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Value Creation in Direct Private Equity

An active approach to driving persistent returns

When investors look at public markets today, many see high current valuations, low expected returns and a likelihood of increased volatility. Against this backdrop, it’s little surprise that more than a few are increasing their focus on private markets, and on private equity specifically. Their interest is amplified by a shift in the public-private balance of company ownership. With more companies going private or staying private for longer, allocators who want to be invested in growth over the next decade have even more reason to consider private equity.

There are several ways for institutional investors to access private equity today, including the traditional route of being invested in GP/LP structures; co-investments alongside those structures; and secondary markets. As private equity matures and investors’ needs evolve, the need for innovation increases — setting the stage for a direct, flexible-hold strategy, aimed at better alignment among GPs, LPs, and portfolio companies to maximize value and capital appreciation. 

This II interview with BlackRock’s Colm Lanigan, Co-Founder, Managing Director and Senior Investor, Long Term Private Capital, focuses on value creation in such a strategy, and is one of a three-part series on creating persistent alpha in private equity.

You are a founding partner of a flexible-hold private equity strategy. There’s a perception among some people that such a strategy is a form of hands-off, passive private equity ownership. Do you see it that way?

Not at all. There’s almost nothing passive about private equity. In the private markets there is much greater disparity across both scale and quality, so the whole screening process is, itself, active. In addition, fees are not the differentiator between alpha and beta in private equity. They’re part of it, but a much bigger part of alpha generation is the active management of the business, active governance, and value creation — regardless of the time frame, shorter or longer.  

There have been approaches to longer-term investing in private equity that focused on asset selection as the number one indicator of earnings over a longer period, and then used the long holding periods to achieve something resembling private equity multiples, though not alpha. But those approaches have focused on assets that are infrastructure-like or on asset-intensive businesses with stable earnings, as opposed to businesses that can drive private equity IRR and multiples over long periods of time. There’s a big difference between the two, and the key to the latter is still active management of the business and active governance to drive return on invested capital (ROIC) and growth. 

You’re an advocate of the importance of persistent private equity returns. What are the keys to achieving them? 

I think what we’ve learned is that good companies often remain good companies as long as they are effectively managed. The business model matters – do they have a slightly better mouse trap? – as do other things, such as having better gross margins than their competitors. But it really comes down to superb management teams who think and act like company founders, and who unfailingly and unwaveringly focus on execution of the plan and the strategy that they know makes their companies successful. And part of that founder mindset is rigor around capital allocation. Favorable market positioning from differentiated business models, durable economics, and seasoned management teams with disciplined strategy execution are what drive ROIC, and those companies succeed for longer periods of time. Sponsors covet those types of companies because they know they have the potential to make them even more successful.

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What do you see as the most important aspects of a value-creation plan? 

Developing a value-creation plan begins with identifying the fundamental variables that drive the business’ success. You’re looking for no more than five such points that allow you to focus management practices and create continuing value. For example, operational excellence is one, and it’s a must-have for every successful business. Drivers of scale are another. Which elements of the business are on the right side of pervasive disruption is another, so you can focus your efforts on the greatest opportunities for growth. A final one should be your digital strategy — it’s imperative that it supports your day-to-day analytics so you can make the right decisions in an environment that’s moving faster, and is tougher to navigate, than ever.

When you focus on those few things that matter the most, you don’t overstretch your organization, and you can match capabilities with goals and incentives. People’s behaviors are shaped by incentives and associated performance metrics. If employees know that you are focused on — and measuring — the right things, and that’s how they’re going to be compensated from top to bottom in the organization, you have all the ingredients of success.

Are there any special considerations that come into play in a late-cycle climate? 

Having managed through a couple of cycles, I would mention several. 

You need to be careful about leverage, which instead of adding to your returns can very easily subtract from them when the cycle turns. And you have to be wary of deals that have a lot of execution risk — for example, from moving plants or expanding margins. If you haven’t built in a recession scenario, you’re probably playing with a little bit more risk than you anticipated. Looking left on the return curve — thinking about what could go wrong and factoring that into your due diligence and underwriting — is probably even more important right now than looking to the right. 

In good times, extra volume through a business can hide a lot of inefficiencies and problems. It has been a little easier to take lower-confidence bets when you’ve had margin expansion due to 12 years of economic prosperity and growth that’s higher than trend. Multiple expansion has been a major driver of returns in the deals done since 2010. You’d be on shaky ground if you relied on that continuing. It may, but it’s less likely than before.

If it looks like the business will be tested by an economic trough, it is key to focus on the fundamental business variables that generate lasting value and to position for growth. That can help generate a couple of quick wins to build confidence throughout the organization and put you in a slightly better position going into what could be a tougher period. 

A robust capital structure is a big plus. Private equity is a long option, and if you have a capital structure that can withstand some of the hiccups, you’ll come through the other side. I would focus a little more on the balance sheet in this environment, too. If you have enough capital available, you’re in position to be the consolidator of your weaker competitors over time.

Of course, human capital is perhaps the most important element of all. To achieve long-lasting success, there is no substitute for having the right people and forging the right partnerships. 

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