In the first part of this two-part series, I shared some of the basics of value creation in private equity from the perspective of an individual deal, explaining the basic structure of a private equity deal and the most common value levers. In this second part I want to step back and look at what value creation means from the perspective of a private equity firm and how that impacts management teams of portfolio companies.
This post aims to provide you with practical insights into the inner workings of PE firms, shedding light on the different roles involved in value creation, and the common internal processes. I'll cover what goes on behind the scenes from the initial diligence stages to the ongoing management of their portfolio companies and some of the practical implications that can have for the management team.
Private equity firms are usually managing several funds at once, with different years, and perhaps different strategies, remits and investors. The aim of the private equity firm is to generate a return for investors in each fund, by using that capital to buy companies and sell them at a profit. The 10-year horizon IRR for US and Western European buyout funds has hovered around 15% over the last 10 years (Source: Bain Global Private Equity Report 2024 – Fig 25). What this translates to is a target return on each portfolio company of 2-4x. Unlike venture capital where the majority of returns are driven by a few star performers, private equity relies on a more balanced portfolio of returns.
However, assets do play different roles within the broader fund, which can change depending on the economic or PE firm context, in turn affecting the value creation plan and the management team executing it. For example, in the current environment with high interest rates and economic uncertainty, PE firms have been struggling to sell assets due to a mismatch in valuations between buyers (who are having to use more expensive debt and are looking to buy at lower multiples) and sellers (who are looking for higher valuations to meet their return targets). This has led to a slowdown in exit activity, with a 44% decline in buyout-backed exits from 2022 to 2023, which has continued in 2024.
All this leads private equity firms to have to rethink their fund strategy in order to return some liquidity to investors. They will be assessing which companies will reap a ‘good enough’ return if sold now, versus which are worth holding onto to reap the returns on more growth. As a management team, this might mean that the timeline to exit becomes more compressed, or extended, than you had originally planned for.
In this macro context, ‘value creation’ has become more important than ever. In a sense, value creation is the entire job of a private equity fund. However, in private equity ‘value creation’ usually refers to specific teams, roles, capabilities and processes that are focused on assisting portfolio companies during the hold period to achieve their strategic plan and to meet or exceed growth targets. This is in contrast to the ‘deal’ or ‘Investment’ team, which is responsible for sourcing, assessing and investing in companies. In most firms, the deal team also retains overall responsibility for the portfolio through to when the PE firm exits, including company board representation.
There are as many different structures for setting up value creation teams as there are PE firms. Value creation roles usually fit in to four types:
In-house generalists who provide broad support to the portfolio in achieving the value creation plan. They are often also responsible for reporting internally on performance versus plan.
In-house specialists who focus on specific areas such as operations, finance, or marketing.
Operating partners who are external to the PE firm, thought might be retained by them, and work closely with the portfolio companies. They typically bring deep operational expertise and industry-specific knowledge to help drive initiatives and improvements in portfolio companies.
Advisors/network who are external experts and consultants brought in on a project basis to address particular challenges or opportunities.
What is involved in ‘Value creation’ from the private equity team’s perspective?
Whilst the detailed planning and execution of value creation levers are happening on the ground in the portfolio company. There is a lot of value creation planning going on behind the scenes within the PE firm. We thought it would be helpful to share some examples of what that can look like through the hold period, to shed some light on the investor’s context.
Pre-deal:
Whilst each fund will have a house style, there are typically 2 threads that the deal team are thinking about pre deal:
Due diligence – due diligence is essentially trying to validate the factors that underpin the EBITDA x multiple calculation, e.g. Financial due diligence to validate the EBITDA figure, Commercial due diligence to validate the market opportunity and competitive position which underpin the multiple
Value creation planning – how will this investment make money? Management will have presented a growth plan, but the deal team will have their own view on this and may do quite a lot of additional work on testing the assumptions, and planning for different scenarios.
The team will present the investment case to Investment Committee (typically the most senior investors in the fund) who will scrutinise and question the plan. If a company is planning for 10% organic growth, in a flat market, there needs to be strong evidence for why this is achievable! In our work at Coppett Hill, we see that value creation teams are starting to engage much earlier within the deal cycle and are often working alongside the deal team on the value creation planning.
When the market is more challenging, such as over the last 18 months, value creation plans need to be even tighter as buyers can’t rely on multiple expansion and low-cost debt packages supporting returns. As we mentioned in Part 1, investors will usually have their own plan, the ‘investment case’, that they are investing against. This is often, but not always, an adapted version of the management plan with some sensitivities, and perhaps some ‘big bets’, applied.
Implications for Management:
The strength of the value creation team and what support they can provide management teams during the hold period is increasingly part of the pitch and a key differentiator.
As the process progresses and a deal looks more likely, the value creation team may start to shift into gear to ‘hit the ground running’ post deal and want to align on workstreams, potential issues and priorities.
It’s important for the management team to be involved in the creation of the investment case and buy in to the key assumptions, as they are the ones who will have to deliver it.
Hold period
This is where the value creation work really starts on the ground. PE investors typically plan for a hold of 3-5 years, although we’ve been seeing that extending in recent years with a slow deal environment.
From the investor’s perspective during the hold period, they are looking for visibility on how execution of the value creation plan is going and how the company is performing against that plan. The reality is that the first year of an investment rarely goes quite as anyone (either management, or the investors) expected and therefore it is highly likely that the value creation plan and strategy will be updated and revised.
