Private Equity’s New Challenge

A changed competitive landscape calls for a different business model.

Last, another competitive edge will likely come from the better sizing of funds to targeted investment opportunities. Successful fund managers have tended to raise funds as large as the market will allow. While there is nothing inherently wrong with large funds — some of the top performers have been large, and there are some deals that are so large that only a few funds can compete — size has several unfortunate and unintended consequences. First, in the United States and Europe, competition for big deals is often fierce, with multiple funds and consortia chasing most deals. Second, very large funds force buyout firms to “institutionalize” as organizations grow, and many fund managers feel a threat to their entrepreneurial culture — a key to success. Finally, as the size of deals increases with fund size, so does the difficulty of ensuring that fund managers have the appropriate skills to effect multidimensional change in organizations with substantial portfolios. Although large funds should not necessarily be avoided, fund managers should think carefully about their firm’s focus and the nature and scale of its likely opportunities and then adjust their fund-raising accordingly.

Corporate Connections

The trends altering the private equity landscape can offer opportunities to CFOs and other corporate strategists. Because of the surplus of capital in the current market, corporations looking at acquisitions are seeing more and more competition from a broader set of financial buyers in addition to the anticipated strategic buyers. However, buyout firms are increasingly willing to partner with corporations that bring complementary industry knowledge and managerial and operating skills. These partnerships create new strategic opportunities for public companies — and might even reassure some shareholders that they are investing alongside smart money.

What’s more, corporate buyers often bring assets that can be combined attractively with the target business. While preparing a bid for a technology company during a recent auction, one corporation was approached by four buyout funds, for example, each with varying complementary assets and strikingly different proposals for alternative forms of partnership.

Many buyout firms also have increased their interest in private investment in public equity (PIPE). These investments are typically minority equity or convertible stakes in public entities that can in some cases be linked to financing for specific acquisitions. PIPE investments can also be part of an attempt to broaden the available set of opportunities beyond private deals, to get ahead of the competition for privileged access to divestitures of nonstrategic assets, or even to involve leveraged buyouts of complete public entities. Corporations will increasingly see buyout firms positioning themselves as potential minority shareholders and strategic partners, but CEOs and CFOs should consider carefully the true cost of such capital infusions from these players compared with the alternatives.

Finally, corporate executives should be prepared to encounter more competition from buyout firms for top managerial talent. Not only will buyout fund managers seek to add operational and strategic expertise to their ever-broadening teams that evaluate, execute, and monitor investments but also to offer more compelling financial incentives for such talent to accept positions in the turnaround and ongoing management of portfolio companies.

Neil Harper is a principal in McKinsey’s New York office, and Antoon Schneider is a consultant in the London office. The authors would like to thank Richard N. Foster and Andreas Beroutsos for their contribution to this article, which first published in the Summer 2004 issue of McKinsey on Finance.

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