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Strategic CA(SA) - Strategy in Private Equity Industry
Investors place funds with PE fund managers, which in turn place and manage investments in investee companies. Each set of players needs to have an industry-wide perspective to formulate and implement their strategies effectively. Each individual player is faced with strategic choices regarding who to be, where to play, and how to win.
Strategy from the perspective of the investor
PE fund managers obtain their funds from various types of investors, ranging from high net worth individual investors, to large corporate investors, to professional investment asset managers. In the interests of brevity this discussion focuses on asset managers, which comprise a major source of funds in the PE industry. Asset managers are professional managers of investment funds such as pension funds, endowment funds and insurance funds. Their primary objective is to achieve or exceed a target return on assets under management, within given risk parameters. Asset managers have a portfolio strategy that is influenced by the risk-return profiles of different asset classes.
The range of asset classes in which the asset manager may choose to invest includes fixed income investments such as government and corporate bonds, listed equity investments and equity-linked investments in various industry sectors and types of economies, and alternative asset classes such as real estate based investments and PE funds. The risk and return expectations of the asset manager are influenced by investment benchmarks, trends and expectations in the broader asset management industry, including expectations based on the type of economy in which funds are being invested, for example developed economies, developing economies or emerging economies.
Investing in PE is a strategic choice in the context of the asset manager's overall investment portfolio strategy. PE is usually regarded as an asset class with a higher than average risk profile, compensated by a higher than average potential return. Having decided to invest in PE as an asset class, another strategic choice is that of PE fund manager. The asset manager seeks to place funds with PE fund managers that have experience and a proven track record in the asset manager's choice of investment focus. Strategy execution for the asset manager includes the ongoing management of the relationship with the PE fund manager and its portfolio of investee companies.
Strategy from the perspective of the PE fund manager
The PE industry includes a wide range of PE fund managers, investment mandates and financing structures. One PE fund may be mandated to invest venture capital in technology start-ups with a global potential, while another fund's mandate may be to invest in medium sized engineering and manufacturing businesses in developing economies. A third fund may focus on management buy-outs and leveraged buy-outs of large, established companies.
Despite this diversity, there are common strategic challenges across all PE fund managers. The PE fund manager has to manage two key constituencies – investors who provide capital for their funds, and prospective investee companies as its source of potential investment returns. The success of a PE fund manager depends on how he/she manages its relationship with each constituency, on a medium-to long-term basis. In its relationship with investors, such as asset managers, PE fund managers need to ensure there is alignment of expectations regarding investment mandate, risks, rewards and time frames.
In its relationship with individual investee companies, the PE fund manager plays the role of a business investor. A PE fund functions as an investment portfolio comprising a number of investee companies. The strategic objective of the PE fund manager is to achieve a target return for the portfolio as a whole, within a certain level of risk, and within a certain investment time frame, for example between five and seven years.
The investment related tasks of the PE fund manager may be divided into four stages, each with its own strategic challenges and choices. The first stage is pre-investment. This includes tasks such as marketing the fund to prospective investees and identifying potential investment opportunities that fit the investment mandate. The strategic challenge is to identify and select the best businesses in which to invest.
The second stage is investment. This includes tasks such as negotiating the terms, conditions and structure of the investment in the investee company, and assisting in sourcing non-equity sources of capital, for example loan capital, to leverage the equity investment. The strategic challenge is to create the conditions for a long term investment relationship that has the potential to succeed in its return objectives.
Stage three is post investment venture management. It focuses on adding value to the investee company and monitoring the risk profile of the investment. This is arguably the stage with the greatest opportunity for the PE fund manager to add value by contributing to the strategic management of the investee company. Key tasks include assisting the investee company to review the strategy of the business and linking the investee company to the PE fund manager's business network to support strategic initiatives in sales, marketing and business development.
The final stage is investment exit. This involves tasks such as identifying and assessing various exit options, and exiting the investment in a manner that achieves or exceeds the target profit. Profits are only realised on exit, so this stage needs careful planning. A good PE fund manager starts developing an exit strategy even before making the initial investment.
The PE fund manager is rewarded on the basis of the returns achieved on the overall portfolio. However, these returns are comprised of returns on each individual investee company. A key challenge for the PE fund manager therefore is to combine an investment portfolio perspective of its investee companies as a group, with an understanding of the key drivers of investment risks and returns in each investee company. The PE fund manager needs to decide the strategic role it should play in each company. A minimum contribution would be reviewing the strategy of the investee company on a regular basis, focusing on both strategy formulation and strategy execution.
Strategy from the perspective of the investee company
The role played by the investee company, particularly its senior management and executive team, is that of an entrepreneur in an entrepreneur-investor relationship. There is an inherent expectation in such a relationship that the entrepreneur will use the investor's funds to grow the value of the investor's interest in the business, in an ethical and responsible manner, and that the entrepreneur understands the business and the industry and has a basic level of strategic management capability to develop and manage the business.
The investee company views the PE fund manager as an investor over the medium to long term (for example five to seven years) who shares in the risks and rewards of ownership, and who plays a role in the strategy of the business, usually as a member of the board of directors. A key contributor to the success of the entrepreneur-investor relationship is the alignment between the two parties regarding the strategic management of the investee company. The investee should also seek to maximise the value of the relationship by leveraging the business experience, skills and network of the PE fund manager, which should ideally be significant and value-adding to the investee. The investee company needs to consider this factor in making a choice of PE investor as part of its growth strategy.
The strategic management focus of the investee company depends on various factors, including the development stage and size of the business, and its growth targets. For example, a medium to large sized investee company, comprising a corporate office and several business units, would need to consider at a minimum two levels of strategy – corporate strategy at the level of the corporate parent, and business strategy for each business unit. In addition, it would need to consider the strategies within each business unit for key functions such as marketing, operations and finance. It may also decide to develop a portfolio strategy for the set of business units in aggregate.
The common strategic challenge
We have looked at strategy from the perspective of three key players in the private equity industry. They all face a common strategic challenge, shared with most businesses – how to convert human ingenuity and initiative, plus financial investment, into business value and shareholder wealth. asa
Troy Dyer CA(SA), MBA (Wharton), CFA, is a strategy coach and business adviser. He has consulted to a range of players in the private equity industry, including asset managers, private equity fund managers and investee companies. He is the owner of Audax Ideas (www.audaxideas.com), a professional services firm.
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...and how many PE fund managers actually beat the equity market
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