Setting, and updating, the 2-5 year company strategy should be the role of the Board. With the executive team preparing a plan for the Board to debate, and then being responsible for implementing it. The Board is one of the key channels through which investors have influence. The make-up of a Board can vary, but at a minimum will usually contain a non-executive Chair, the CEO, and a lead investor, and often the CFO. The lead investor (also called PE representative, or Investment Director) is the primary interface between the PE firm and the company during the hold period.
Year 1 of the hold is especially important because of the compounding effects of growth, if key projects or launches get delayed for example, it can easily set back the plan by a year or 2. Equally, it’s important for the Board to get a good understanding of the company before launching into any no-regrets decisions and the first 6 months is usually a post-deal adjustment period. Boards will usually aim to have a post-deal strategy day within the first 6 months, which should bring together the management plan and the value creation plan, once the Board members have a better understanding of the business.
A really useful exercise at this strategy day can be to ‘work backwards’ from what you want to be true when it comes to the next sale process. For step-changes rather than incremental growth, there needs to be very focused use of resources on a few areas, rather than trying to spread too thin across the value chain. Investors will usually want to focus in on 1-3 priority areas, such as sales, marketing, finance, technology, or human capital.
These priority areas are often where value creation teams are brought in. They will work with management in a more practical way, outside of the Board. For example, if organic customer acquisition is a key pillar of the value creation plan, here are some ways the 4 different type of value creation roles might support:
In-house generalists – share relevant examples from other portfolio companies, make introductions to peers in the portfolio who can share their experience.
In-house specialists – work closely with the marketing team, sharing best practice and advising on specific growth levers. They might support on some specific analysis or rolling out tools/programs used across the portfolio.
Operating partners – the investor might bring in an ex-CMO with relevant industry experience to support the company on the ground with execution, hiring and managing the team. Often, they are brought in part-time and for a fixed time period.
Advisors/network – the investor may recommend a specialist consultancy that they have worked with before on similar challenges. For example, at Coppett Hill we might be brought in to help better understand marketing economics, working closely with the marketing team and building data and insight infrastructure that the company then owns.
Investment Committee continues to play a key role, with the PE representatives on the Board typically going back to IC every 6 months to report on performance vs plan (which may or may not be visible to the Management team). If numbers are off target, IC will want to understand why and to feel assured there’s a plan to remedy it. The IC has visibility across the whole fund so they can provide a useful perspective on market and industry dynamics, and also share lessons from previous investments.
Implications for Management:
You will likely be asked for much more granular reporting – the PE representative is ‘on the hook’ for performance against the value creation plan, but they’re not in the business and close to the detail. The individuals also tend to be quantitative by nature (ex-accountants, bankers, consultants) and want the comfort of understanding the numbers.
Investment committee reporting and discussions may drive requests for information or changes in priorities. Your PE representative is likely having to write an update paper every 6 months which they need data for, and they may get questions or feedback from the IC which they need to answer and will often play into Board discussions and strategy.
Fund dynamics – the IC is responsible for managing the performance of the overall fund and best serving the PE firm’s investors (Limited Partners). This may impact things like exit strategy and may not always be aligned with what the Investment Director wants. For example, the Investment Director will typically want to hold out for an extra half turn on returns for that company, whereas the PE firm’s interests overall may be better served by generating cash now to keep LPs happy.
Heavy focus on a few key areas. Your investor might get very into-the-details on the few priority areas (which may feel frustrating at times), whilst giving management a much longer rope and much less oversight in other areas and just monitoring top level KPIs.
Exit
When it comes to exit, it’s not just about what value has been generated over this hold, but the exit process is another sale process and therefore a view on value creation for the next stage is needed. Good investors will be thinking about this from the start, such as ‘preparing the Investment Memorandum’ for exit at the very first strategy day. An exit process can take a year or more, and the lead investor should play a really valuable role in providing an ‘investors’ perspective’ on the exit story and what the next investor will be putting in their value creation plan.
As my colleague Harry von Behr has recently set out, from a value creation perspective the key things at exit are:
Reliable and granular management information that can evidence the key points in the IM, e.g. ‘Sticky customers’ being backed up with strong data on customer retention over the last 5 years
Evidence that the value creation plan drove success during the hold period (i.e. linking specific initiatives to growth) – investors want to know that growth was strategic and replicable, and not just down to luck of the market
A clear plan for future value creation, mainly through accelerating revenue or improving profitability, not reliant on assumed multiple expansion
Evidence that the company can achieve this next value creation plan, ideally with some green shoots / tests of key parts of the plan e.g. if a big part of the plan is International expansion, having done a small MVP launch in that market, or having beachhead customers there pulling you over
Implications for Management:
In the run up to exit, there will be a lot of focus on data and evidence and preparing detailed performance information for the data room.
There will be a lot of focus on consistent performance and hitting targets, especially EBITDA, in the run up to an exit, as this underpins the valuation. Historically ‘valuation EBITDA’ could include adjustments and exceptions such as one-off projects and costs, meaning that these might sometimes be preferred over ongoing expenses, even when the latter is cheaper in cash terms. However, in the current market buyers are less willing to accept adjustments and the investor is likely to be very focussed on achieving the EBITDA that underpins their returns target.
‘Look forward’ earnings can be used to underpin higher valuations if you have proof points about the impact of an initiative that is already being rolled out, resulting in a push to get proof points ahead of an exit.
Hopefully the above sheds some light on the context behind certain Board dynamics, requests from your PE representative, or changes in priorities. One of the things that differentiates us at Coppett Hill is that we have worked in private equity value creation and investment roles, as operators and as consultants, meaning we can help to translate between these worlds. We work across the whole value creation cycle, from pre-deal DD through to supporting execution of the value creation plan and preparing for exit.
If you’d like to talk about value creation planning and which levers we can help with, please Contact Us.
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