“The past five years have witnessed unparalleled success in the private equity industry. During the time, more money got raised, invested and distributed back to investors than in any other period in the industry’s history,” states Bain’s 2019 Global Private Equity report.
Private equity (PE) has a secular penetration curve with no end in sight. The huge amounts that private equity firms may evoke reverence for all other professionals. The commonly cited advantages for PE firms include:
- aggressive use of debt,
- invigilance on cash flow and margins,
- imposed discipline,
- tax advantages,
- no restrictive regulations, and
- hefty incentives for managers.
Digging deep the lane, the basic reason for private equity’s success is the strategy of buying to sell. The central dogma of a private equity firm is to secure undermanaged or undervalued businesses, increase business value, and sell for a maximum return.
Quite fascinating, right?!
Yes, it is!
The Private Equity professionals commit their time persistently on value creation throughout the investment lie cycle. They identify issues, upside opportunities, margin enhancement, and revenue growth to derive insights. Then, they develop a targeted performance improvement initiative by strategically sourcing key commodities.
Moving forward, the PE firms develop a roadmap. The roadmap details key activities, anticipates results, assigns responsibilities, identify key milestones, develops metrics and dashboards to track performance. They accomplish quick wins to gain confidence for the mission ahead.
For instance, let us consider an acquisition from a PE firm.
Under its previous owners, the businesses had often suffered neglect, low performance, and other constraints. The PE firms identify the pitfalls, make necessary changes, and achieve an uplift in value for say, two-three years.
It quickly generates, says 30% a year for the first three years and a 10% return in the later years. As per the buy-to-sell strategy, PE sells it after three years earning 30% as the final returns. But, in the case of a diversified public company, it buys the firm as a long-term investment and will earn a return close to 10%, the longer it holds the business. Holding on to the business even after creating value dilutes the final return.
The private equity firm acts as the general partner and charges a huge amount of money as fees for taking partnership.
The private equity approach is sensible for the companies that own a delinked portfolio of businesses. PE firms know to cut excess costs, improve operating margins, reduce non-value-added processes, simplify core processes, manage product-pipelines, optimize high-value-added processes and help the business to stay ahead of the curve.
The PE best practice involves the adoption of a value-creation strategy based on industry dynamics, size of the company, available resources, governance policies, shareholder expectations, and quality of business processes. PE firms invest short-term but to achieve long-term objectives.
The major highlight is that as the business will be sold in due course, there is constant pressure to perform. As the main goal is to manage performance, there is no deviation from the objective and cash returns on investments can be quickly realized.