Value creation models haven’t always been the lifeblood of private equity operations. In fact, the private equity industry has matured and changed shape several times since its birth in the 1980’s. The original strategy of financial leverage was replaced by a focus on multiple expansion in the 90’s, and later earnings growth in the 00’s. The current evolution is often referred to as the “operational improvement era” due to the increased focus on value creation across the portfolio companies.
The increased, time-endured emphasis on private company value creation through private capital has expanded the role of Operating Partners. It has also forced countless general partners (GPs) to devise and execute on top-line growth strategies. Further, GPs are now expected to facilitate product development, market expansion, and strategic synergies rather than simply provide the financial optimisation that private equity became famous for.
All of these trends have fueled the tremendous growth in importance of value creation models. Now, private equity uses the term “value creation” on their website, in their conversations with private company owners and founders, and in their pitches to limited partners (LPs). More importantly, private equity abides by value creation frameworks to propel growth within their portfolio companies and across their funds.
Obviously, there is no “one-size-fits-all” value creation model that can always fit any company in any general partnership. Depending on the strategy and focus of the GP, their value creation model will be different, not only in its structure but also in how flexible it needs to be. A GP focused solely on a portfolio of SaaS B2C entertainment companies will have a more focused model compared to a GP that is sector agnostic or one with a diverse portfolio in terms of size, business type and geography.
Below, we have identified the most commonly seen attributes of successful value creation models that have been adopted by GPs:
- Cross-Portfolio Transparency and Aggregate Reporting Capabilities: The identification and deployment of a framework that allows for analysis across a portfolio is very important. The definition of 4-5 strategies like “Revenue Enhancement,” “EBITDA Optimisation,” “M&A,” can give a common structure to very different portfolio company value plans, allowing aggregate analysis at portfolio level of strategies that are working or not.
- Flexibility and Elasticity: Put simply, value creation models need to be flexible. Private equity firms and their investments change and evolve over time, as does their performance and reliance on their private equity investors. Any value creation model that’s worth its salt will easily accommodate very different strategies depending on sector, size, geography, etc. of the portfolio company. It will also easily accommodate the changing demands that GPs, LPs, and investor relations teams alike will put on it over a decade or more.
- Modularity: In the fast-paced and competitive modern world of private equity, firms need not reinvent the wheel every time they make a new investment. Ask any tenured investor and they’ll tell you that lessons learned from one portfolio company can often be applied with success to another one, even in a different sector. A proven successful strategy to expand commercially in a new country can function as a blueprint that can be easily adapted to different companies, and as such, the value creation model the firm leverages should allow for institutional knowledge to flourish.
- Best-in-Class Measurement: In order to be successful (with LPs, but also in hard dollars), private equity investors need clarity in terms of KPIs measured. The main financial KPIs (e.g., EBITDA, COGS, Revenues etc) are clearly applicable to any portfolio company, but most private equity firms have other meaningful KPIs to track. In fact, a recent McKinsey piece finds that “Managers and investors too often fixate on short-term performance metrics, particularly earnings per share, rather than on the creation of value over the long term.” In this way, value creation models that allow firms to be optimally successful are those that can accommodate standard practice, long-term thinking, creative strategies, and every meaningful metric in between.
Not sure where to get started with your firm’s value creation model design or deployment? Contact us today to learn more about our value creation blueprints and best practices.