ODGERS INTERIM OPINION

18 December 2013

Simon Havers, Head of the Private Equity Practice at Odgers Berndtson and Odgers Interim, discusses the need for interim executives in the Private Equity sector...

After Lehman Brothers filed for bankruptcy on 15th September 2008, the rate at which new private equity (PE) deals were done fell dramatically and has yet to recover. In the four years 2005-2008, members of the British Private Equity and Venture Capital Association (BVCA) invested at an average rate of 1,308 UK companies per year. In the following four years 2009-2012, the corresponding average rate was just 820 UK companies per year, a drop of 37%. Current indications are that 2013 will see a lower rate still.

In contrast, PE firms’ portfolios have fared better than many expected. Helped by low interest rates, portfolio companies have survived to fight another day. However, although interest rates have been low, the hurdle rate which PE funds must beat in order to earn carried interest (the long-term incentive for private equity executives) has remained at around 8% per annum, with the clock ticking since the day each investment was made. If they are to earn this carried interest and delight their investors sufficiently to raise more funds in future, PE firms need to get growth into their portfolio companies. Not just pedestrian growth but significant growth as they need to make up for a lot of time lost during the downturn. 

At the current rate of exits, the average PE ownership period will stretch to 11 years, requiring an equity money multiple of as much as 2.3x just to reach the hurdle rate. Beating these returns will be made harder by the backcloth of rising interest rates, with the Bank of England forecast yield curve showing rates rising by 4%.

In 2011 EY carried out a piece of ground-breaking research (“Return to Warmer Waters”) which looked at how PE firms achieved organic growth. EY states: “Our study demonstrates that the more fundamental changes that PE investors are able to achieve in portfolio companies have the greatest impact on profit growth. It is a harder route to improving performance but it generates better results for companies and, ultimately, enhanced returns for PE.” 

The study found that, for the companies in the sample, only 4% of EBITDA growth came from growth in market demand, whereas 96% of EBITDA growth resulted from management action: selling initiatives (25%); new products (22%); price initiatives (19%); geographical expansion (17%) and change of offering (13%). Two aspects of these findings strike me as particularly important: first, how little benefit is to be gained from a passive “keep doing what we’re doing and hope that demand picks up” approach; secondly, how broadly the gains are spread across the different possible management actions. In other words, it is folly to rely for growth on just one selling or price initiative or a new product development or geographical expansion.

To give their portfolio companies the best shot at growth, private equity firms need to be doing all of these things at once. However, incumbent management simply don’t have the hours in the week to make all these things happen on top of their existing workload. Grasping this opportunity requires additional resource.

This additional resource can be provided by interim managers. Interim management enables an organisation to use the skills of a highly experienced executive to fulfil its needs at a particular time. Interim executives are often hired to deliver a specific project where they can bring change and fresh thinking to an organisation. 

Effective interim management is about embedding good practice and leaving a legacy of improvement. Interims tend to be overqualified for the role so they can ‘hit the ground running’. They are results-oriented and used to working towards a specific goal and delivering to a deadline. Interim executives are also cost effective because they are a variable cost, not a fixed overhead.

The Office for Budget Responsibility (OBR) has just upgraded its forecast for growth in 2013 from 0.6% to 1.4%, and in 2014 from 1.8% to 2.4%. All very welcome but not enough to drive the returns that PE firms and their investors want and need. Peter Drucker once said: "Management is doing things right. Leadership is doing the right things".

Now is the time for PE firms to do the right thing by making sure their portfolio companies have the additional management resources to achieve the level of growth that will attract the attention of buyers and give the strong exits and strong returns that PE needs.

If you would like to learn more about Simon or his work, please do look at his profile.


Categories: Private Equity and Venture Capital

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