The Private Equity Challenge

This isn't an article bashing private equity. I invest in private equity and I believe it plays an important role in our economy, particularly as it pertains to venture capital and growth capital and often in optimizing companies to be more competitive and create greater value. And also…

Private equity represents an increasingly large portion of the work world. For those who don't deal with it actively it's based on a simple model where institutions - like pension funds, insurance companies, and other investment groups - along with individual investors put their money into a fund and purchase or invest in non-public companies. Sometimes they take a minority stake; more often they take a majority or controlling interest.

The model has blown up over the past 20 years, in part because it's had tremendous financial success. In fact, there are over 5,000 private equity firms in the U.S. alone. And yet, generally for the average employee, manager or leader the sound of private equity is a little unnerving. And for good reason. There are some fundamental challenges with the private equity model that, if not considered in advance, can create significant strain on organizations and on leaders. I'm going to point out a few of them. But to be clear my goal isn't to disaparage PE firms, but to help improve the system. They are not going away. Like many things in the business world the issues lie not in the institutions but in the choices leaders make within them.

The first challenge is the purchase process and the subsequent effects it has. Many private equity purchases follow a typical pattern. An individual or family (or even another PE firm) wants to sell a company. They hire an investment banker who puts together a Confidential Information Memorandum (CIM) which is used to gather interest. The interested parties then compete for the firm by submitting an Indication of Interest (IOI). This is often done with very limited relationship with the company (if any). IOIs turn into Letters of Intent (LOIs) and often the highest bidder wins. This is stress point number one. By the sheer nature of asymmetric information, you often end up with serious risk of a "winners curse" - that is, the company who bought the firm paid the most for it or, in essence, paid greater than "market value". While they may have done so because they have a strategic advantage and can get more out of it than others (and that is an ideal situation), they might have also done so because they simply didn't know better or they were overly optimisitc in what the business could do. And now you have pressure on the organization to perform beyond what the general market believed it could.

The second pressure point then comes with the leverage of the deal itself. Most private equity firms use some form of debt to increase the value of their equity investment. This is not only not bad by itself, it's smart finance. Nonetheless a business already under pressure from expectations that might not have been realistic, is now under even more pressure becuase of the debt obligations that exist.?

The third pressure point then is the time horizon. The vast majority of private equity firms work under a three to five year window of investment (although this is necessarily extending in curent times). Their funds last the life of about 10 years, they spend the first few years raising capital and finding companies to invest in, they then hold the companies for 3 to 5 years ideally growing the business, and then they sell, harvest, and return the money. This time horizon often pushes an urgency into everything the business is doing, creating increased pressure and sometimes forcing short-term decision making.

A final challenge with private equity is that it too often treats business as a transaction. That is, businesses are often viewed simply as an asset to be bought and sold to make money off of. Such a transaction mindset can often ignore or overlook the fact that people's lives are affected by the businesses and even by the transaction iteself.

Now that sounds like a pretty bleak picture. And at its worst, it is. If you've been in business for any length of time, you likely know someone who's had a substantively negative experience with private equity. But like most things in life, blaming a faceless organization is not very helpful. So what then?

MAKING PE WORK

If you're in leadership of a PE backed company, get to know your PE sponsor. Understand the individuals and their motivations. Push for transparency. The more you understand their movitations, priorities, values and drivers, the better you can shepherd your team to meet them. You and your organization deserve to know how the firm will operate, what its timeline is, and where it expects to go. Full transparency is foundational to trust in any organization and you need to expect full transparency. Find out how they will operate under stress - regardless of what that is - and help everyone understand the implications.

If you're looking to sell your company to private equity, do it with eyes wide open. You have responsibility for what comes after you! Too many individuals sell to private equity to the highest bidder and are disappointed when the outcome isn't what they thought. But business owners have a responsibility to think more clearly about the consequences of their sale and who it affects and not rationalize the future. Make sure the firm brings unique business advantages and expertise so it truly can make you better. Do your homework on how they've handle downturns and surprises. Do reverse diligence exploring who they have invested in ....and don't rationalize the results! Know where you are in their funding cycle. You have a repsonsibility to all other stakeholders to ensure your firm ends in good hands.

Finally if you're a leader in a PE firm, there is an opportunity, from a financial and human perspecitve, to think differently, to think longer term. It's encouraging to see more PE firms doing this. Be courageous. Don't succomb to whatever everyone else does. You can't financially engineer your way out of everything. Don't be afraid to be different. Commit to healthy leadership, healthy cultures and a real purpose. Build a healthy leadership team. Invest in the "soft stuff" because the soft stuff is the hard stuff. Spreadsheets are a commodity, dynamic leadership of high-performing teams is not. Lean in to it. Invest in creating long-term impactful organizations, even knowing you won't own them forever. Your work will be more meaningful and your reputation will be stronger. Commit to transparency and human-centered operations. If you do, you will be different, you will stand apart, and you will have greater returns.

CONCLUSION

The private equity model is transactional in nature. As such it can quickly dehumanize organizations. It takes leaders on all sides to prevent that from happening. PE isn't going away but those firms that take a human-centered approach to relationships, those that pursue a positive impact on the world, will ultimately rise above the rest and have truly meaningful results.

How does this point impact you? What resonates? What's missing? What might you add?

"Points of Impact" is a publication expressing thoughts on how we might approach our work differently to have a better impact on others and the world. For more related perspectives, check out the book Impact with Love: Building Business for a Better World.