The Next Step in Private Equity

With the nadir of the recession behind them, the biggest private equity (PE) firms, since early 2010, have made numerous strategic shifts in their business. Since its emergence as a high-profile asset class, private equity has evolved in direct response to discovering new means of creating value: financial engineering in the 1980s and operational enhancement in the 1990s. Today, these approaches are standard across all the best firms and no longer offer the competitive advantage they once did. Moreover, gone are the days when top tier PE firms were returning in excess of 20 percent through their traditional core business, the leveraged buyout (LBO). In fact, buyout returns are down, have been (even before the financial crisis), and seem unlikely to rebound anytime soon. Given Blackstone, KKR, and Apollo Management’s recent shift toward public ownership of their PE Firms as well as portfolio diversification away from the LBO and into credit investing, real estate, advisory services, and proprietary trading, PE firms have apparently noticed…but the question remains: What necessary innovation in private equity’s value creation model is next?

In the 1980s, private equity developed its first innovation: financial engineering, or the idea of buying companies with debt, taking them private, and then, in theory, reselling them after a few years with a rate of return enhanced by leverage. According to Henry Silverman, chief operating officer of Apollo Management, this strategy can be explained simply: “If I have 10 cents, borrow 90 cents, buy your tie for a dollar, and sell it to Joe for $1.05, I didn’t make a nickel; I made a 50 percent return on my investment.” By the 1990s, however, financial engineering had become commonplace across competent PE firms; as a result, PE firms looked for another innovation and found operational enhancement. This strategy seeks to increase the value of portfolio companies by reducing cost in any form, whether that involves process improvements, outsourcing, or restructuring.

Success in private equity hinges on a firm’s capabilities in fund raising, deal making, and adding value to its investments. These capabilities are inextricably linked such that the strength of each depends on that of the other two. That is, if a firm has more ways to add value, it will naturally discover more investment opportunities. Winning more investments means a better track record, which, in turn, helps in fund raising. As firms have matched each other’s ability to add value via the two aforementioned innovations, the question remains, “What’s next?” The answer, though seemingly apparent, will distinguish the winners from the losers in the near future: PE firms must be able to spur organic growth in their portfolio companies—that is, the ability to systematically expand or increase the revenue of companies they already own (using internal resources) through increasing their customer base, output per customer, etc. Indeed, this requires PE firms to hold a deeply rooted knowledge of the customers, their behavior, and their wants and needs per industry.

The next critical question then, is how PE firms can improve their ability to engineer organic growth without changing the firm’s structure and limiting flexibility. The answer comes in three parts: adding new growth capabilities, making growth in their portfolio companies the primary focus, and finding ways to make this growth net free.

Adding growth capabilities involves enhancing pricing ability as well as improving sales-force practices. According to the McKinsey Quarterly’s article “Freeing up the sales force for selling,” “Most sales reps spend less than half of their time actually selling.” KKR’s acquisition of Dollar General, a chain of variety stores, illustrates just how PE Firms can add these growth capabilities. When KKR helped take Dollar General private in 2007, its enterprise value stood at $7.3 billion; today, now public, Dollar General has an enterprise value in excess of $12 billion. What changed? When KKR first acquired Dollar General, its management based its decision about which products to put on shelves by simply looking at the profit margin of individual items. Although their logic aligns with common sensical thought, KKR suggested that, given Dollar General’s niche as a place to pick up a few small items (not to do major shopping), management should instead look at dollars of margin per linear foot, “a common measure in food retailing that takes into account not only how much profit a given product generates per dollar of sales, but how quickly the product sells.” This strategy prompted Dollar General to start carrying milk and other basic products as well as offering Coca-Cola in addition to the Pepsi they once were limited to. Ultimately, the “right” products maximized foot traffic among customers and increased revenue exponentially.

With constant attention to eliminating costs, how can PE firms make growth in their portfolio companies a primary focus? One way is to keep in mind the concept of “headroom” as a structure for determining available growth in a market. Headroom equals the market share that a company does NOT have minus the market share that it will NOT get. Headroom essentially outlines which customers can be targeted to switch from rival companies to their own, and what it would take to have those customers make the switch. Thinking along these lines will naturally improve coordination within the company. The last challenging aspect of this innovation involves adding growth capabilities and making growth a primary focus net free—cash invested in these initiatives must come from internal resources of the portfolio company. Doing so, will further align incentives throughout this process of spurring organic growth.

Still, as organic growth increasingly becomes important in private equity, the previous means of value creation will undoubtedly remain important. Nevertheless, as this third innovation truly makes headway, without a strategy for spurring organic growth in portfolio companies, PE firms will become less and less competitive in fund raising and deal making. Ultimately, this means returning to their role of being in the solutions business—promoting growth through real improvements in portfolio companies and increasing overall profitability in the process.