The use of operating executives is not a new practice, but as private investment firms (venture capital, private equity, growth equity, family offices, search funds) look to continually boost returns on invested capital, they are getting more creative and building out more advanced methodologies as a core characteristic of the firm strategy. As the majority of mega funds and upper middle market funds have their own internal operating groups, which can be thought of as an internal consulting wing, these groups are their way of reducing fees paid to traditional consulting firms while keeping their value creation "secrets" under wraps.
Since private equity 20 years ago was more aligned to buying a company with strong fundamentals at a good price and holding it, a more prevalent strategy now is acquiring and optimizing every core function, from operations, financials, product offerings, and most other granular aspects of the company. With such a robust and intensive process now, making a couple of key hires is no longer enough. More capital is being returned, which allows more (and better) hires to be made, creating a flywheel of value creation that the ever-increasing quest for IRR must continually achieve.
Post-acquisition, the first few steps investors look to adjust are the low-hanging fruit projects, initiatives that have the highest actionable ROI versus time and capital invested—"where can we do the least to achieve the most?". A lot of these will be centered around achieving economies of scale with vendors, suppliers, technology build-outs, and KPI tracking with other relationships and/or systems that are already in place with other portfolio companies. Once more scalable systems and deeper metric tracking are in place, monitoring and reporting can be enhanced, and now a more robust, data-driven approach can be made going forward to find where the true value is coming from at every turn, pitfall, and massive success. Concurrently, new internal team leaders are being brought in, operating executives, specialized c-suite leaders, and any contractual project hires necessary to begin the value creation process. It is worth noting that every single investment firm has different strategies for different industries, I am speaking from a generalist standpoint for example's sake.
Once the new teams, reporting, and systems are in place, it is time to execute on the specific playbook the firm has done dozens of times—rinse and repeat—leaving no wiggle room for errors. The majority of the time, this playbook is learned through trials by fire with other portfolio companies, seeing them go through previous market cycles and picking up lesson by lesson along the way. This is another reason that it is rare for a fund's inaugural fund to outperform its later funds, provided fund size and strategy remain consistent. What about newer PE firms without reps under their belts? This is where the functional operators come in, lending a hand and expertise to guide change and ensure continuous value creation and positive change.
For larger PE firms, internal operating groups will continue to be the main value-creation lever being pulled, and lower middle market funds will continue to need support for mid and senior level roles within the portfolio company. Interaction with portfolio companies will remain at an all-time high, with investors not wanting to leave anything on the table or any decision up to chance as we head into a recessionary environment. For these functional operators who are experts in each of their respective fields, the competition will be heightened as all firms continue to adopt this strategy and have a stronger need for the expertise and ‘time in the trenches’. They will look to external services like Flywheel, who have an entire database of experts ready to execute on a seasoned playbook, for any specialty needed.
As previously stated, private equity has a couple of year lag time compared to public markets, which allows for more preparation time and less pressure from external economic factors. Regardless of the market cycle, there is still an intense amount of dry powder, fundamentally strong companies, and an astounding number of truly excellent individuals in their respective crafts. If you can connect these three points (or are one of these points), there is a large amount of success to be had and capital to be returned, but it all starts with the first.