wharton PE articlep-1 important, tangible, valuation, themselves

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Private Equity Bidding Wars: When Capital-rich Funds Compete, Intangibles Win the Deal
Published: April 26, 2007 in Knowledge@Wharton
     
With so much money pouring into private equity funds, competitors for deals are able to match one another easily when it comes to price. Clearly, valuation remains the most important part of any transaction, but in today's capital-soaked private equity environment, bidders must also come up with other, less tangible ways to set themselves apart. According to private equity experts, timing, sound strategy, operational expertise and a track record of successful deals are the new currency in a market where money is no object.

"Capital is now a commodity, so sellers are looking for anything else that the bidder is going to add," says Robert Chalfin, a Wharton management lecturer and president of The Chalfin Group, a Metuchen, N.J., advisory firm specializing in closely held companies. "Price is not the only determinant, especially if the sellers are keeping some equity."

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The private equity firms bidding for TXU have already aligned themselves with environmental groups and have pledged they will not sell the company for at least five years in an attempt to fend off opposition that began to boil up in the Texas statehouse within days of the announcement. "Change in corporate control at this level is fraught with regulatory uncertainty and a need to appease a broad array of political constituents," says White. "It's a daunting prospect."

At the same time, Dillavou notes, the repeal of the Public Utility Holding Act in 2005 is expected to encourage private equity investment in energy because it eliminated numerous restrictions on ownership, particularly in electricity. "We've seen some activity as a result of the repeal, although maybe not as much as some expected, but a lot of people think it could be coming."

Risky Pipeline

White says that it will be interesting to see if private investment begins to flow into exploration and oil field service firms. "Private equity at that level would be one more source of capital for a fairly risky line of business."

Farber of Lime Rock Partners believes the business is likely to remain highly volatile because the capital spending cycles don't match up to the price signals the market sends out daily. If the market needs more capacity, it can take years to find new sources of energy and construct additional pipelines and processing plants. If companies build excess capacity, the price remains low for years, stifling new investment until an acute shortage drives prices up again.

"The nature of the industry is that it can't remove or add capacity on a dime," says Farber. "That still hasn't changed and can't physically change." Indeed, he argues, industry volatility has grown worse as the easiest exploration targets have been exploited. "Now, we're moving into areas with greater political challenges, like Sudan, or technical challenges, like deepwater offshore drilling."

Bill Macaulay, chairman of First Reserve Corp., a 25-year-old private equity firm focused on energy, notes that while activity in the sector is up, it still lags behind other industries that are attracting record private equity investment. In the U.S. and Europe, private equity activity as a percentage of all merger and acquisition transactions is around 20%, while in the energy sector it remains below 5%. "It is still difficult to put leverage on [companies] in the energy business given the volatility of the commodity prices," he says.

Opportunities for Entry

Over the long term that may change, and already new mechanisms to hedge against swings in commodity prices have made leveraged investment in energy easier over the past five years. Macaulay notes that, in particular, hedging in electrical power has made that piece of the energy business more attractive to private equity firms.

The spectacular collapse of Enron has also had an impact on private equity involvement in energy, says Dillavou. "After Enron, energy investment dried up for a while, and everyone's stock price was hurt. That opened up opportunities for private equity to step in and we saw some spectacular returns on investment for people who were able to pick things up on the cheap." In 2004, a consortium of TPG, KKR, The Blackstone Group, and Hellman & Friedman bought Texas Genco, a power generation company, for $3.7 billion. A little more than a year later, they sold it to NRG Energy for $5.7 billion.

According to Dillavou, the rise in infrastructure funds also gives private equity investors a way to participate in the energy industry. The Macquarie Bank, Goldman Sachs and JP Morgan all have created infrastructure funds, he notes. "That is a different profile than the historical private equity investment because of the long-term horizon for the investment," he adds. "The investor is trying to take assets that historically have earned a steady but sleepy return, and increase the return from additional leverage with relatively low-cost, long-term debt and add-on investments. The return is enhanced by the management fees and the ability to profitably sell down its ownership interests in the fund over time."

