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IN MY OPINION - UPPING THE ANTE ON ACTIVE VALUE MANAGEMENT AFTER RECESSION

PUBLISHED: 28 May 2010, Financial Mail - SAVCA Handbook

Stuart Mackenzie, partner - Ethos Private Equity

The principle of active value management is a cornerstone of private equity and a key industry differentiator, coupled with long term investment horizons and superior incentive structures..

But the global financial crisis has left its mark on South African private equity resulting in the accelerating need for managers to refocus their capabilities in active value management from competence back to excellence. 

For some, this is a significant – yet necessary shift, and for others a migration of focus.

Traditionally, private equity managers give themselves four to seven years to build returns in portfolio companies, which allows them to implement long-term strategies to create shareholder value.  Furthermore, private equity incentive structures require fund managers to personally invest alongside portfolio executives and institutional investors.  Additionally, fund managers typically only earn returns on the fund after the institutional investors have received their capital, costs and management fees back, along with a hurdle rate of return.  This structure ensures an alignment of interests between the key parties and a persistent focus on long term value creation for the fund investments.

During the period 2003-2007, the abundance of debt skewed the private equity model in the first world, with cheap debt providing a larger portion of the investment return over a shorter investment horizon.  This dynamic was also at play in the South African market - although to a somewhat lesser extent given that the debt bubble was not as pronounced - and managers may have been lured into de-emphasizing the importance of active value management in the model.

Following the global recession, this has all changed.  Now, in an environment where transactions will be concluded with less debt but where competitive processes will ensure pricing pressure, active value management of the underlying portfolio companies will play an increasingly prominent role in driving returns. 

So what will it mean for companies to ‘up the ante’ on active value management?

Firstly, South African private equity firms need to enhance (or add) strategic and operational excellence to their financial structuring and deal making competence.  There are many approaches to achieving this and firms will have to match their strategy to their economics. 

Models range from building in-house expertise to outsourcing targeted activities on a project basis, with a host of variants in between.  Firms will have to review their internal resources to best achieve optimal operational and/or consulting bias to generate ongoing value at their investee companies.

Secondly, the primary objective of the firm’s value add function is to deliver earnings growth outperformance in portfolio companies; this activity begins and ends with strategy. 

Private equity firms have to identify growth, optimization and efficiency opportunities, and define strategies for executing on them prior to making investment decisions.  This process needs to be concluded in a manner that achieves the portfolio company management’s ownership of the strategy. 

Thirdly, after an investment is made, the private equity firm should assist management and act as an additional resource for the management team, where needed, to roll out the defined strategy and monitor delivery to achieve value growth. 

Of course, strategy is dynamic and a major element of this post-investment phase is the constant monitoring and evaluation of strategy, to ensure it is appropriate for changing market conditions. Being able to catalyze and incentivize management into adopting and implementing changing strategies to achieve value growth is a critical success factor and a challenge.  Crucially, this challenge is easier met when the private equity firm has the ability to engage with CEOs and their executive teams at a peer level.

In conclusion, successful private equity firms of the future will be able to demonstrate their ability to repeatedly deliver returns that are predominantly derived from earnings outperformance.  An ‘active value management’ strategy that is excellent, and not merely competent, will be the key to sustained success.