Secrets of the Private Equity Trade

Private equity firms manage some $1 trillion of global capital, yet because they are highly secretive, much remains unknown about their internal economics. How do PE firms organize themselves, for example, and how do they capitalize on their success?

Some answers emerge from a paper by Wharton finance professor Ayako Yasuda and Yale School of Management finance professor Andrew Metrick titled, "The Economics of Private Equity Funds." The paper was presented at a recent Wharton conference, sponsored by the Weiss Center for International Financial Research, whose theme was "A Global Perspective on Alternative Investments." The authors gained access to an unusually fertile data set, the private equity portfolio of one of the world's largest limited partner investors. On condition of anonymity, the investor furnished data on 238 different PE funds in which it had invested between 1992 and 2006. Of those 238 investments, 144 were buyout funds and the other 94 venture capital funds.

Stable Fee Revenues

The study's most important conclusions, according to Yasuda: First, some 60% of PE firm revenues come from fixed-revenue components that are unaffected by performance; and second, while venture capital firms tend to earn more than buyout firms per dollar under management, buyout funds are substantially more scalable and, therefore, can earn much more per partner and per employee. In addition, managers of successful funds can command better terms for themselves as they launch new, larger funds.

Most private equity funds take the form of limited partnerships, with a PE firm serving as general partner; the limited partners -- large institutions and wealthy individuals -- put up the bulk of the capital. Each limited partnership typically lasts for 10 years, with terms of the general partner's compensation spelled out at the fund's inception. The general partner's compensation contains a fixed component -- an annual management fee of 2% or more -- plus a variable component that includes carried interests in partnership holdings. Successful buyout firms often lay claim to some of the transactions fees that their funds generate. In addition, the most powerful limited partners -- large state pension funds, for instance -- may also command a share of the carried interest.

Private equity firms stay in business by launching new funds every three-to-five years. If a firm's previous funds have been successful, it can generally earn higher revenues with the new one by setting higher fees, demanding more variable compensation and raising more capital.

But there are striking differences in strategy and practice between venture capital and buyout funds -- the principal components of the private equity industry. To begin with, Yasuda notes, the study confirms what many investors already sense -- that the economics of venture capital and buyout firms are different, even though both depend upon fixed management fees for the preponderance of their revenues. The differences lie not only in the superior scalability of buyout versus venture capital funds, but also in the fundamental skill sets required.

Early-Stage Investing

Venture capitalists tend to be scientists and engineers by training, with the necessary experience in operations, marketing, management and related skills to help small companies grow. Early-stage investing is time- and labor-intensive, notes Yasuda, and even experienced VC professionals have difficulty overseeing more than five companies at once.

The typical venture capital firm has five partners and invests in five companies per year over the first five years of a fund's 10-year life, with the value of each early-stage investment rarely exceeding $100 million. On average, each VC professional is apt to be responsible for one new investment a year during the fund's first five years -- for an aggregate investment of $350 million to $500 million. That professional typically spends the fund's second five years aggressively fostering and monitoring those five companies.

VC funds tend to derive the bulk of their revenues from just 20% of their investments. They depend on hitting a "home run" -- a return five times greater than invested capital -- with one in every five investments. Another 20% of VC investments can be expected to fail or achieve minimal returns, with the remaining 60% returning an average 2.5-to-3 times invested capital -- not a fabulous result, considering the risks, but one most firms can live with.

Larger, more successful VC firms -- like Kleiner Perkins Claufield & Byers, known for such home runs as Amazon, Compaq, Genentech and Netscape; and Sequoia Capital (Google, Yahoo!, PayPal, Apple and YouTube) -- can raise substantially more capital in launching new funds, but they, too, are constrained by the time-consuming nature of VC work. To invest in more small companies with outsized potential, they must hire more VC professionals. Thus, in the world of VC firms, larger scale does not necessarily mean greater profitability.

Less Hand-Holding

The reason buyout funds are much more scalable than VC funds is that they invest in larger, more mature companies that typically need less hand-holding. In Metrick and Yasuda's sample, the median buyout fund began with $600 million in capital and invested an average $50 million in 10 to 12 different companies over its 10-year lifespan. By applying substantial leverage, buyout funds can acquire very large businesses -- on the order of Chrysler, RJR Nabisco or Hilton Hotels.

Because buyout funds invest in businesses already equipped with sophisticated management structures, a buyout firm partner can oversee large investments without a proportionate increase in personnel. The job is not to supply needed management skills, but rather to make sure there is effective management in place, to oversee financial strategy and to help identify new efficiencies.