Dillavou also points out master limited partnerships provide an exit strategy for private equity investments that is unique to the energy sector. The master limited partnership allows earnings to flow to investors in a partnership form in a public environment and only be taxed once. "We have seen private equity firms come in and make investments in companies they believe would have a future existence as a master limited partnership," he says.

Alternative Energy

Another potential area for private equity investment in energy is alternative technologies, although this area remains highly speculative and difficult for most private equity firms.

"There is tremendous potential there, but in our view -- to date -- most alternative energy investments need to either have a government mandate, such as tax subsidies, or other government assistance if you're going to have a significant change in the technology to make it truly economic," says Farber.

Macaulay explains that alternative energy investments may be attractive for smaller firms or venture capitalists, but they are unlikely to attract classic buyout artists because there is often little, if any, cash flow to pay down debt. "The other important thing to remember is that alternative energy is extremely price sensitive," he says. "You need high prices to justify almost any alternative."

When it comes to energy, some of the concerns about too much capital driving private equity investment are easing because the sector has, at least so far, been less attractive than other industries. But for firms focused on the energy space, there is a larger force to be reckoned with, says Macaulay.

"We still have competition from the major oil companies, and if you roll forward, the national oil companies are a much bigger new competitor to [a firm] like First Reserve than the leverage buyout concerns," he says. Macaulay points to Saudi, Russian and, more recently, Indian national champions as major competitors, desperate to tie up resources to meet demand at home. "Those companies are much more of a factor in our industry in competing for deals than the buyout shops."

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Earlier this year, a consortium of private equity firms led by Kohlberg Kravis Roberts banded together to acquire TXU Corp., the Texas utility company, for $32 billion in one of the largest private equity deals ever proposed. According to private equity experts, a new regulatory climate and innovative derivatives smoothing volatility are drawing attention to energy, along with a macro-environment in which emerging economies demand a growing share of the world's energy resources. Meanwhile, other firms are making investments throughout the sector, including funds established to finance infrastructure and others dabbling in alternative energy.

"I would say this has been the most active period for private equity involvement in energy I've ever experienced. There's a lot of competition for deals that are out there, and there seems to be interest in just about all sectors of the energy industry," says Jim Dillavou, who leads the national energy and utilities practice at Deloitte & Touche in Houston, Tex.

While energy encompasses a range of businesses with widely varying profiles, a survey by the Association for Corporate Growth and Thomson Financial predicts that energy will be among the top three sectors for deal-making in the coming year, behind health care and life sciences, but ahead of business services.

Demand for energy is expected to keep growing. According to the U.S. Energy Information Administration, despite world oil prices that are predicted to be 35% higher in 2025 than was projected in 2005, world economic growth continues to increase at an average annual rate of 3.8% over the period through 2030. Total world consumption of marketed energy is expected to expand from 421 quadrillion British thermal units (Btu) in 2003 to 563 quadrillion Btu in 2015, and then to 722 quadrillion Btu in 2030 -- representing a 71% increase.

Now Within Reach

In This Special Section
Private Equity Bidding Wars: When Capital-rich Funds Compete, Intangibles Win the Deal


From Star-power to Branding, Firms Look for New Ways to Court Private Equity Deals


Operating Partners Promise Performance and Higher Returns, but Do They Always Deliver?


Private Equity Firms Discover Electricity -- and Lead the Charge for Energy Investment


Lender Roundtable: Outlook on Debt Markets


Back to Special Section Home
When Jonathan Farber, cofounder and managing director of Lime Rock Partners, a private equity firm specializing in energy, started the company in 1998, there were just five or six other private equity firms in the energy business with about $2 billion worth of capital invested. Now, there are 15 to 20 competing firms with $30 billion invested in the industry.

"It was very rare, to the point of never happening, that generalist private equity firms would dip their toe in the water of the hard-core energy space," says Farber. "Firms didn't look to oil and gas as an appropriate place to invest."

