Industrial Revolution

Now that the days of quick flips and overleveraging are gone, private equity firms are faced with internal conflict. Just what is the new private equity model?

Bruno Deschamps, a senior adviser to 3i and founder and managing partner of development capital firm, Entrepreneurs Partners LLP, shares his views on the future role of private equity and why it will mean a cultural evolution for many firms. Interview by Katherine Steiner-Dicks

You followed up a successful corporate career by joining private equity firms, such as Clayton, Dubilier & Rice and 3i; how do you feel your corporate experience benefited your PE capabilities? 
I believe corporate experience is essential to the private equity industry. As an entrepreneur, I have been able to bring the skills and experiences that go hand in hand with building a business and I am well aware of the old mantra that "cash is king".

Growth is crucial to all businesses and one way to build it is through creating niche markets. No business exists without a team that values growth and what it takes to get it. As an entrepreneur when you start a business from scratch and then become a leader in your market, you realize that experience is much more valuable than just theory.

My experience as an industrialist means I have also had to deal with the tough management issues of worker disputes, liabilities, and restructuring; all the way up to the issues that an executive board has to face, such as international acquisitions and joint ventures.

Looking back, I loved every minute of it. I learned the different sides of the business; the service business, the sales, the technical side. I learned the value of people and different business cultures, which I have come across in France, Germany, the US and the UK.

Moving into the private equity industry in New York and London enabled me to value my corporate experience and to put it to work within an operational role.

What I like is that I went from an entrepreneur to industrialist to an investor in an international evolution.

Do you think that at least some of the challenging deals done by some PE firms are due to a lack of real life corporate experience?
Yes, I think it could be one of the reasons. Money was too cheap and the world was growing too fast to see the potential pitfalls; the liquidity available was too good to resist. But now that the music has stopped to some extent, only growth can solve that original sin long-term. Of course, adjusting cost base is essential and often painful, but as they say "growth is hell."

That is where industry experience can help you to know how to develop niche growth areas. Despite that the deals done today are perhaps fewer in number they tend to be healthier in their financial structure. And it seems that the deal flow in the US and UK is picking up again, although there seems to be a lot of "pass the parcel" going on through secondaries.

And with the current debt to equity split, now often at 50/50, profitable exits are going to take longer to create the exit multiples previously experienced. If investments are going to be held for longer then it makes perfect sense to have an intimate understanding of an investee company's industry.

I think industry and operational experience in private equity usually only comes into private equity in the form of an advisory role or board. While that has been useful in the past, it may not be sufficient for this new investment climate.

Financial expertise will remain important, but to a lesser extent and will need to be supplemented with strong operational expertise. There will be some tension in this business model evolution between the financial experts where some will struggle. LPs will also have to decide what the best model for their returns will be and if they prefer a hands-on private equity management style going forward.

Currently, we see a lot of industrialist expertise, but rather in an adviser or consultant role, which is expensive and not always as effective as having someone in a permanent role. When push comes to shove you need a hands-on embedded permanent solution, not a temporary consulting one.

The most effective people to go into an investment portfolio are those that are not afraid to face the facts and favour substance over style; they speak the same language as management and at the end of the day, management often appreciates this style of straight talking.

Where do you see private equity 5 or 10 years from now? 
There is a place and will always be a place for private equity and a role for it to play. Private equity is an excellent catalyst for so many industries. It provides focus, momentum, alignment of interest and motivation. Indeed, you are always on a race with little chance to rest, but quite often success is indisputable. Of course, it is not a recipe for every company it is rather a transition to refocus businesses and management teams.

I think that in the next five to ten years the private equity model will change to one that is more hands-on and operational rather than predominately financial with longer investment holding times.

But clearly this approach will change a firm's internal culture and it won't be easy to integrate a more operational model into the one that many have grown to know up until now. This however will vary from firm to firm as they come from different backgrounds.

How important do you think incumbent management is versus bringing in new board level executives? Some of PILOT's clients experience senior management turnover in excess of 2/3 post-acquisition.
Keeping on incumbent management is always preferable, but can prove difficult, especially if it is the case where the incumbent management was part of the problem and partially the reason why the company had to do the private equity deal in the first place.

Unfortunately, as it sometimes happens, you have to supplement management talent and strengthen operational efficiencies.

There are times when you need to bring in new people for a change in culture and greater momentum and focus. Many entrepreneurs are extremely busy and as a result need to focus on fewer targets and learn to discontinue others.

The role of private equity is to assess management talent very quickly and help them focus on key priorities and eventually supplement in some key areas.

Most PE first firms have built up internal expertise of tracking and nurturing senior executives that they could call upon to help their portfolio businesses. Do you feel that some firms have missed out on this competitive advantage?
I think most of the firms can attract talent, but often do not use them in the right role. Sending in financial experts and consultants very often frustrates management and is a waste of time and money.

If you do use outside talent, then they should be legitimate, recognized operators and be used in a straight forward operational way. They should be the voice that speaks out the truth sooner rather than later and be the one that motivates management.

As this industry goes through a major transition of its business model and culture it needs to realize that long-term value will come primarily from operational improvement and also take greater social responsibility when it comes to people, jobs, etc… Again, operational improvement has to come primarily from growing top line rather than just from cutting costs. While it is much more challenging, this is where true operational expertise will make the difference.