Buyout partners are usually grounded in finance and operations. And because buyout funds invest in larger, more sophisticated businesses, the typical buyout partner need monitor no more than two or three investments at a time.

The paucity of debt capital available to private equity firms has had relatively little effect on venture capitalists, Yasuda says, because the investments they make are seldom highly leveraged. Right now, venture capital firms are much more concerned about the long-term drought in the IPO market, which limits their ability to exit investments and makes them more dependent upon selling their businesses to larger companies.

The depressed IPO market dates from the post-2000 technology crash, which occurred just after VC firms had launched their largest funds ever. Those funds are now eight or nine years old, Yasuda notes, and will have to exit their investments over the next two years. Should they fail to do so successfully, a number of venture capital firms could themselves go out of business.

By contrast, illiquid credit markets do direct harm to buyout firms because few investments look attractive to them without a heavy dollop of leverage. The buyout firms raised record amounts of equity capital before the debt markets collapsed last summer, and many now find it difficult to put that money to work. The longer the credit markets remain in the doldrums, the higher the odds that some funds will have to return capital to their limited partners or else start investing in a greater number of small- or mid-sized companies requiring greater oversight.

Should that happen, the buyout business might become a lot less scalable, and the economic differences between buyout and venture capital funds may be somewhat harder to discern.

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The Myth of Differentiation

Mike Schultz pointed out what we might not know the pitfalls of differentiation.

"One is the loneliest number." —Three Dog Night

Few would question this simple truth: Businesses must differentiate. Growth, profit—survival, even—hinge on their ability to set themselves apart from competition.

Professors Terrell and Middlebrooks of the Northwestern University's Kellogg School of Management and University of Chicago Graduate School of Business, respectively, say it well:

Service companies need to dare to be different. To find a leadership position in the market...and then to lead. The key strategy is to be different from competitors.... They break free from "be better," internally oriented initiatives to "be different," externally oriented strategies. Being different is grounded in providing customers with unique value that they cannot get from any other competitor.1

They go on to cite McKinsey as their first example.

The "need" for differentiation is so well accepted, it's considered simplistic to even make the case for differentiation. Why make a case for something everyone already knows?

Much of the differentiation conversation therefore centers more on how to do it and how strongly to do it. (Terrell and Middlebrooks go as far as to say you should position yourself so far opposite competitors that they coin the nifty term "oppositioning" to describe it.)

That we need to be differentiated at all... accepted without further thought.

I disagree. Put some further thought in it. Most everything I've read and heard about differentiation is wrong. I suspect the same is true for you.

On Unique Selling Propositions

Among the favorite platitudes of the high priests of business is that every business—nay, every person—must have a unique selling proposition (USP). A USP can be defined as doing or saying something about yourself or company that is unlike what anyone else does or offers. In other words, unique... one of a kind.

I deliver about 40 speeches and presentations per year. During presentations I frequently ask the members of the audience to take a few minutes to deliver their elevator pitches—the minute or so discussion they would use to describe themselves to the CEO of a company they would like to win as a client.

When they're done, I ask folks to raise their hands if their partner delivered a fabulous elevator pitch. Many hands go up. When I ask what was so great about them, I typically hear things like this: They were clear about what they do, what difference they make for their clients, and which industries they serve. Often I hear of stories told that brought their companies to life.

I then ask who has heard of the concept of a USP, and who has been told at least once in their business lives that they need to have one. Most hands go up. I then ask whose elevator pitch partner said something unique. Usually no hands go up, but here and there a bold person or two jump into the fray.

In the end, good as their elevator pitch partner's delivery might have been, most people back off their stance that their partner was unique.

The "Unique and Different" Label

Too often in elevator pitches, and in marketing messages in general, professional services firms ill-advisedly label themselves as unique and different. A quick Google search for "unique consulting firm" (with the quotes, so it would get results that only had these words in a string), yielded close to 4,000 sites. Here's one from the first page:

[Firm Name] is a rather unique consulting firm.... Our target audience is composed of those firms that seek quality rather than quantity and price. Our company specializes on small and mid size businesses, but we are looking for clients that are less worried about prices, than exclusive services and results that they will receive. Thus, a price conscious client is not really suited for our firm; our services are of high quality and slightly higher priced, but the customer service and end results are virtually almost exceeding the client's expectation.

[Author's note: I tried to find more professional-sounding copy that included the term "unique consulting firm," but they were all pretty much like this. Can't make this stuff up, folks.]

