By Chase Nerison
Private Equity, or PE, is a form of financing where capital is invested into a company typically in exchange for equity (What is private equity and how does it work). Along with many other players, private equity acts as a pivotal piece of the private markets. These firms invest in businesses with a goal of increasing their value and being able to sell the company for a profit. Unlike venture capital (another player in private markets), PE firms often take a majority stake in their investments and usually are working with multiple companies at once (What is private equity and how does it work?). They make money from management fees and performance fees, which are a calculated percentage of assets under management and a calculated percentage of the profits from investing. This is the typical 2-and-20 rule for 2% management fees and 20% performance fees (What is private equity and how does it work?). Clearly, the performance fees of selling their companies at a profit are significant to a firm’s success. Over the past decade, many firms have experienced great success and growth as shown in the graph below.
According to McKinsey's article, a hands-on approach is most effective in private equity. With the overarching theme of active ownership, there are five steps with a strong, researched correlation to outperformance as an investment and company (Heel, J., & Kehoe, C.).
1. Outperformance is the biggest factor in creating value for a private equity firm. With performance fees being the main source of revenue, it is very important to improve the company’s valuation while under management to sell at a profit (Heel, J., & Kehoe, C.).
2. Most successful deal partners seek external advice before committing to selling the company to a PE firm. According to McKinsey’s research, 83% of the best deals began with the sharing of privileged knowledge: insights from the board, management, or trusted external source (Heel, J., & Kehoe, C.).
3. The business plan must be under constant review and revision. Additionally, defined key performance indicators ensure its goals remain on track. 92% of the best-performing deals are when firms implemented this system (Heel, J., & Kehoe, C.).
4. Effective deal partners devote more hours in the initial stages. These meetings are very important in identifying key contributors and the company’s strategic priorities. Though it is assumed private equity ownership is short-term, building relationships and detailing responsibilities make a big difference. This allows the two sides to challenge assumptions and understand each other (Heel, J., & Kehoe, C.).
5. If a private equity firm would like to the company’s management, it is advantageous to do so early in the investment. 83% of the best deals contained firms strengthening the management before the closing (Heel, J., & Kehoe, C.).
Several PE firms have embraced and encouraged these steps, but it can be difficult to hold this approach consistent. If this systematic way is performed, this active-ownership style should increase returns.
From a CFO’s perspective, there are four essentials to set up for success. This finance leader will typically participate in developing the company’s growth plan while improving operations and controlling costs (Agrawal, A., et al.). Sorting the details of what creates value and costs can be very perplexing and deceivingly time-consuming. These four tips should help with the challenge.
6. Understand the economics. Since the CFO’s responsibility is understanding its financial standing through the company’s balance sheet, debt, cash flow, and more, the economics are likely complex. With debt being a key contributor to a PE firm’s investments, it is not uncommon to require weekly reporting on cash (Agrawal, A., et al.).
7. Find the right people for the job. One CFO interviewed by McKinsey emphasized the superiority of skills over job titles (Agrawal, A., et al.). With major transitions, C-level executives should not be afraid of rearranging and reallocating talent.
8. Use data efficiently. When this occurs, business leaders are able to uncover new value opportunities. Many firms lack adequate data analysis and tracking capacities in order to capitalize on these opportunities (Agrawal, A., et al.).
9. Keep the transformation on track. Key performance indicators and monitoring metrics should assist in this aspect. The CFO must understand how value is created to construct relevant KPIs and metrics related to the company’s outcome. It is preferred this position owns these KPIs to illustrate the change (Agrawal, A., et al.).
PE firms succeed in a variety of ways, but most significantly, it is through the profit of their outperforming companies. With two relevant perspectives, the combination of these nine steps displays how to increase the likelihood of success as a private equity firm once the deal is made.
Works Cited
Agrawal, A., Connolly, J., & Maloney, M. (2021, April 1). The PE company CFO: Essentials for success. McKinsey & Company. Retrieved September 26, 2021, from https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-pe-company-cfo-essentials-for-success.
Heel, J., & Kehoe, C. (2018, February 9). Why some private equity firms do better than others. McKinsey & Company. Retrieved September 26, 2021, from https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/why-some-private-equity-firms-do-better-than-others.
What is private equity and how does it work? PitchBook. (2021, June 9). Retrieved September 26, 2021, from https://pitchbook.com/blog/what-is-private-equity.
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