Now, some of the biggest names in private equity -- Kohlberg Kravis Roberts and Texas Pacific Group -- are teaming up to buy TXU. Dillavou says the new interest in energy is driven by the volume of capital pouring into private equity overall. At the same time, he says, investors are deciding they want to be more involved in this key segment of the economy, particularly following the recent rise in commodity prices. Meanwhile, capacity shortages in many markets make energy an appealing sector for private equity investors, at least for the near future.

"There are a lot of opportunities, and some that didn't look that attractive a few years ago look much different today," says Dillavou.

Wharton professor of business and public policy Matthew White says the enormous capital requirements of most energy investments have, until now, been beyond the reach of private equity firms. These days, however, with so much money pouring into private equity funds, deals on the scale of the TXU transaction are possible.

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[More results for: economic growth] Regulatory Uncertainty

White adds that private equity movement into the electricity and gas markets remains difficult because these parts of the energy business have a lot of regulatory and political oversight. "The rules of the game are changing substantially over time. Deregulation in electricity and gas continues in fits and starts, and a lot of it is at the state level. There's a great deal of uncertainty about the reward to investors, and that will give any set of investors pause during due diligence," says White. "One might look at this and say there are greener pastures elsewhere -- at least until the regulatory environment becomes a little more transparent."

Pulling off a change of control in this area is very difficult given the political approvals that are necessary, according to White. New Jersey regulators balked when publicly held Exelon, of Chicago, attempted to take control of Public Service & Gas in their state. Private equity firms have hit similar roadblocks. In 2005, regulators prevented a $1.25 billion bid for Portland General Electric Co. over concerns about potential rate increases and the short-term nature of TPG's investments. Arizona regulators refused to sanction a buyout of UniSource Energy Corp. in 2004 by a group of investors that included KKR, J.P. Morgan Partners and Wachovia Capital Partners.

farflcfa

this interview is very insightful

think

JK: For a period of time earlier this year, credit spreads for second lien and mezzanine financing were sizable: possibly 200/300 bps. With an increase in LIBOR and tightening of the second lien market, we have seen an increase in mezzanine debt in transaction structures. This has also been driven by an increasing leverage marketplace where we have seen more aggressive structuring, 4x/6x/6.5x with HoldCo PIK Notes, necessary to help PEGs finance LBOs.

GH: We've also seen mezzanine providers get more active over the past year by lowering their pricing to the low to mid-teens. They've also shown a willingness to take larger tranches as a way to differentiate themselves. Much of this is generated by the type of investor taking the mezzanine debt. Hedge funds that are typically in second lien tranches are open to unsecured sub-debt to obtain enhanced yields (generally by 2% or 3%). These deals are structured similarly to second lien financings, excluding the security. More traditional mezzanine investors will generally have higher yield requirements and more restrictive terms (i.e., non-call periods, etc.)

JF: The mezzanine market has been very attractive for issuers over the past year as alternative to both second lien and high yield tranches. As compared to second lien, issuers frequently view mezzanine as more patient capital and as mezzanine coupons have trended lower and LIBOR has trended up, pricing is more competitive. Also, as mentioned by others, with the increase in tranche sizes for mezzanine, we have seen mezzanine with "bond-like" covenants and favorable call structures replace some volume in the high yield market.

WPEC: To follow up on Jerome's comment -- have private equity firms become more adamant about who ultimately holds their debt? Furthermore, has this changed the amount of paper you are looking to hold?

JK: Balance sheet management is always something of interest from a lender's perspective. Even in this frothy market our hold sizes continue to be in the $20 million to $30 million range, depending on deal size and PEG preference. PEGs are more interested in who is holding their paper, and it certainly has bearing on who is awarded debt mandates. PEGs want to see their relationship lenders hold more meaningful positions and bank groups don't want to see one or two lenders of a syndicate (for a middle market transaction) control voting. Most PEGs, unless necessary, don't want to see hedge funds leading their deals because of the portfolio management uncertainty or loan to own reputation.

