Fewer pull-through opportunities for banks. Buyout funds within financial institutions can create value both by earning a basic investment return and by creating opportunities to pull through fee-based business such as M&A advisory and underwriting fees. Indeed, much buyout activity has been carried out within broader corporate-form financial institutions (predominantly investment banks) using both their own capital and that of third-party investors. A number of such bank funds historically have been very strong performers, although investors, unlike those in partnership-form peers, have suffered from double taxation of fund returns.
Recent market conditions, however, have severely limited pull-through business: few significant IPOs have been completed, and the fees per deal related to debt financing have continued to fall. Hence, while some banks will likely continue to create value from buyout activity, it may be worthwhile for all banks to reconsider carefully how much of their own capital they must invest to optimize total returns — including the pull-through of fee-based business.
Changing the Model for Success
Some forward-thinking fund managers have already begun to respond to this dramatically changed environment, but so far few have embarked on a broader effort to redesign their historical investment and value-creation model.
In a new environment for private equity firms, a logical first step would be to begin investing more aggressively in due diligence. Funds traditionally have been reluctant to invest heavily up front to really 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. Early, detailed, and rigorous transaction screening can yield significant dividends in the appropriate deployment of fund professionals’ time and the ultimate success of each deal.
Another likely source of competitive advantage in this new landscape is the development of a more hands-on approach to ownership and management. Several buyout firms now recognize that they can create value (in conjunction with management teams) by participating more in managing the companies in their investment portfolio and by developing cross-industry functional skills — including marketing, pricing, lean manufacturing, and procurement and supply chain management.
To develop these sources of competitive advantage, fund managers must add to their teams more professionals with deep strategic and industry insight, operational-improvement expertise, and other functional skills. Several firms have begun to build groups of strategists, former operating executives, and turnaround specialists, while others have entered into alliances with third parties to provide such services. Success will require extending this effort further; to attract the highest-quality operating and strategic talent, leveraged-buyout firms will have to cast aside past practices and increasingly offer up a share of the carry to such professionals.
Some firms will want to focus on a limited number of industry segments. 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.