People power: PE and management

The halcyon days of investments based on multiples arbitrage alone are long gone. Few would deny that the work done with the management team is now the single most important factor in determining the success of a private equity deal. As TPG Capital's James Coulter said at the recent AVCJ Forum, in today's climate transactions based on bringing operational value add hold a much greater currency than the debt-backed investments of the 1990s - a view which was shared by the majority of GPs in attendance.

But what strategies do firms employ when they work with management teams? The unpredictability of human nature must require for a certain amount of flexibility, while the challenge of dealing with people across language barriers represents an extra obstacle for non-Asian investors.

The first hurdle to overcome is sourcing the key individuals who will make up the team. In most companies, the quality of the CEO is the most critical piece of the jigsaw.

"CEO selection has become extremely important," says Paul McCullagh, managing director of Pacific Equity Partners (PEP). "A superior CEO has no excuses, always has ideas, always has inspiration to bring to board meetings - they're the sort of partnerships that we think is the secret sauce in these times."

PEP-backed companies whose success McCullagh attributes to effective managers include food businesses Tegel and Griffins Food, both of which seemed to be beyond growth when the investor bought them. Having been acquired in 2005 for around NZ$250 million ($194 million), Tegel's parent company NZ Poultry Enterprises was sold to Affinity Equity Partners for just over NZ$600 million earlier this year, reaping returns of 5x. The ongoing sale of Griffins, meanwhile, is on track to generate similar multiples: having been bought for a reported NZ$385 million in 2006, the business has now been valued at around NZ$985 million. UBS and Goldman Sachs are managing the sale process and potential trade suitors include Kellogg, General Mills, Nestle and China's Bright Food Group.

It's not enough to source competent individuals with a strong track record, however. Jamie Paton, managing director at First Reserve Asia, warns that the managers themselves need to actively welcome private equity backing: "You have to work with people who want your experience, who actually enjoy it and relish it. They must be prepared to reach out to you to get it."

Yet while enthusiasm is vital in new managers, excellent English language skills are not - although head-hunting across language barriers does add an extra complication to the process, especially for monolingual Western GPs.

Benjamin Fanger, co-founder of Shoreline Capital Management professes to never having spoken English with any of his portfolio company employees. He believes that "really smart, capable" individuals exist who are ideal for certain roles but simply fall under the radar of many foreign investors. "As we've been hiring over the years I've felt like there's an inverse correlation between someone's ability to speak English and their ability to do things like work out debt in Chinese courts," he says.

Once the team is in place, the most common tactic for aligning interests is through the use of management incentives. Having five cents in every dollar going back to the management is often particularly effective in the case of corporate divestitures or where the individuals previously worked for family-owned businesses, where significant behavior changes may be noted.

Andrew Liu, CEO of Unitas Capital, has seen executives who worked for large public companies frustrated by the fact their compensation is tied not just to the division they were running but to the entire the parent company. "When you buy the division and give them options or make them part-owner, you do see the difference," he says, recalling a recent corporate spin-out from a US company where "you saw the elevated performance right away." However, he admits there have also been cases in which management failed to live up to expectations and new people had to be brought in.

Another potential drawback which the incentive model doesn't account for is what happens when managers feel sufficiently sated by rewards. McCullagh points out that often teams in Australia start declaring a victory after the first few years because of the amount of shares they've acquired. "At that point you've got to keep pushing and driving people on," he asserts. "You tell them we haven't declared victory, we've a lot more things to do and that this is for the long haul."

Rapid changes

Sometimes, though, management isn't in it for the long haul. McCullagh compares the recruitment of some teams to hiring an architect who does what he wants to a client's house rather than what he's been asked to do. Independent Liquor, the beverage brand sold for NZ$1.53 billion to Japan's Asahi Group by PEP and Unitas is one example of this. "We were hit mid-ships in the investment by government regulatory change and figured out very quickly that the management team which had previously been terrifically successful were not equipped - skill-set-wise and mindset-wise - to deal with what happened," admits McCullagh.

A very different set of people was therefore drafted in 2009, which appears to have prevented the deal from going entirely awry, as the GPs reaped a modest 1.5x on their original NZ$1.2 billion investment of 2006. The returns might be even seen as a victory given the negative impact of a 70% tax hike on alcopops in April 2008 and a general decline in Australasian consumer spending the GPs' tenure.

Another PEP-owned company saw the CEO last less time than the investment due what McCullagh describes as unhelpful attitude. "He was always very disparaging about competitors, always believing that our technology was better, which made him a blind spot for the company in that space," he says. The replacement though went on to acquire a series of competitors, which was far more in tune with PEP's vision for the business.

One thing which helps enormously when it comes to replacing any manager is knowledge of the industry in which the company operates. For generalist GPs, a favored approach for harnessing this is through the use of operating partners - industry specialists who work with investee firms, usually on a part-time basis. Having sector experts with the deal-doing team is another popular strategy.

"Within all our teams at First Reserve, we've got people who have been there and done that and have real operating experience," says Paton. "They can sit down with the team and talk as an operator."

So if worst comes to the worst and the management are ousted, the operating partner may be a firm's most useful tool for sourcing new personnel. In any case, the most crucial rule to remember, according to Paton, is that such decisions must be taken as soon as possible. "If there's a problem with the team, you change it," he says. "There's no secret sauce, but if there's one thing I've learnt it's to take decisions early - if you wait it always comes back to bite you."

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• Topics
• People
• GPs
• Pacific Equity Partners
• Unitas Capital
• Andrew Liu
• Paul McCullagh
• First Reserve Corp
• Benjamin Fanger
• Jamie Paton