GH: I think the general trend has been for relationship banks to hold less, but we try to hold more to further develop the relationship with the sponsor. Who ultimately holds the debt has become more of an issue in the middle market. Issuers can get good terms from a wide range of institutions so many of them don't want to take the risk of having hedge funds in their syndication group.

JF: The answer varies by private equity group, but if I were to try and generalize, for broadly syndicated transactions we have seen less focus on the final hold positions for the lead arrangers and more focus on allocations to second lien and mezzanine markets. Also, for mezzanine financing, most private equity firms have strong preferences on who is approached for mezzanine opportunities.

WPEC: An industry perception exists that the "mega funds" receive premium terms on their deals because of their brand name and relationships. Does such a premium exist in the middle market? How much does a firm's brand name and your relationship with that firm matter when securing debt for a new transaction or working out a difficult situation with an existing company?

JK: In middle market transactions, I am not sure that either proprietary deal flow or sponsor preferences exist. A PEGs "brand" name may add some cache to the process, but with so much PEG money chasing middle market deals, and recognizing that most PEGs are well banked, I-Bankers and intermediaries can afford to widen the net when representing companies in the sale process. From a debt perspective, I think relationships are important when PEGs are looking to secure financing for their acquisitions. This relationship may be worth 25 bps or a last look at a transaction, which certainly is representative of the increased competition for deals. Relationships are built at the front end, but solidified and maintained based on certainty of execution and delivery. Credibility is key, and that includes behavior from a portfolio perspective. Not all deals go as we all hope and there will inevitably be difficult discussions at some point. Rational thinking is part of relationship building, and PEGs value lenders that act as true partners.

JE: I don't think the middle market gets anywhere near the terms that the mega funds get. We definitely go into a deal with a middle market sponsor with different expectations than when we invest with a mega fund.

GH: Relationships and reputations are important in the middle market -- a well known operator in the space certainly helps syndication. Lenders will stretch further for groups who have a demonstrated track record in a certain industry.

WPEC: Have any of you participated in the growing buyout markets outside the United States? What are the primary differences that lenders must consider in these transactions?

JE: We invest globally, mainly in Europe and Australia. The primary differences with the U.S. relate to creditors' rights if things go badly for the company. The bankruptcy rules are significantly different in other parts of the world, most of which follow "strict priority," which greatly lessens the ability of subordinated lenders to have their voices heard in a restructuring.

JK: Last year we opened an office in London and are looking to capitalize on the growing European LBO marketplace. The European marketplace is different from the States and we have encountered numerous legal challenges. Given the flow of dollars from U.S. PEGs into Europe, we view this as a tremendous opportunity, but recognize this effort is still early stage. We have been primarily a participant in other people's deals to date, but believe we have our first agency role locked up.

WPEC: Do you have any general advice for sponsors when they are dealing with a company that has not performed well and may need to restructure? What can a sponsor do to improve its chances of a successful outcome?

GH: The best advice I can give is to understand the investor base and communicate. Issuers and sponsors who fail to communicate can leave a bad taste in investors' mouths, which will ultimately affect their willingness to bend on certain issues. Be responsive to information requests. Sponsors who keep the lender group informed fair better than those who do not.

JK: I agree. The best advice I have for PEGs that have troubled situations is maintain an open and honest dialogue with your lender. No one wants to be surprised. Don't limit communication to good news. Communication of bad news and a clear plan to seeking a solution is the best course of action. This does not insure a positive outcome, but working together with your lender and keeping all parties apprised is the favored approach.

JE: A sponsor needs to do the right thing. Whether that's putting in new money or working in partnership with the company's creditors, or even handing over the keys to the company -- it's those sponsors that maintain their reputation for acting properly that keep financing sources interested in doing their deals.

JF: I agree with all the points made. Open and honest communication is critical.

WPEC: Have your views on dividend recaps changed in the current environment?

