Our interviews with private-equity partners and portfolio company CEOs identified six different “operating models” for operational value creation. (See the exhibit below.) It is useful to think of these operating models in terms of three clusters, each defined by the degree of internal operational-value infrastructure the firms have created.
Firms in the first cluster have not invested at all in building an internal capability for improving operations at their portfolio companies. Either they function like a traditional private-equity firm with no operating capabilities. Or they rely on a network of external advisors.
Firms in the second cluster have built an internal capability at the partner level. They have hired either generalist operating partners or functional operating partners, or some combination of the two.
Firms in the third cluster have invested significantly in the creation of operational teams at multiple levels of the organization below that of partner. Some firms rely on a relatively small in-house operating team; others, however, have built a large in-house operating team that can rival the number of members on the deal team itself.
None of these operating models is necessarily better than the others; each can be executed well—or poorly. Which model is appropriate for a particular private-equity firm depends on two factors.
The first is the private-equity firm’s preferred style for engaging and working with its portfolio companies. For example, is the philosophy of a firm’s general partners to hire high-quality managers, provide them with the right incentives, and then play only an oversight role? Or do the general partners tend to get more involved in the day-to-day management of the company, playing more of a hands-on role?
The second is the private-equity firm’s basic organization structure, culture, and design. For instance, are the firm’s funds large or small? Does it have many portfolio companies or just a few? Does it primarily target healthy companies or distressed businesses that have a high potential for turnaround? Does it focus on a specific set of industries or is it present in many sectors? Does it have operations in one country or in several? Do its deal teams consist mainly of people with financial backgrounds or do these teams include people with consulting or industry-specific expertise?
To understand how these two factors interact with the different operating models and what constitutes best practice for each model, let’s explore each of them in turn.
Despite the growing importance of operational value creation, some private-equity firms have chosen not to develop internal operating capabilities and to rely only selectively on external providers with operating expertise.
Firms in this category tend to influence their portfolio companies primarily through governance mechanisms such as the appointment of top management, the design of incentives, and ongoing involvement on the company board. Typically, they target relatively healthy companies that can operate without major hands-on intervention. And they focus carefully on building a strong management team—whether by giving existing managers a stake in the business or by bringing in an entirely new team. “We change management in nearly half the cases at the beginning of our ownership,” a general partner at one such firm said.
In a world in which operational value creation is becoming more important, we believe that this traditional private-equity model will likely struggle to perform. But there are a few exceptions in which firms are still making it work. A private-equity firm with no operating capabilities can still be successful, but only if it has other differentiating characteristics in its business model that make it an attractive partner—for example, privileged access to deals or a network advantage upon exit. In such cases, a firm can partner with other private-equity firms, but only in a minority role.
Other private-equity firms avoid building an internal operational infrastructure by choosing to rely on a network of external advisors—typically former CEOs and CFOs—to provide leadership on operational value creation. These advisors, who may have functional or sector-specific expertise, typically have an equity stake in the private-equity firm’s fund or in one or more of the firm’s portfolio companies. However, they are not on the firm’s payroll.
External advisors typically fill two roles. In some cases, they identify potential deals. But more often they function as a coach to the CEO and, sometimes, an intermediary between the CEO and the private-equity firm—for example, by serving as chair of the portfolio company’s board. Although advisors are usually not involved in the day-to-day running of the business, their degree of engagement with the portfolio company can range from working closely with the CEO and senior management to being available for the occasional meeting as needed.
The most important success factor for this model is to develop strong relationships with genuinely high-caliber former CEOs or CFOs who are industry veterans in the sectors the private-equity firm targets. This is easier said than done. Although there may be many former executives who have held the title of CEO or CFO, relatively few have the skills and the flexibility to adapt to the private-equity environment and to make a material contribution to the businesses they are involved in.
Once a firm has found the right advisors, it must also empower them so that they can play a meaningful role in portfolio companies and in the fund—for instance, by involving them fully in the front end of the deal process in order to draw on their deep industry expertise.
Finally, the role of the senior advisor must be clearly defined so that he or she is not perceived as a CEO-in-waiting by the portfolio company’s management team.
In this model, former senior executives with sector-specific experience join the private-equity firm as general partners. Like deal partners, these generalist operating partners are typically compensated through some combination of fixed salary, annual bonus, and carried interest (carry), which is a share in the profits that the private-equity firm makes on its investments. They may also receive options in the portfolio companies they work with, and they sometimes are required to coinvest as a limited partner in the private-equity firm’s fund.
Much like external advisors, generalist operating partners are usually former CEOs or CFOs with enough experience in the private-equity firm’s target industries to have credibility with portfolio company CEOs. They act as key interlocutors with those CEOs in the development of company strategy and generally serve as coaches and “sparring partners” on a whole range of issues on the CEO agenda. Another important role is to be the private-equity firm’s primary overseer of operational-improvement programs at portfolio companies. They do not, however, get deeply involved in the day-to-day running of the business.
One of the attractions of this model, compared with the external-advisor model, is that it brings substantial industry and operational expertise directly into the private-equity firm and therefore offers the opportunity to integrate this expertise more fully into both predeal due diligence and postdeal work at the portfolio companies. But for the model to work, it is critical that the generalist partners be fully accepted by the deal team. If generalist operating partners are simply imposed on the deal team by the firm’s management or have backgrounds so different from those of the deal team that the two sides never really connect, the model tends to break down. Therefore, it is critical to hire operating partners who already have or can develop the right mindset for work in private equity. Traditional “command and control” executives typically do poorly in this role.
