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The need for Executive Interims in the Private Equity sector
Private Equity firms’ portfolios have fared better than many expected since the recession. While no one expects a repeat of 2014 in private equity given last year’s record-setting pace, all indications suggest that 2015 will be another record year in terms of private equity investment, according to the Canadian Venture Capital and Private Equity Association (CVCA). Aided by low interest rates, portfolio companies have survived to fight another day. However, while interest rates have been low, the hurdle rate which PE funds must beat in order to earn carried interest (the long-term incentive for private equity executives) has remained at around 8% per annum, with the clock ticking since the day each investment was made. If PE firms are to earn this carried interest and delight their investors sufficiently to raise more funds in the future, they need to get growth into their portfolio companies - not just pedestrian growth, but significant growth in order to make up for the time lost during the downturn.
At the current rate of exits, the average PE ownership period will stretch to 11 years, requiring an equity money multiple of as much as 2.3x just to reach the hurdle rate. Beating these returns will be made harder by the backcloth of rising interest rates in late 2016.
In 2011, EY carried out a piece of ground-breaking research (“Return to Warmer Waters”) which looked at how PE firms achieved organic growth. EY states: “Our study demonstrates that the more fundamental changes that PE investors are able to achieve in portfolio companies have the greatest impact on profit growth. It is a harder route to improving performance but it generates better results for companies and, ultimately, enhanced returns for PE.”
The study found that, for the companies in the sample, only 4% of EBITDA growth came from growth in market demand, whereas 96% of EBITDA growth resulted from management action: selling initiatives (25%); new products (22%); price initiatives (19%); geographical expansion (17%) and change of offering (13%). Two aspects of these findings strike me as particularly important: first, how little benefit is to be gained from a passive “keep doing what we’re doing and hope that demand picks up” approach; secondly, how broadly the gains are spread across the different possible management actions. In other words, it is folly to rely for growth on just one selling or price initiative, or a new product development or geographical expansion.
To give their portfolio companies the best shot at growth, private equity firms need to be doing all of these things at once. However, incumbent management simply don’t have enough hours in the week to make all these things happen on top of their existing workload. Grasping this opportunity requires additional resources.
This additional resource can be provided by Interim Executives; hiring Interim Executives enables an organization to use the skills of a highly experienced executive to fulfill its needs at a particular time. Interim Executives are often hired to deliver a specific project where they can bring change and fresh thinking to an organization’s mandate.
Effective interim management is about embedding good practice and leaving a legacy of improvement. Interim Executives tend to be overqualified for the role so they can ‘hit the ground running’. They are results-oriented and used to working towards a specific goal and delivering to a deadline. Interim Executives are also cost effective because they are a variable cost, not a fixed overhead.
The global economy could be headed for a “modest revival” in trade and economic growth, despite concerns over weak commodity prices that have derailed growth in resources-dependent countries such as Canada. A number of private equity members believe that depressed oil prices will improve their business outlook for 2016, but not enough to drive the returns that PE firms and their investors want and need. Peter Drucker once said: "Management is doing things right. Leadership is doing the right things".
Now is the time for PE firms to do the right thing by making sure their portfolio companies have the additional management resources to achieve the level of growth that will attract the attention of buyers and provide the strong exits and strong returns that PE needs.