Pursuit of investment returns has ushered in an era of portfolio operating groups in private equity firms. According to the Private Equity International Ranking Index, top twenty-five private equity funds have a well-established internal portfolio operating group.
One of the reasons behind this sudden fascination with portfolio operating groups is down to the mounting competition for acquisitions that has led to a colossal rise in valuations. Private equity firms are also keen on providing tactical support and direction to their portfolio companies to keep pace with pivoting investor strategy from the historical "purchase-and-hold" to "acquire-and-upgrade".
In order to understand how private equity firms are relying upon portfolio operating groups to prop up their investment vision, a leading industry wide research was carried out by McKinsey and Company in 2018, which pointed towards the growing influence of portfolio operating groups in private equity firms.
The study noted that the time operating groups spent on assessing and reporting performance of portfolio companies dropped from 29% in 2015 to 19% in 2018. However, the time spent by operating groups on improving measurable performance of portfolio companies increased from the 2015 level of 40% to the 2018 level of 49%.
Responding to the research, private equity firms emphasized that the trend of portfolio operating groups focussing on raising the quantifiable "performance bar" is likely to continue in the near future. In fact, several private equity firms have given a green light to the expansion of in-house operating groups in order to facilitate optimization of portfolio companies' performance. This trend makes sense given that half of private equity returns for the decade ending with 2019 were driven by multiple expansion, a trend that cannot be reliably counted on, driving an increased focus on operations. You can read another of our articles on improving private equity operations here.
Private equity firms have also specified that more former directors, consultants and c-suite executives will be added to the composition of their internal operating groups.
The research also inferred remarkably that in 2018 only 59% of private equity firms had a structured model that created operational value for portfolio companies, as compared to 65% firms in 2015. The number of firms that have an efficient value creation model to regularly use across their portfolio increased from 50% in 2015 to 75% in 2018.
The study clearly demonstrates that firms are trying to embrace consistent value creation models their portfolio companies.
This study into the operations of private equity portfolio companies also stumbled upon some startling facts. Prominent among them was that smaller private equity firms employ three times more professionals than bigger firms, per $1 billion of asset under management (AUM).
While smaller firms employed approximately 22 to 30 individuals per $1 billion AUM, firms trading at $5 billion to $10 billion in AUM employed just nine. For firms with more than $50 billion in AUM, the number of employees on payroll dropped to a further eight per $1 billion AUM.
The research concluded that it is very rare for a firm, with more that $25 million in AUM, to have fifteen or more professionals in their internal portfolio operating groups. The once practiced approach of constructing large internal portfolio operating groups for the purpose of consulting and administration appears to have fallen out of favour for private equity firms.
On the subject of operations groups' compositions, the study found that the majority of private equity firms employed both external and internal operations professionals.
External operating group members are typically former C-suite executives and, at times, former directors. These members usually work in an advisory capacity and help out in assessment of prospective investments apart from providing support and guidance to portfolio outlets. As per the research, external operating group members spend approximately 30-40% of their time providing support to firms and their portfolios.
Internal operating groups, on the other hand, are made up of former C-suit executives, former directors and former consultants.
The study anticipates that portfolio operating groups will continue to evolve in the years to come.
With the looming expansion of operating groups, private equity firms will be turning more towards former C-suite executives, directors and consultants to give shape to their operating groups.
It is expected that private equity firms will multiply their active engagement with portfolio companies in order to make up for the loss of near guaranteed multiple expansion. Piqued interest in proprietary deals means private equity firms will look to recruit more former C-suite personnel to grow the potential of external operating groups. As the competition between private equity firms escalates, retention of talent in portfolio operating groups will more often than not become a crucial element of business.
Portfolio operating groups are no longer the flag-bearers for only massive funds. These groups are now spreading their roots throughout the private equity market. Explosion of portfolio operations capabilities are enabling private equity firms to not only free their "deal-making squads" to focus on making deals and carrying out monetary scrutiny but also to add value to their business transactions with portfolio companies. As the study observed, the private equity industry, traditionally a playground for investment bankers, is gradually warming up to consultants and operational executives.
Even though portfolio operations may seem to be a relatively new career path, it is here to stay as evidenced by the McKinsey study. Exciting career opportunities presented by portfolio operations are likely to keep on attracting interest from old and new professionals who are looking for a career filled with modern-day challenges and experiences.
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Matt is an ex-Morgan Stanley investment banker, bringing an innovative, go-getter mentality and facilitating new opportunities for the business.