Once a firm labels itself as unique, it elicits this question from the reader: Is it really unique (or, as in the case of the firm above, "rather unique") while, at the same time, "virtually almost exceeding the client's expectation?" Ugh.

Should the answer be no, and by and large it is, the firm loses credibility. More than anything, its sounds as if they've read in some marketing textbook that they have to have a USP or differentiated message, thus they use words to that effect.

Many admit later just how amateurish they sound, and sometimes acknowledge that they thought it sounded amateurish before they launched their unique-speak publicly. Firm leaders tend to have good common-sense radar, but they seem to check common sense at the door when it comes to self-designated uniqueness.

Some firms seem to take the quest for differentiation literally, creating a spate of "we're different" messages. Consider a top Boston law firm with the following message:

At [FIRM Name], we practice law differently. While our attorneys agree that results drive our business, building relationships with our clients and providing value-added service is the key to our success.

This firm might be amazingly good—and, from what I know of their reputation, they are. However, results' driving business, building relationships, and providing value-add are pretty par for the course—both as firm goals and marketing copy.

What Clients Really Want

Much as firms might hear otherwise, being different isn't much of a factor in winning or keeping clients. Often, the "we're different" message affects them negatively. Consider the following scenario: Your tooth hurts and your dentist is out of town. You need an oral surgeon and you need one fast, so you ask a few trusted close friends, Trip and Beverly, if they know anyone.

Referral #1: Close friend Trip suggest Dr. Phlox.

He says that his aunt Deanna needed oral surgery and went to Dr. Phlox, who has been in the town next door for 20 years and has a very busy oral surgery practice. Word on the street is that he's pretty solid. When aunt Deanna went in, the doctor took the time to explain the surgery and what was going to happen, and to answer all the questions that Deanna had.

The surgery went fine (for all they knew) and Deanna hasn't had any problems since. He's a little more expensive than average, but Deanna says he's very booked and established so it's understandable.

Referral #2: Close friend Beverly suggests Dr. McCoy.

Supposedly McCoy is well known throughout the nation as a cutting-edge oral surgeon, often going where no other oral surgeon has gone before. He has a unique blend of people at his office, process for oral surgery, and tooth technology that he has pioneered. His results, says his brochure and Web site, are 22% better than all other oral surgeons', which is how he justifies his very high prices.

His uncle Pavel went to McCoy and all went well with the surgery (for all he knew), though uncle Pavel met McCoy only for about 30 seconds, as he was so busy.

At a gut level, even with uncle Pavel's satisfaction, few people would choose referral #2. This is because many of the dynamics of how clients buy business-to-business professional services is similar to how people choose dentists:

* Should failure happen, the consequences are painful.
* You don't need the world's greatest outcome. You just need a very good outcome.
* Since you can't sample a service like you might sample a piece of gum, you have to rely on reputation, experience, and expertise as proxies for expected results.
* Price is a factor, but you'd rather not skimp when the outcome is important. (Side note: if I told you that Dr. McCoy's innovations have enabled him to charge less than half of what other oral surgeons charge, would you have been more interested in buying his services, or less?)

Innovation in the sense that the doctor does something different from others, or is somehow unique, by and large won't tip the scales of purchase preference in the favor of the innovator.

So what is it that clients are, indeed, looking for? In my experience, and according to research such as How Clients Buy, most buyers want to tell service providers the following:

* Reliability. Do what you say you are going to do, and be on time about it. (This is listed first, because it's so important. If only the service providers I've worked with in my life were better at keeping their commitments...)
* Accessibility. Be there when I need you.
* Impact. Help me buy the most helpful and impactful services from you, and help me translate your services into success for my business in my industry.
* Fit. Be a good fit for the specific needs that I have. If you're not the best fit, help me find a provider that is. Don't shoehorn your service into something that, in the end, won't meet my needs as well as something else would.
* Importance. Make me feel like we are, as a client, important to you and your team.
* Service. Deliver great service as well as great services.
* Prudence. Be careful and do your homework before you suggest a course of action for me.
* Research. Stay on top of the developments and trends in your industry and in mine.
* Listening. Understand my business, my team, and my clients so you can come up with ideas relevant to me.
* Teaching. Help me understand what you're doing. I might not be an expert in your area, but I'm pretty bright and I make the decisions here. Help me understand what's new in your area of expertise so I can apply that knowledge in my business.
* Business management. Run an efficient operation and constantly improve so I don't pay for your inefficiency.
* Relationship management. Be pleasant and fair, and work with me through communication or other breakdowns on your end or mine. In essence, treat me like a person.

