The Common Trait Shared by the Best Private Equity Firms

In the private equity world, buzz terms like “strip and flip” or “burn and churn” are used to describe horror stories of cutthroat investment strategies in which private equity firms give little thought to their obligations to multiple stakeholder groups in order to drive quick (and presumably thoughtless) returns.

In reality, the streamlining of operational processes, the improvement to growth strategies, the augmentation of new managerial talent and development of current management teams, and the implementation of stronger business models are necessary steps for any company’s evolution — whether they are owned through private equity or other vehicles.

Much of what you’ve seen on TV screens and in movie scenes or read in the popular press can be a bit misleading. The good outweighs the bad.

Consider this: Private equity firms have long outperformed the public market, and that’s because they don’t passively invest, focus on day trading, or merely gamble their investors’ capital. Moreoever, the vast majority of firms are not focused on strip-and-flip investment strategies. Rather, these firms absolutely follow tried-and-true investment strategies — such as buy low and sell high — coupled with some of the most disciplined, sophisticated, and cutting-edge management processes across any industry.

The strategy of value buying and letting good management teams govern themselves has been championed by none other than Warren Buffett, who has single-handedly outperformed virtually every other investor in public equities for four decades. He’s the anomaly, though, as private equity as a whole does a better job of preparing its businesses to increase earnings. From 2003-13, according to Cambridge Associates, private equity returns provided an annualized return of 16 percent; the S&P 500 garnered only a 7.4 percent annualized return in that time. For the past three decades, it’s fairly well known that private equity has been the top-performing asset class. Why?

First and foremost, PE firms choose where to invest their capital. PE firms spend a lot of time thinking about the industries in which they should focus and the companies they should acquire. Then, after identifying potential investments through effective sourcing teams and executing the best deal possible, firms are obliged to increase value, decrease risk, and create a more sustainable business model than when they started. Every company inevitably needs to evolve, and private equity firms are a catalyst for this evolution in an organization’s history.

It’s not easy for businesses to optimize for production and quality scalability; it’s not easy to consistently recruit the best management teams; it’s not easy to de-risk an entire business. But that’s what PE firms do, and it’s how these sponsors consistently ensure that their investments create the highest returns. Rigid banks and overrepresented companies (by extremely successful investment banks) can make financing difficult; macroeconomic factors can impair leveraged companies more meaningfully than low-leveraged businesses; and the potential for trade wars from the current administration creates an even more volatile market environment.

Nevertheless, the mission statement for private equity firms is clear: Overcome these hurdles to increase value at the underlying businesses. PE firms are incentivized to actively manage companies toward future sales growth, material cost reduction, and obstacle elimination.

Grooming a Future Champion

Successful companies have solid people and effective processes in place to create high-quality products and value-added services. That’s how long-term profits are made. But rather than passively betting on who will get it right, PE firms use their broad experience from other investments (along with the network of companies collected along the way) to streamline business operations. Agility and prior experience help us make sharp decisions in real time.

My company, Blackford Capital, is heavily involved with its portfolio companies and maintains constant contact to compare notes and track progress against forecasts. We hold weekly meetings at a minimum — and daily status meetings at a maximum — with our companies to review their KPIs and overall progress, and we meet monthly with their management teams and the board to provide further direction for reaching goals. Each month, we distribute the equity value creation for each portfolio company and rank those companies across the portfolio. Quarterly board meetings and annual planning sessions reinforce these ideas and clear any obstacles.

We maintain a steady cadence. Not every company performs at the top of its game every week or month or year. So we have gap processes (referring to when a gap exists between expectations and actual performance) for underperforming businesses. There’s even more oversight and more communication with those businesses. We have had remarkable success at turning them around.

By the time a company has gone through this transition period, requirements are understood, and people start working with experience in the right directions with optimized processes. This process is like employee onboarding but for an entire business. As with individual employees, if you take a hands-off approach, you’ll quickly find your portfolio is filled with unreliable investments. Relaxing your oversight efforts will undoubtedly lead to productivity slippage, profit shrinkage, or outright atrophy.

Surpassing Passive Investors

Good private equity firms are heavily invested in both money and resources with each of their portfolio companies. They partner with management teams to create value through optimized performance processes that have been proved across their entire portfolios. Once each company creates value and generates revenue through production and quality, the firm can either leverage those companies or sell them at much higher values with stronger track records.

A recent survey of 267 European buyouts, along with secondary performance data of 29 portfolio companies, found that operational performance does increase through interaction with investor resources and guidance. PE firms differentiate themselves from consumer investors by bringing world-class processes and procedures into investments.

If a firm doesn’t stay actively interested and involved in the success of its portfolio, it’s just another passive investor in the stock market. Wise PE firms don’t gamble unless they know they play an active role in whether they win.

Martin Stein is the founder and managing director of Blackford Capital, focused on dramatically transforming lower middle-market industrial enterprises through exponentially profitable growth. Since receiving his Bachelor of Arts from University of Chicago and his MBA from Harvard Business School, he has had almost two decades of private equity experience. Among other awards, Martin has been honored as the nation’s Private Equity Professional of the Year by M&A Advisor.