The shift to operational value creation is creating one final challenge for the private-equity industry. As the staffs at private-equity firms become bigger—and include people with backgrounds and disciplines that go beyond the financial expertise of the industry’s early years—these firms’ organizations are becoming more complex. This complexity will force firms to professionalize their management processes.
In a sense, the private-equity industry faces a situation not so different from that of a successful start-up that has become a big company. The ad hoc practices that worked well during its early years are no longer effective. Instead, the company has to take a more structured approach to key internal issues. So, too, do private-equity firms today.
More professional management does not necessarily mean more bureaucracy; it can be achieved in ways that preserve the flexibility and fast decision-making of the traditional private-equity organization. What it does mean, however, is paying closer attention to key internal processes that govern how employees are developed, how they are compensated, and how they work together.
In the early days of private equity, the career path for people in the industry was straightforward. They did deals; if the deals were successful, they were promoted; the more successful the deals were, the more money they would make.
Today, things have become more complicated. As private-equity firms grow bigger and include not only financial but also industry and functional experts, questions of professional and career development come to the fore. And in a tougher economic environment, it is no longer enough to assume that outsized pay packages will attract the right kind of people. Much like their portfolio companies, firms will have to define appropriate metrics for recruiting, nurturing, and rewarding many different kinds of talent and put into place a comprehensive review process that reinforces those metrics.
Another key area in which practices need to be professionalized concerns interactions between a private-equity firm’s deal-team staff and operating personnel. Effecting change in this area is more a matter of organizational culture than formal processes. Probably the biggest obstacle to successful operational value creation in private equity today is the perception on the part of at least some operating personnel at some firms that they are not treated as equal partners in the private-equity enterprise. In our interviews, we heard phrases such as “lack of empowerment” and “second-class citizens.” Until industry and functional experts are full members of the private-equity team—sitting on boards, involved in making key decisions, considered equal partners in realizing the private-equity firm’s mission, and compensated according to their actual contribution to value creation—a firm’s commitment to operational value creation is not really complete.
To address this problem, firms need to encourage clear communication, especially regarding decision-making responsibilities and teaming expectations. There needs to be clarity about who on the deal and operating teams makes a particular decision and who should provide input before a decision is made. There also need to be clear expectations about reporting structure, roles, and responsibilities.
In the end, improving a private-equity firm’s capacity to create operational value—especially when delivering that value depends on top-line growth—will require a new kind of partnership. In the traditional world of private equity, the partnership was between the private-equity firm’s deal team and the management of its portfolio companies. In private equity’s next phase, deal teams, operating teams, and portfolio company management all need to work together to ensure top performance.
The precise outlines of that partnership will differ depending on the size of the private-equity firm and the particular operating model that it pursues. But whatever the source or form of a private-equity firm’s operational expertise, it will succeed at top-line operational value creation only if that expertise is fully integrated into the firm’s business model and if there is seamless teaming among the private-equity firm’s deal and operating teams and the portfolio company’s management. Ultimately, the strength and quality of that three-way partnership will be the key determinant of a firm’s competitive advantage in the years ahead.