Different situations warrant different mixes and degrees of the above. For example, with many necessary-type services like Sarbanes-Oxley compliance, efficiency is important as well as expertise. On the other hand, buyers looking to hire product-innovation consultants will likely be concerned less about efficiency and more about the creativity and innovative thinking of your team.

Regardless of the mix of what's most important to your buyers, you probably won't see many of them inserting this into the list of client wants: "Different and Unique: Be one of a kind, offering something that no one else in the market offers."

So be different: Stop listening to the continuous pleas from consultants, marketers, and textbooks to be different... one of a kind.. .a shining beacon of newness in a sea of same-old same-old.

Focus instead on actually delivering the value to the market that you say you deliver (which, in and of itself, can be uncommon if not unique), and find ways to create a conversation with buyers around that message.

Not only is it better marketing, it's less lonely than being unique.

Endnote:

1 Terrell and Middlebrooks, Market Leadership Strategies for Service Companies. 2000 McGraw Hill. P. 31.

Mike Schultz is president of the Wellesley Hills Group (www.whillsgroup.com), a consulting and marketing services firm, and publisher of RainToday.com. Mike can be reached at mschultz@whillsgroup.com.

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Seven Tips for Managing Price Increases

Another article sent to me by MBA Depot. However, the article is originally from Harvard Business School.

Published: June 16, 2008
Author: John Quelch

Editor's Note: Harvard Business School professor John Quelch writes a blog on marketing issues, called Marketing Know: How, for Harvard Business Online. It is reprinted on HBS Working Knowledge.

When driving these days, do you look at the prices every time you pass a gas station? Do you notice yourself paying more attention to the prices of everything you buy? You are not alone. Consumers everywhere are more price aware. People who've been indifferent to price increases for years are suddenly amazed at what things now cost. How can marketers cope not just with inflation but with consumer sticker shock?

1. Understand Your Customers. There are at least four ways in which customers can respond to higher gas prices: downgrade from premium to regular; take fewer trips by car, consolidate errands, switch to public transportation; take the same number of trips but reduce the miles driven per trip by, for example, vacationing closer to home; drive more economically and less aggressively to improve miles per gallon; and buy a specific dollar amount of gas rather than filling up every time, even though this may mean more visits to the pump. Some consumers may even trade in (at a loss) the SUV for a hybrid, an example of how price inflation on one product can cause demand shifts in a second, related, category.

More customers than usual will be looking out for price promotions, but don't give away the store to those who don't need the discount.

2. Invest in Market Research. You must discard your existing customer segmentation assumptions and segment consumers around product usage behavior and price sensitivity. You must get out into the marketplace yourself and talk to consumers directly to understand their pain points and how they are changing attitudes and behaviors in response to price inflation. You must then quantify these shifts and develop product and pricing strategies that balance the need to maintain both profitability and market share.

3. Redefine Value. Customers buying soft drinks can think about price in three ways: the absolute cost per can or bottle, the cost per ounce, and, less common in this category, the monthly consumption cost. Customers short on cash will focus much more on the absolute price. They'll go for the 99 cent soft drink rather than the $1.29 container with 50 percent more volume. To motivate cash-poor consumers, marketers must reverse engineer products and packaging to hit key retail price points. This may mean downsizing package sizes, something the candy industry always does in response to inflation.

4. Use Promotions. If you've always passed through raw material price increases to the end consumer, you don't necessarily need to change that policy. However, lagging competitors in passing on price increases can have the same effect as a temporary price promotion. More customers than usual will be looking out for price promotions, but don't give away the store to those who don't need the discount, and cut prices not across the board but only on items selected as your inflation-busters. For cash poor consumers, these promotions should hit the key price points on small pack sizes. For cash rich consumers, encourage multi-unit purchases ahead of the inevitable next price increase.

Strong brands can hold consumer loyalty while increasing retail price points.

5. Unbundle. Customers who previously welcomed the convenience of buying product, options, and services rolled into one may now ask for a detailed price breakdown. Make it easy for your more price-sensitive customers to better cherry-pick the options and services that they truly need by giving them an unbundled menu of options.

6. Monitor Trade Terms. Beware of powerful distributors paying you more slowly than they turn the inventory they buy from you. In an inflationary environment, they're making money on the float by stretching their payables. Manage your inventory on a last-in, first-out basis to insure that increases in your realized selling prices do not trail the increases in your input costs.