Even more than senior advisors, a generalist operating partner runs the risk of being perceived as a CEO-in-waiting by management at the firm’s portfolio companies. “Our experience is that it is difficult to bring in generalists,” one general partner told us. “The CEO immediately starts worrying, ‘Is this guy going to be my replacement?’” This risk can be mitigated by linking the incentives of generalist operating partners to overall fund performance, which gives a clear sign that they will be staying in their roles at the private-equity firm for the long term.
A key limitation of this model is that it is not easily scalable. Generalist operating partners can engage with, at most, about five portfolio companies during the same time period. When they try to cover more, their involvement is usually restricted to board-level interactions, where their ability to impact the business is relatively limited. In a typical midsize private-equity firm using this model, there might be at most a handful of generalist operating partners, which can make it difficult to have the necessary breadth of sector experience to support a multi-industry investment strategy.
Another approach at the partner level is to hire executives with expertise in functional areas such as procurement or sales force effectiveness. Typically, functional operating partners are not as senior as generalist operating partners. They rarely serve on the boards of portfolio companies. Rather, they function more like consultants to portfolio company CEOs, working on specific operational-improvement initiatives and moving from one initiative to the next as each is completed (a fact that tends to make them more easily accepted by a portfolio company CEO). Functional operating partners receive a salary but, depending on the private-equity firm, do not always participate in the carry. It is also common for these specialists to receive a success fee that is based on the results of the specific operational-improvement projects that they lead.
This operating model works best when a private-equity firm has a large and frequently changing number of portfolio companies, so that functional value-creation initiatives can be systematically rolled out across the entire portfolio in a relatively standardized manner. The model also seems more appropriate for primary rather than secondary investments, because companies that are already owned by another private-equity firm tend to have far fewer opportunities left for cost cutting and other standard improvement activities.
To ensure that functional initiatives are applied systematically across the portfolio, it is critical for the private-equity firms that follow this model to develop mechanisms that embed the functional partner’s expertise deeply within the firm. Functional operating partners need to have strong incentives to contribute to the success of the fund and its portfolio companies. In our experience, it is generally more effective to link incentives, at least in part, to predefined targets in the different portfolio companies rather than to the overall success of an entire fund.
The primary limitation of the functional-operating-partner model is that it is focused mainly on well-defined, bottom-line operational-improvement initiatives. If there are unexpected discontinuities in a company’s business, requiring fresh thinking about strategy and top-line growth, that thinking is unlikely to come from functional operating partners. The private-equity firm will have to find it elsewhere.
The third and final level of operational-value infrastructure concerns those private-equity firms that have developed a full in-house operating capability. This capability takes the form of a multitier team of operating professionals (below the partner level) who leverage the work of the operating partner.
Owing to the high cost of maintaining such a team, this option is appropriate primarily for the largest private-equity firms with operations in multiple markets and regions. These firms tend to have a minimum of 40 companies in their portfolio at any one time, with companies regularly moving into and out of their ownership. “Scale is absolutely critical for this model to work,” one general partner said.
In some of the firms we studied, the in-house operating team is quite small in comparison with the deal team, and it mainly plays a supporting role. Board-level engagement is restricted to deal team partners, who manage the deal from predeal through closing and, eventually, exit. The operating-team partners focus on specific management-level projects with the CEO, which the operating team then helps the company implement. In effect, the operating team functions as an in-house consultant that the private-equity firm can deploy as needed across its portfolio companies.
The singular advantage of having an in-house team is that the private-equity firm develops a comprehensive understanding of the team’s capabilities and can deliver a consistent approach to operational improvement at its portfolio companies. The existence of an in-house operating team also expands the universe of potential targets for a private-equity firm. Specifically, it allows a firm to consider distressed assets with high turnaround potential that require intensive hands-on involvement and a level of attention that firms without an in-house capability cannot offer.
A major challenge with this model, however, is continuously refreshing the knowledge base and approaches of the team so that it keeps current with the latest best practice in operational value creation. Unless the private-equity firm invests in creating a sustainable learning environment (including clear career paths for associates to become operating partners themselves at some point), an in-house team runs the risk of becoming too insular and losing its best people. An in-house operating team can also be perceived negatively by a firm’s portfolio companies, especially if they are forced to use—and pay for—it (as opposed to solving problems themselves or going outside for help).
At some of the largest private-equity firms we studied, the in-house operating team has reached such a critical mass of people and expertise that it plays a considerably more central role than do typical small in-house operating teams. In these firms, the operating team is so large that in any particular transaction, it functions more as an equal partner to the firm’s deal team. In some situations, deal management is a shared responsibility, with deal team partners taking the lead until closing and operating-team partners taking the lead during implementation of the value creation plan.
What we have observed is that once an in-house operating team reaches critical mass in terms of numbers, depth, and breadth of expertise, there is a subtle but significant shift in the private-equity firm’s culture. Operating-team members acquire more influence. The operating team’s organization structure and career paths increasingly mirror those of the deal team. And operating-team partners’ compensation is structured in the same way as that of deal team partners. “Operating teams need to be completely integrated,” said an operating partner at one such firm. “We have a clear and agreed-upon role to play at each step of the deal process.”
It should be clear from the above descriptions that these models are not all necessarily mutually exclusive. Indeed, a number of the firms we interviewed appeared to be in a state of flux about the evolution of their own model, and some have embraced creative combinations of different elements of these models. For example, one private-equity firm has invested in building a large in-house operating team. But it also regularly calls on an external network of world-class functional experts who are brought in as needed (as independent contractors) to solve specific problems at the firm’s portfolio companies.