us if they were. Someone simply asking me what I want does not add to my thinking.'

There is another way…
These are some of the more common ways in which firms are increasing their access to operational experience, but there are many other approaches. Many firms incorporate a variety of different access points, for example, chosen according to the needs of a particular portfolio company. Phoenix Equity Partners' approach typifies this. ‘Our team does not have operational experience, but we have access to it,' says Phoenix co-founder and managing partner Hugh Lenon. ‘We took the view that with a team our size, it didn't make sense to bring in people with that type of background and put them on the payroll. Besides, I think there is often an issue with cultural fit. Instead, we have rather more informal networks of people we can call on or who we retain to work exclusively with us.'

The firm uses a combination of three different access points. One of these is a network of people with operational experience that it can all on to become portfolio company board members. These act as something ‘in between non-executive and full-time executive directors', explains Lenon, and are remunerated by portfolio companies. It also uses what Lenon calls ‘retained, exclusive consultants', who specialise in a particular sector and who are able to provide expertise on a deal-by-deal basis. These are people that the firm tends to use to help with deal flow rather than with managing portfolio companies. And the third approach is to make use of its network of buy-in candidates - people the firm has worked with before who can be brought in to sit full-time on a company board.

Lenon believes that this three-pronged method allows the firm to make use of the most appropriate people for each portfolio company without having to build a cumbersome team structure. ‘I think that bringing people in-house can work well for some of the larger teams, but we felt that we didn't really need a lot of operational people on our books,' he says. ‘I think that some investors can be impressed if a firm can reel off a list of good names, but sometimes these people add up to little more than a garnish to the team.'

A more cynical view
It's a view that finds sympathy among some investors. While they may recognise the need for access to operational talent, some are cynical about the attempts made by firms to highlight their capabilities in this area. ‘I think a lot of GPs over-stress the operational experience they have on board,' says Selkirk. ‘Many of them see having those skills as an essential part of the tool kit. But I don't think that there is any substitute for buying well, backing the right management and bringing in the right experience to match the company's needs. Someone who has experience in one type of company may not be able to translate that to another type of company in the same broad sector - it's like trying to fit a square peg into a round hole.'

And, as Lewis points out, the use of operational people in private equity transactions is still relatively untested in the buy-out world. ‘I think that bringing in operational people could be potentially valuable - there is no doubt that firms are not working in the same environment as they were in the last decade,' she says. ‘But we don't yet have any proof as to how effective the various models are.'

The problem investors have when looking at the various teams is in assessing where a firm has added value to portfolio companies if it claims to have done so. Many firms can talk eloquently about the structures they have in place to access that all-important operational experience. But investors still have to do their homework. ‘We are interested in firms that have looked at this area and acted on it,' says Lewis. ‘But they have to be able to demonstrate to us that they have actually been able to add value as a result. We don't just take their word for it - we have to find it out for ourselves by talking to the portfolio companies ourselves. There is no substitute for rigorous due diligence.' Finatem's Hemmerle agrees: ‘A lot of funds sell the operational experience concept to investors. But to be really sure, talk to portfolio companies, get their views. Take a look at the company before and after the involvement of these operational people. And, importantly, look at the abort costs - are they lower than you might expect? The involvement of good business-minded people at the early stages should prevent a firm going down the wrong routes.'

The overall package
But despite all this recent interest in the operational capability of a firm, it is only a component of an overall package. It may have crept up the average investor's list of requirements, yet the most critical factor they look for is still private equity experience - and it is likely always to be so. It was cited by 89 per cent of respondents to the AltAssets survey as vital to an investment decision.

There is no getting away from the fact that, for all their hands-on involvement with portfolio companies, the bread and butter for buy-out fund managers is essentially to lead financial transactions. Operational people may be able to enhance the overall returns of a fund, but it's the quality and level of private equity experience that will invariably provide the basis of a fund's performance. As one investor commented: ‘Firms tell us that improving the operational performance of their portfolio companies makes the difference. I guess I'm old-fashioned because I still think that buying at low prices increases the chances of generating a good return on the investment.'

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