As the margin of error shrinks, private equity develops institutional-like operations
Facing higher valuations and more competition, PE firms are developing more rigorous operating models to reduce the chances of making business or investing errors, a consulting firm has found.
Many private equity firms are coming off well from a strong showing in 2021 – and more money has followed. More than a trillion dollars flowed into private equity last year, according to a new report by Ernst & Young LLP, which is based on a survey of PE leaders and investors.
All that new capital comes with new risks. For example, it has pushed up valuations – both among portfolio companies and among PE firms themselves. The latter is important because the EY report suggests some fund managers are considering an exit.
It’s also forcing the business of PE to add more rigorous processes to their business operations. PE firms are transforming into “more complex financial institutions with responsibility for multiple portfolio companies and the growing alternatives allocation from investors.”
This means the margin of error on business and investment decisions is shrinking. The report puts it this way:
“As increasing amounts of capital flow into the private equity space and firms are seeing high multiples paid for private equity businesses, fund managers realize the stakes of making the right choice are growing exponentially higher.”
In response, many are “strategically building out more rigorous operating models” which is putting PE firms “on par with larger financial institutions.” This includes process improvement, controls, and an increasing reliance on data to drive business decisions.
The report details several ways PE firms are growing the maturity of their operations. Below are three that stood out to us.
Please note, the survey responses are broken out by the size of the PE firm based on assets under management (AUM):
- Large PE firms are defined as managing more than $15 billion in AUM;
- Mid-sized PE firms are defined as managing between $2.5 and $15 billion in AUM; and
- Small PE firms are defined as managing less than $2.5 billion in AUM.
1. Establishing dedicated teams for corporate operations
As their funds and firms grow, PE leaders are increasingly turning to specialists to help manage their corporate operations. This includes operations staff, who are focused on synchronizing business activities and processes for optimal performance.
Here’s how the survey results break out:
- 97% of large PE firms have a dedicated corporate team;
- 82% of mid-sized PE firms have a dedicated corporate team; and
- 61% of small PE firms have a dedicated corporate team
The report says, “While smaller firms lagged a bit on this question, they have clearly realized that private equity firms require someone to have oversight over all key business functions.”
We’ve seen use cases for operations professionals emerge in our studies of legal spending in private equity. For example, fund managers often instruct law firms directly to get deals across the finish line. The in-house lawyers may not even be aware of a specific matter until someone from finance asks them why that matter is over budget.
2. Sharp focus on people process and technology
Last year when EY conducted this survey, CFOs and financial leaders in PE intended to “double down” on technology investments. The findings this year are consistent, but they also indicated technology is part of a larger effort to add rigor and process to the operating model.
“Further reflecting the sharpened focus on building out a broader set of processes at the management company level, more than 43% of the largest firms said they had significantly increased their investment in people, processes and technology over the past two years,” according to the report.
While the survey shows fewer PE firms in the small or medium categories did the same, the number is not insignificant. EY says, “roughly one out of five said they had increased their investments significantly, 19% and 23%, respectively.”
Decisions can no longer be made by “taking a gamble” according to the report. These processes facilitate data collection and analysis to allow “for more informed decisions.”
3. Top strategies to protect margins
“Although top-line revenue has been growing for many private equity and venture capital firms over the past few years, firms have to understand the impact of their spend,” according to the report. As such, EY asked survey respondents about strategies they’ve implemented to protect margins.
Across firms of all sizes, the top three were as follows:
- Deployed new technology
- Increased outsourcing
- Renegotiated fees with vendors
However, the survey revealed some disparity by firm size among those choices. For example, while 63% of large firms said they had deployed technology to protect margins – just 40% of mid-sized and 37% of small firms said the same.
These positions flipped when asked about outsourcing. Nearly half (47%) of both small and mid-sized firms had implemented an outsourcing strategy compared to 38% of large firms.
Here too our research draws parallels to PE spending on legal services. For example, technology is woven throughout the top processes private equity firms use to control legal costs (see this case study with EQT). Similarly, PE firms also frequently negotiate discounts in response to higher-than-expected law firm invoices.
* * *
EY commissioned Greenwich Associates to survey 107 private equity COOs, CFOs and financial executives – and 54 investors – to produce the report. The full report covers other issues top of mind for PE firms including talent management and DE&I and can be found here: 2022 Global Private Equity Survey.
Image credit: Pexels