Musings on Entrepreneurship and Innovation
Saturday, September 18, 2004Private Equity's New Challenge
The August 2004 edition of The McKinsey Quarterly included a pretty good article titled Private equity's new challenge: A changed competitive landscape calls for a different business model (premium). In their examination of nonventure private equity funds, the authors noted the following:
- There is an excess supply of capital. In the late 1990s, private equity funds raised as much as $60 billion per year, but deployment has fallen to less than $40 billion per year leaving an overhang of some $90 billion in the U.S. alone.
- Privileged access is less important. The era of the inside deal is over. "Almost all significant deals today are subject to a visible and public auction process..."
- Financial-engineering skills are a commodity. In the 1980s, structured finance skills may have provided differentiation, but now such skills are a necessary but insufficient capability.
- Tough IPO market. Whether the market is experiencing a cyclical or structural downturn, it's tough to take a company public. Between 2002 and 2003, the average private equity investment holding period increased by 41% to 52 months. Consequently, the pressure to create value over time versus buying and flipping opportunistically has increased in relative importance.
- Emergence of new types of competitors. Some new entrants to the private equity market are raising money on a deal-by-deal basis rather than raising traditional committed funds. Thrive Capital and Entrada Ventures are two examples that come to mind. Other new competitors offer ways to accelerate a company's path to the public markets (e.g., Publex Ventures).
McKinsey's prescription for private equity success in this increasingly competitive environment focuses on the following:
- Investment more aggressively in due diligence. "Funds traditionally have been reluctant to invest heavily up front to understand what is needed to realize the upside potential in a proposed buyout. This pattern may be partially due to the incentive structure of most funds, where up-front investment in incomplete deals effectively reduces the cash available for the compensation of fund managers and other professionals. The likely result, however, is too many deals being taken too far through the process." The concept of "undiscovered rework" is familiar in the context of project management and product development. Every project has mistakes in design and execution. Rework discovered late in the game is typically 100 times more expensive to fix than rework discovered early. The cost penalty for "undiscovered rework" in the context of a private equity investments, I suspect, may be higher by orders of magnitude. Furthermore, the chances for such rework may increase to the extent that value creation is predicated upon superior strategy and execution rather than on financial engineering and favorable capital markets.
- Focus more narrowly on industry and geographic niches. "Truly superior strategic and operational insights and the development of potentially privileged networks for sourcing require deeper industry knowledge in today's environment. Firms that quickly develop their knowledge of a few narrowly defined industry segments and geographies will be better positioned to translate this expertise into a perspective on value-creation potential, transaction price, and potential returns." This is the conclusion that Steve Smiley and his colleagues at Hunt Private Equity Group when they made the strategic decision to focus on consumer-oriented products and services companies based in the Southeast quadrant of the U.S.
In the first quarter of this year, my Venture Dynamics Group colleagues and I came to similar conclusions about the private equity market. We formed our collaboration with the aim of helping companies and growth capital investors develop shared understanding of, and commitment to, robust, actionable value creation and realization strategies. Our proposition is that better upfront work yields superior returns in a competitive environment. Among the initial challenges we've encountered are the following:
- Many, if not most, private equity investors have not experienced the value of more intensive forms of strategic due diligence. The value of superior strategy is manifested in the accumulation of better decisions over time. The effect is powerful, but often indirect. Given the dynamics of experience goods, investors and companies are justifiably reluctant to engage us in this context. Consequently, we're experimenting with different forms of phased engagements.
- The payoff to learning how to develop more robust strategies emerges not only over time for a single investment, but also accrues over the life of a portfolio of investments. Consequently, it makes the most economic sense for the private equity firm to incur the costs of such learning. However, as McKinsey notes, private equity firms are reluctant to spend their management fees on "nonessential" services. My guess is that this will continue to be a tough barrier to cross until fund managers make more intensive due diligence an explicit part of their strategies and are funded accordingly. That could take some time.
- Meaningful work of this kind is intensive and requires skilled, experienced professionals. Consequently, traditional time-and-materials consulting fees can be quite high. In order to overcome this barrier, our group has been experimenting with different forms of compensation that are tied more closely to actual value creation over time.
Systematic approaches to private equity investing are not likely to be adopted if they are deemed to be optional. The learning curve is steep and the costs significant. Nevertheless, they are very likely to be adopted over time out of necessity in the face of increasing efficiency and competition in the private equity market.
