Wanted: Heavy Lifters for the PE World

Get enough smart people involved, and you’re likely to achieve success. During my last job as publisher of Buyouts, I heard some variation of that phrase from general partners of private equity funds all the time. That belief, a standard in the financial community, is especially prevalent at PE firms, which are largely staffed by MBAs from business schools like Wharton and Harvard or, at the principal and partner levels, by former investment bankers and consultants who graduated from those schools. This strategy is tough to knock given how much money PE firms have made over the years. It was probably most ideal during the 1980s and early 1990s, when buyout firms sometimes were the only sources of capital and thus in a position to take advantage of market inefficiencies, currency arbitrage, and the general lack of market information. Of course, there are countless turnaround stories about buyout firms that achieved success by hiring a new CEO or expanding a product line, but the potential for financial engineering was greater back then and thus more commonly employed. The argument was: Smart partners plus smart MBAs who craft financial models and work crazy hours plus enough capital to win deals equals fat IRRs. In today’s market, where intensified competition and increased transparency make returns tougher to achieve, that equation has been altered. Financial models that used to project 30% IRRs now are projecting median returns of 15%, in some cases. Buyers acknowledge that prices are inflated and that there’s downward pressure on returns, which makes it harder to buy low and sell high. And while every deal benefits from some financial engineering, the reality is that the most likely path to the old 30% IRRs is through operational improvement. Firms tap operations talent Several buyout shops have taken steps to enhance operating expertise by hiring operational partners and executive advisers. High-profile examples are Clayton Dubilier & Rice, which brought on Jack Welch, and Providence Equity Partners, where Colin Powell now advises. Another approach is to partner with executives in specific industries to draw on their knowledge and contacts, a tactic used by Wind Point Partners and GTCR Golder Rauner, among others. Looking ahead, I question whether emphasis on operational knowledge will start influencing the personnel mix at the low end of the PE hierarchy. The need for bright numbers crunchers isn’t going away, and smart people always will be useful. But ultimately, an MBA from a lower-profile business school who worked as a Wal-Mart store manager may prove more valuable than his or her Wharton counterpart whose only job experience was a summer internship at a relative’s asset management company. That may sound like heresy, and it’s admittedly a bit Pollyannaish, since I’m discounting the fact that private equity is a relatively small, homogeneous world. But PE firms would be well served to tap new areas for talent. As I write this, firms like Blackstone Group probably are readying their next quick exit to disprove my cautions on financial engineering. But most market pros agree that only a handful of firms will be able to rely on financial engineering to win hefty returns in the 21st Century. In the middle market, in particular, only those buyers with firm commitments to specific industries, that partner with committed executives, and that are willing to get their hands dirty will capture big yields through LBOs. The bottom line is that the PE market – and, more important, the entire landscape of buyers – is changing, reason enough for PE firms to examine the mix of people who work for them. Adam Reinebach Publisher Note: As the new publisher of Mergers & Acquisitions, I’d love to get your feedback. Feel free to contact me at [email protected]. (c) 2006 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com