JK: We have done our fair share of dividend recaps and will continue to evaluate them, but pushing the leverage envelope in order to pay dividends is not necessarily something that interests us. Dividend recaps can be a means of retaining solid performing assets in the portfolio. I do like to see PEGs with some level of monetary commitment post recap. While there is still risk, it offers a little added comfort knowing the PEG still has principal exposure.

JE: We will not finance a dividend recap. We believe strongly that the equity sponsor needs to have risk capital in the deal. We've passed on many dividend recaps that have done very well the past few years, but our belief hasn't changed that it's a fundamentally bad investment.

GH: Dividend recaps have grown dramatically over the past three to six months. With so many sponsors currently raising new funds, the need for monetization or partial monetization has increased. Generally, the debt markets will go a bit deeper in the capital structure on an acquisition vs. a recap of the same business. This is due to the validation of value that is provided with an acquisition. In a recap, market value of a business is more subjective. That being said, this is still a great time for sponsors to pursue a recap.

peachfly

Lender Roundtable: Outlook on Debt Markets
Published: April 26, 2007 in Knowledge@Wharton
     
In March, members of the Wharton Private Equity Club coordinated a roundtable discussion between four influential lenders to talk about the currently robust debt markets, trends in the sub-debt markets, the impact of hedge funds, and ways firms can differentiate themselves from the competition, among other topics.

Jerome Egan (WG'01) is a senior vice president at TCW/Crescent Mezzanine, a Los Angeles-based mezzanine provider with approximately $4.7 billion of capital under management. TCW typically invests in senior subordinated notes with equity upside (obtained through warrants or equity co-investments) in connection with sponsored LBO transactions. Its typical investment size is approximately $80 million, but it can commit up to $400 million for any given transaction. TCW invests across industries.

Jeff Foley (WG' 99) is a director in Wachovia Securities' Leveraged Finance Group, a leading provider of leveraged finance solutions, including senior debt, second lien, mezzanine, and high yield products serving both financial sponsors and traditional large and middle market corporate clients.

J. Gardner Horan is a senior vice president in GE Commercial Finance's Global Media & Communications Group. With over $7 billion in assets under management, GE's Global Media & Communications Group offers a wide range of financing solutions to middle market and large cap media, communications and entertainment companies ranging from $20 million to over $1 billion. These include senior secured debt, mezzanine and high yield, second lien, and equity co-investments.

Jeff Kilrea serves as the co-president of CapitalSource, Inc. CapitalSource (NYSE: CSE) offers a wide range of financing solutions, including senior term loans (first and second lien), asset-based revolvers, mezzanine financing, and equity co-investments. CapitalSource targets middle-market companies that generate EBITDA between $5 million and $35 million on an annual basis. It can arrange transactions up to $200 million.

In This Special Section
Private Equity Bidding Wars: When Capital-rich Funds Compete, Intangibles Win the Deal


From Star-power to Branding, Firms Look for New Ways to Court Private Equity Deals


Operating Partners Promise Performance and Higher Returns, but Do They Always Deliver?


Private Equity Firms Discover Electricity -- and Lead the Charge for Energy Investment


Lender Roundtable: Outlook on Debt Markets


Back to Special Section Home
WPEC: In your opinion, what are the primary factors that have led to today's robust debt markets?

JK: The robust debt markets are being driven, in my opinion, by one primary factor: market liquidity. There is a glut of capital in the market today from CLOs (Collateralized Loan Obligations), BDCs (Business Development Corporations), Hedge Funds, new Commercial Finance companies and Regional Banks, not to mention significant capital from PEGs (Private Equity Groups) anxious to deploy capital as they seek their next round of fund raising. From a debt perspective, some of these new or alternative sources of capital did not even exist 5 to 10 years ago. From an equity perspective, the opportunity for higher returns generated by PEGs has increased the dollars committed to this sector from endowments, pension funds and other investors, which also has contributed to the debt markets.

