In our Private Equity Finance course, we learned about how PE firms are uniquely equipped to create value for their portfolio firms. Importantly, these levers have direct parallels to the world of search, and as the M&A space becomes more crowded, it will become more important for entrepreneurs to differentiate themselves along operational expertise. On the other hand, assistance in financial and governance value creation will become less valuable to investors (who will be able to handle those levers on their own).
In this blog, we will analyze the financial, governance and operational levers and consider how searchers may think about utilizing them in their own search and management of a business.
Financial
At a high level, financial value creation involves adding debt to a firm in order to impose discipline onto management. By reducing access to free cash flows, managers have less discretion over their decision-making and effort, and are prompted to follow along with the board’s recommendations. Overall, PE firms cultivate connections to financing partners to raise debt as part of the bundle of value they provide LPs.
In the world of search, debt plays an important role, and many investors are experts in evaluating how much leverage makes sense for a manager to handle with a company. As a result, entrepreneurs seeking uncorrelated skillsets to their board do not need to worry as much about understanding this aspect of value creation. In fact, doing things like worrying about capital structure is the last thing a small business CEO should be doing anyways.
Governance
Similar to financial levers to creating value, governance levers are widely accessible to investors. Typically governence value creation involves updating management incentives and upgrading the team. When combined with the right operational levers, this can be very lucrative for the PE firm and managers alike.
Again, with respect to searchers, this is not something to worry about. Most tradtiional search funds are structured the same way: they all require a certain amount of performance for the CEO to succeed so the new manager has plenty of incentive to grow the business. Again, this means there is not much for a searcher to differentiate on.
Operational
Finally, operational levers refer to the manager’s skill in running the business. For PE firms, this is just one of the many things they bundle on behalf LPs. In this case, bringing providing otherwise inaccessible expertise to portfolio companies can be tremendously valuable. Over time, this has become the differentiating characteristic of PE firms. Another factor is that operating expertise lends reputational capital to the PE firm, making deals more amenable to managers.
For searches, this is likely to be even more important. Between the importance of connecting with owners (likely to only be possible with the right background) and operational skill playing a key role in actually growing the company, managers stand the most to gain by developing a strong thesis around how they can run the operations of a business smoothly.
Concluding thoughts
It is widely known that the M&A space is becoming increasingly crowded as technology brings the world closer together and reduces barriers to information. What remains rare is tacit (operational) skill. In turn, searchers should think long and hard about what operational ability they can provide to a business.