The credit crunch has fundamentally changed the world of private equity. The consequences for finance directors of portfolio companies and those who aspire to join the sector are highly significant.
2002 to 2007 was a spectacular period for the private equity (PE) industry, since nine of the largest buyouts in history occurred during this period. However, the credit crunch has created a series of new challenges and the industry faces a number of obstacles on the path to recovery, including profitably exiting investments, finding new investments, the impact of lower leverage on future returns, the relationship with investors and the ability to raise new funds with more competitive fee structures and impending debt refinancing within the portfolio companies.
Historically, PE has generated its returns in equal measure from the use of leverage, a rising exit multiple and growth in the underlying operating performance of the portfolio companies. Going forward the first two are looking difficult to achieve.
The active ownership model adopted by PE worked well during the last couple of decades – seeing the installation of new leadership teams, provision of strategic advice and use of operational partners for creating operational advantage. Immense returns were achieved while favourable market conditions prevailed that are unlikely to be repeated.
Private equity firms now find themselves as long-term owners of businesses with significant operational challenges. They can expect limited growth in capital value and there may be no immediate option for a profitable exit. This means they have little choice but to become operators.
What does this all mean for operational finance directors that work in the portfolio companies of the PE firms and those who would like to do so?
The specific nature of the FD’s role has changed. Many of those recruited as FD’s joined at a time when growth and a lucrative exit were on the agenda. They were hired to build infrastructure, prepare for the exit event and to financially engineer the business to maximise returns. The brief is very different now – reduce debt, reduce costs and maximise cash flow. It’s a different mood and a very different set of skills that are required.
Some things have remained constant. The truly valuable finance director is able to instil in the PE investors the confidence that he or she can answer the myriad questions that PE investors have. He or she must bridge the gap between management and investors. The right finance director is likely to be intellectually sharp, commercially astute, clued up about the industry, proactive, organised, hands on and willing to get deeply involved in the business; able to alternate seamlessly between the big picture and the detail.
Even if the finance director ticks all of those boxes and more, it is difficult to build that confidence when the same person who built the expensive organisational infrastructure is now charged with cutting it back. PE investors question the appetite, energy and skills the builder will have to deliver on the restructuring task. For some incumbents it is a risky position to be in.
Those individuals are not always helped by the constant requests for information arising from the PE company head office. Driven by remarkably intelligent analysts, recruited from the cream of the crop of the world’s top business schools, the requests for information can be regular, complex, to tight deadlines and may often serve only to satisfy intellectual curiosity. Meanwhile, they can disrupt the running of the business. How easy is it for a finance director who is concerned for his or her job security to refuse such requests?
Even worse, some PE leaders may simply view company management as having had enough. Management may have done a great job, shown superb leadership through the most difficult of market conditions, but if it is perceived that you are a spent force, track record may not be sufficient to save you.
In addition, there are at present many immensely experienced and talented finance directors out of work. They are rested, keen, and talented; have in-depth industry knowledge; and are immediately available. This group is proving increasingly adept at offering valuable industry insights that may be hugely significant to the PE firm, as long as they can demonstrate that they have learned from mistakes and developed as a result.
We should therefore expect to see changes in the financial leadership of portfolio companies. Private equity bosses are shrewd commercial operators and they will do what they think is right for the business. There is nothing personal; people know from the outset that in seeking the opportunity to achieve significant personal financial gain they must also take a risk. It’s business.
On the other side of the equation, leadership will be equally commercial when hiring. They are unlikely to have much interest in an HR-led recruitment processes, preferring to apply their own brand of judgment and commercial acumen. And who is to argue with people who have so often been so successful.
Paul Goodman, the founder of financial recruitment specialist Goodman Masson, says he expects that there will be change in the financial leadership of private equity portfolio companies even though he points out that “private equity bosses are not the stereotypical hire and fire types that people may think”.
“These people know what they are doing and will properly consider all of the implications of making important changes to the leadership of their businesses,” he says.
Goodman also offers the following assessment to would-be finance directors of private equity businesses. “There are clearly attractions – freedom from stock market demands, intense commercial focus and the chance to gain financially from a successful exit strategy. However, it can take a certain sort of person to handle the day-to-day operational stress, deal with the investors, deliver on the regular requirements for information and be able to think strategically.
“You have to think very carefully and decide if you are truly the right person for this type of business life.”
Slow to exit: why Private Equity FDs need to change their game
Recent figures show that while the size of private equity backed buyouts is rising rapidly again, the exit market remains slow.
Data published by the Centre for Management Buyout Research over the summer found that the value of buyouts in the first half of 2010 had surpassed the total for 2009 by 45% – £8.1bn compared to £5.6bn – with the average size of deals more than doubling to £91.2m from £39.5m.
However, the exit strategies for PE companies are still troubled, with just 70 being recorded by the research, with the majority through trade sale. Exits from private equity-backed companies falling into administration was lower – 21 compared to 56 last year. Just two private equity-backed flotations had taken place in the first half of the year, although only one had taken place during the whole of 2008 and 2009.
Sean Rowbotham is CFO of Calastone
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