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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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