7. Increase Relevance. You need to persuade customers to cut back their expenditures on other products, not on yours. In tough times, consumers more than ever need and deserve the occasional treat. So, if you are Haagen Dazs, tell the consumer to substitute private label peas for the name brand but to not forego the comfort of curling up on the sofa with a tub of her favorite ice cream. Strong brands can hold consumer loyalty while increasing retail price points. Weaker brands risk private label and generic substitution.

Clearly, not all marketers are equally affected by price inflation. Commodities like gasoline, where the manufacturer adds little value before the product reaches the end consumer, are more vulnerable, while sales of the most exclusive global luxury brands hold up pretty well regardless of price. Especially challenged are marketers of goods and services for which consumers don't necessarily understand the input costs: decorative candles, for example, are highly sensitive to oil prices and the purchases are discretionary. The key here is to educate the consumer, apologize for the uncontrollable price increases, give price-sensitive consumers some promotional options, and reemphasize product benefits.

John Quelch is Senior Associate Dean and Lincoln Filene Professor of Business Administration at Harvard Business School.

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Picking winners

It is a good article about venture capital from the Economist.com. Again I got it through MBA Depot. Enjoy reading it...

Is it better to choose the horse or the jockey?

“A GREAT management team will find a good opportunity even if they have to make a huge leap from the market they currently occupy.” Thus Arthur Rock, a legendary figure in the venture-capital (VC) industry who has argued that it is more important to find outstanding management teams than to try picking winning businesses. His track record, which includes backing the creators of Apple Computer, suggests Mr Rock's belief that first-class entrepreneurs are what matters most to start-up success has much to commend it.

With tougher economic times looming, it seems an especially good time to put one's faith (and cash) behind an experienced management team with a history of success. Of course, investors ideally want to back firms that have brilliant managers and a brilliant business model. But some venture capitalists favour the former.

The view that excellent leaders can make the critical difference to a new company permeates the classroom as well: ask any gathering of MBAs if it is the business “horse” or the management team “jockey” that matters most in an investment appraisal and a sizeable number of students will pick the jockey (perhaps because they fancy sitting in the start-up saddle themselves one day).

Yet a new study* shows that in the real world most venture capitalists put far more emphasis on the runners than the riders. The study's authors—Steven Kaplan of the University of Chicago Graduate School of Business, Berk Sensoy of the University of Southern California and Per Strömberg of the Swedish Institute for Financial Research—look at a sample of 50 firms backed by ten different VC companies, examining their early business plans and then tracking their performance through to initial public offering (IPO) and several years beyond. Most of the early-stage business plans they scrutinise were produced between 1995 and 1998 by firms from a range of different industries. The biggest sector was biotech, which accounts for 17 of the firms.

The research shows that during the period the academics studied—typically from three years before IPO to three years after—only one of the 50 firms changed its line of business and none made acquisitions in areas outside their core activity. In other words, the horses pretty much stayed on the same track.

But the jockeys often changed. At the end of the period covered by the research, only 44% of the CEOs were the same ones involved at the time that the initial business plans had been drawn up. There had been significant turnover among other senior executives too, such as the chief financial officer and chief marketing officer. The implications of this are clear: investors are far more likely to change a firm's managers than its strategic direction.

To test the validity of their findings, the researchers studied all American IPOs that took place in 2004. After removing flotations of closed-end funds and other financial investment vehicles, they were left with 106 offerings, 88 of which involved VC-funded companies. Again, they looked closely at the IPO prospectuses of the firms and at online databases of business news to see if they could identify any significant shifts in their business models. And again they found that only a handful had strayed from their early business plans.

The companies were far less faithful to their original leaders: over the period covered by the research, half of the chief executives were replaced by the firms' owners and only a quarter of the other senior managers remained the same. Such turnover does not mean that managers are irrelevant to a successful start-up: after all, the new CEOs in the sample were given an average of 4-5% of the equity in the firms that they were brought in to run, which is proof of their value. But it's clear that most venture capitalists don't consider them the vital factor in a winning business plan.

Indeed, many well-known investors have minted money by backing start-ups in markets they think have explosive growth potential, even if the firms' managers are not seasoned hands. Take, for instance, the example of Donald Valentine of Sequoia Capital, a leading Silicon Valley VC company. In 1987 he encouraged his firm to invest in a little-known start-up called Cisco, even though the company had been shunned by many other investors who thought it had a feeble management team.

Looked at another way, there is scant evidence that a brilliant management team can take a lousy horse and turn it into a race-winning champion. As Warren Buffett, the Sage of Omaha, likes to remind his many followers: “When a management team with a reputation for brilliance backs a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

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