JE: I think today's debt markets have been largely driven by the interest rate environment as well as the enormous amounts of capital that have been raised by buyout firms. Just as equity sponsors have pushed the envelope on purchase price multiples, so have lenders done with leverage and the pricing on that leverage. In our space and with the investment sizes we deal with, the high yield market is our primary competitor. Spreads are tighter now than ever, making mezzanine a less competitive option. However, many sponsors still prefer large "private high yield" issues because mezzanine providers can be more flexible on call protection and other features, making it a more flexible security from the sponsor's point of view.

GH: Low default rates have been a key factor. I don't have the exact numbers on hand, but I believe they are approaching 45-year lows. This has kept losses off of the books, which has made it easier for institutional investors to raise money. This, in turn, has increased liquidity and pushed yields down. Companies are less likely to default with lower rates. It's a cycle.

JF: The primary factor driving the robust market conditions, particularly in the leveraged loan market, is the market liquidity from the continued fund raising by CLOs and other institutional investors. Despite record M&A activity, the demand for new paper continues to outstrip supply, resulting in favorable pricing and structures from an issuer perspective. As previously mentioned, low default rates are another important factor driving the current environment.

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[More results for: institutional investors] WPEC: The question on everybody's mind -- how long are the good times going to last? What external factors do you believe will lead to an eventual softening?

GH: We think the debt markets will start to tighten towards the end of this year or the beginning of 2008. Eventually housing and manufacturing weakness will take its toll on the economy and filter down to the credit markets. However, several factors such as covenant-lite deals could delay this tightening. As always, industry specific issues will also come into play. For instance, in the media space, advertising dollars from the 2008 presidential election may offset weakness in the broader advertising markets.

JK: It is difficult to predict how long the good times will last, but some type of underlying market correction will be necessary to curb the current enthusiasm. The correction could come in the form of an increase in the interest rate environment, which will impact debt service capabilities and debt leverage of borrowers interested in making acquisitions. The correction could also result from material credit agreement defaults by borrowers in the credit markets, which should lead certain lenders, either temporarily or permanently, to exit the business. Many of the new competitors have not experienced the inevitable cycling of the credit markets so it will be interesting to witness their behavior in a challenging credit market.

JE: If or when the defaults start to occur, then we'll see discipline re-enter the market. There are also many questions regarding what rights holders of second lien paper will have in a default. I also believe that if or when default rates increase, buyout firms will realize that their capital structures are made up largely of hedge funds with a "loan-to-own" mentality.

heart

According to a 2007 Association for Corporate Growth/Thomson Financial survey, private equity professionals see lower returns as the greatest threat looming over them -- more so than competition from other firms and hedge funds. For many, a way to avoid that problem is to install so-called "operating partners" -- senior-level executives with industry expertise -- at portfolio companies. Panelists at the 2007 Wharton Private Equity and Venture Capital Conference and others in the industry say that operating partners with experience running plants and facilities, and rolodexes full of industry contacts, can boost profits and feed higher returns.  

"The financial markets are largely commoditized. One firm can't get much more debt than any other firm," notes Scott Nutall, a partner at Kohlberg Kravis Roberts who was a panelist at the Wharton conference. "All of us focus on deal sourcing, but the real way to generate returns is to improve the business post-purchase."

Any improvement in operations that leads to higher profits is magnified through the leverage in private equity. In a Newsweek article titled, "The Enigma of Private Equity," financial columnist Robert Samuelson cites a hypothetical example of two companies with $10 million in annual profits that are bought for 10 times that, or $100 million. The private equity buyer spends $30 million and borrows $70 million.

At one company, "profits don't increase," Samuelson writes. Five years later, it earns $10 million annually, "but the profits have been used to repay $30 million in debt." If the company is then resold for the same $100 million, the private equity firm has doubled its original investment of $30 million, he notes. It uses $40 million to repay the remaining loan and is left with $60 million.

At the other company, improvements in operational performance increased profits to $15 million after five years. When that company is sold for 10 times profits, the price is $150 million. "After repaying the $70 million loan, the private equity firm has $80 million -- nearly triple its original investment," Samuelson explains.

