China GPs must double down on operational skills - McKinsey

While China's GDP growth has been steadily falling from 10.6% in 2010 to a real rate of 6.1% last year, buyout funds are becoming a larger part of the domestic private equity market, which means GPs are better positioned for value creation, the consulting firm said in its China PE report.

Frank Su, head of Asia private equity at Canada Pension Plan Investment Board (CPPIB), stressed the importance of a well-defined value proposition. For example, CPPIB favors healthcare because GPs must demonstrate specialist expertise in evaluating opportunities.

“We invested in a new manager last year, a China healthcare-focused fund. The GPs are all medical doctors whose expertise generates differentiated insights and vision. Adding those GPs to our network has been very valuable because they bring us not just access to new deals that we typically can’t evaluate, but also knowledge that we can leverage as an external partner,” Su told McKinsey.

For larger GPs, another way to accumulate expertise is through expansion into adjacent asset classes like credit, real estate, and infrastructure. Operating at a larger scale can promote brand recognition, open up more deal opportunities, and deliver economies of scale in the back-office. It also enables risk diversification and the exploitation of synergies between asset classes.

Jean Salata, a founding partner at Baring Private Equity Asia, noted that his firm leverages its large internal debt capital markets team to support portfolio companies in securing debt financing as well as in exit planning.

Retaining and developing talent is another key focus area. Based on its analysis of 180 investments globally, McKinsey found that only 44% of portfolio company CEOs stay from deal signing to exit. On average, CEOs are replaced 2.2 years after an investment closes. Similar trends are apparent in China.

One large China-based PE firm addresses this issue by having every portfolio company conduct a talent-to-value exercise once a deal closes. Typically, 2% of the people in an organization create 80% of the value - and so it is imperative that these individuals are identified and nurtured.

Much the same applies to private equity investment teams, with K.C. Kung, founder of Nexus Point Capital, noting that operating professionals require as much attention as deal professionals. "Make sure that you motivate the operating group properly, so they don’t feel like second-class citizens. In many PE funds, the deal people get all the glory, and the operating group ends up sorting out portfolio problems. That model doesn’t work," Kung said.

McKinsey reviewed the performance of 120 PE firms globally and concluded that portfolio operating groups have proved their worth most clearly during downturns. Between 2009 and 2013, GPs with operating groups achieved IRRs roughly 500 basis points higher than those without.

Kung advocates integrating operating groups into overall deal execution: "That means that instead of having an operating group that comes in after an investment is made, you integrate them early on, so they become part of the team. For example, it’s good to have the operating group involved in governance negotiations -negotiating shareholder agreements - so they have the support to do the things they want to do.”

He added that smaller private equity firms should prioritize functional experts over industry experts because they can cut across many industries.

On execution, Baring's Salata believes that targeting one or two important levers delivers better results than trying to do too many things at once. "It’s generally in one or two areas that there’s an opportunity to show some results. The other issue is how quickly you’re able to do this. Oftentimes, it’s a year before you’ve gotten the right people into the right positions, and the right plan in place. That’s too long," he said.

McKinsey also encourages GPs to start planning their exits at least 18 months ahead of time. Ideally, two to three years before the intended sale, they should start thinking about credible elements that could be part of the equity story and the investment thesis of the next buyer.

“At a more tactical level, it is necessary to tailor an equity story to the level of sophistication and awareness of the universe of potential buyers, educating them where necessary. An equity story provides fact-based answers to difficult questions and plant seeds for the value creation story for the next buyer,” said Ivo Naumann, a China-based partner with McKinsey.

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• Topics
• Greater China
• Exits
• Buyouts
• Buyout
• China
• Baring Private Equity Asia
• Nexus Point Partners
• Operating partners
• Canada Pension Plan Investment Board (CPPIB)