In This Special Section
Private Equity Bidding Wars: When Capital-rich Funds Compete, Intangibles Win the Deal


From Star-power to Branding, Firms Look for New Ways to Court Private Equity Deals


Operating Partners Promise Performance and Higher Returns, but Do They Always Deliver?


Private Equity Firms Discover Electricity -- and Lead the Charge for Energy Investment


Lender Roundtable: Outlook on Debt Markets


Back to Special Section Home
"Skin in the Game"

According to Nutall of KKR, long-time private equity professionals tend to have backgrounds in transactions and finance. Traditionally, private equity firms focused on the financial structure of a deal, then hired outside consultants to orchestrate an operational plan. The consultants would come into the company, write a report, send a bill and leave.

"That didn't do a lot for us," Nutall says. "They didn't have skin in the game." KKR responded by building its own in-house consulting team of senior executives with operational experience to work with management in portfolio companies. The operational partners have experience running plants and businesses, and receive the same incentives as KKR's deal-making partners.

Peter Clare, managing director of The Carlyle Group and another conference panelist, says that with increased competition for deals bidding up valuations, operational improvements are more important than ever for companies hoping to continue to deliver above average returns for their private equity investors.

"We've developed both in-house and loose networks of operations executives who will participate in due diligence and may end up running a company or serving as an executive chairman," Clare says. "Industry expertise helps us set the plan accurately and focuses [us] on what is achievable in the shortest amount of time possible given the competitiveness of our business today. It is fundamental to what we all do. It's a big reason for our ability to generate returns that are above overall equity markets."

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[More results for: financial markets] No Single Formula

Some large private equity firms have hired marquee names as operating partners and consultants, including Louis V. Gerstner Jr., former chairman of IBM who is now chairman of Carlyle; General Electric's former chief executive Jack Welch, who is now at Clayton, Dublier & Rice; and former Treasury secretary Paul O'Neill, who is now a special advisor to The Blackstone Group.

James Quella, senior managing director and senior operating partner at Blackstone, notes that there is no single formula for companies that choose to use operating partners. "There's diversity among the models and an absence in some firms of a deep bench of operational people. However, the trend overall has been unequivocally in the direction of bringing in executives and executive consultants who have a lot of experience in operations."

Blackstone's model, which is also used in various forms at many other firms, is to organize deal teams around industry sectors to bring a depth of understanding about operations to transactions. The industry orientation helps with deal sourcing, but it also can provide a better sense of how much potential upside can come to a transaction through operational improvements.

At KKR, operational executives also serve on deal teams and can provide enough understanding of a potential investment to justify a higher price that will give the firm a leg up in the bidding wars. "It's something that will continue whether it's within the firm or a consulting approach, and more firms are doing it," says Nutall.

Blackstone has a network of executives it can call on to help with the operational issues. "What we have is a bench of partners who have had deep CEO-level experience in running companies in an industry, and they will provide insight and guidance and counsel not only in industry dynamics, but also operational improvement," Quella says. Blackstone keeps about 10 to 15 of these senior-level executives working with it on industry opportunities and sourcing -- including big names such as O'Neill and David Verey, former chairman of Lazard Freres in London.

Bain Capital, founded 23 years ago by former consultants from Bain & Co., has been using operating partners for more than 15 years and has one of the industry's largest stables of dedicated, in-house operations-oriented professionals to partner with and help portfolio companies. Bain now has 30 operating professionals, double the number from 18 months ago.

Bain Capital managing director Steve Barnes says the firm's model is a blend of consultants and operating professionals with several years of experience. In addition, the firm uses outside consultants to leverage the time of management and the Bain team on strategic issues. "Our heritage is deeply rooted in a consulting and operating background. The original thesis was to have professionals who understand strategy and what it takes to get things done within a company. That way we would do a better job of selecting assets and a better job with the assets once we owned them in our portfolio," says Barnes.

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