How private equity operating partner roles are changing

May 13, 2024

Operating teams and partners are transforming to help meet the demands of today’s market

An emerging position in private equity (PE) firms, the operating partner or operating team is designed to help counsel the portfolio company (portco) through the value creation plan — from pre-diligence through exit — that is integral to the original deal thesis. This role traditionally has helped serve multiple purposes from providing strategic insight and advice, to supporting board initiatives or even being on the board itself and, when necessary, stepping in to help portcos execute the value creation plan.

We are seeing an industry shift that is moving the operating partner role to more prominence by relying on their experience to work closely with portco management. The operating partner role now spans the deal life cycle, from diligence through exit and provides support across the value creation levers — growth, cost, and risk. Since 2010, 47% of value creation has come from operations, up from 18% in the 1980s. Meanwhile, financial engineering’s contribution to value creation has fallen to 25% from 51% in the same period.¹ A few causes for this trend are worth highlighting:

With valuations maintaining record highs, traditional financial or management team improvements (i.e., company restructuring/reorganizing) are having less impact on the value of the company as changes in how the company operates.
Many industry leaders in dealmaking know that there may be no winding back of the clock to a time when inflation wasn’t a major factor and interest rates were low. They can adapt to the new macro conditions that favor operations.
With valuations at current levels, fewer deals are taking place, giving a new focus on more substantial transformation of the portcos currently held by the PE firms.
With high interest rates here to stay, limited partners (LPs), the parties investing in PE firms, aren’t looking for firms to do deals based around traditional financial engineering. Many LPs have increased demand for sophisticated operating teams and are looking for specific capabilities in operations. LPs are demanding both industry and functional knowledge to support current portfolio and future investment.

It is our opinion that these market realities can cause PE firms to rethink how their teams are structured and the way the firms go about creating value at their portcos.

Some firms have met the challenge posed in the market, but many others continue to struggle to develop the kind of operating teams that can create value for their current investors. Based on our discussions in the PE industry, we have identified a few areas where we have seen firms struggle, and how industry leading firms have met those challenges to help thrive in this environment. The new economics of value creation are forcing firms to rethink their operating team strategy — our belief is that you can’t wait and still get ahead.

What are the execution difficulties operating partners and teams face?

In the past, operating teams based their support on the investment thesis and associated playbooks that they could apply generally to portcos after they are acquired. Sometimes these still work, but many firms are finding that the business transformation required to unlock value needs nuance and a level of domain knowledge that traditional managers typically did not have. As such, firms are looking for operating partners with specialist knowledge, be that sector experience or transformational experience (technology, operations structure, etc). For example, many firms are looking for operating team members who can quickly work with a portco, have the experience and knowledge to understand what the issues are, and are able to help deploy targeted responses to each of those problems. Some firms may only need certain specialists’ part of the time, as opposed to bringing on additional headcount in the operation team, which may be limited by their investment prospectus.

Further, some operating personnel have come up in the environment of the last 10 years, with low interest rates and without significant inflation. A different skillset is needed to find success in the current market. Regardless of the source of the talent gap, finding the personnel who have the right experience (or have done the work) can remain a perennial struggle. Industry leaders who manage to find success despite these issues succeed by tying their operating team capabilities directly to the overall deal themes and required capabilities of their firm.

While this can differ from firm to firm, the deals team at times tends to be one of the leading voices on how a value creation plan needs to be executed, but the operating team may find issues with the company on the ground that may not seem as serious to the deal team, causing conflict. As such, it can happen where deals teams and operating teams may not see eye-to-eye on how appropriately one can realize the PE firm’s investment thesis. These types of issues can come about for a variety of reasons, such as a lack of defined role for each team across the investment cycle, a lack of trust among teams, difficulties in determining how much of the portco change came from the operating team’s involvement, or unclear accountability for a portco not reaching its goals. Whatever the cause of the conflicts, industry leading firms succeed by making their culture an open topic in internal discussions and making the changes needed to thrive.

Market conditions are leading even larger PE firms to acquire middle-market companies that may have less experience and sophistication than the larger targets we have previously seen many firms focus on. This can bring its own set of issues. For example, management at the portco level may be less experienced than needed to both see how the business will need to change in the future and to help scale the business following the value creation plan. They may also be focused on the wrong metrics. With interest rates being at their current height, earnings before interest, taxes, depreciation and amortization (EBITDA) is no longer the only data point that matters, with some firms looking beyond EBITDA to cash flow conversion in this market. These types of issues and slowdowns can force the private equity owner to replace the management team, causing additional delays across for the value creation plan. Industry leaders are assessing how appropriately one can work with management early (sometimes even at diligence) to understand how to make management true partners in value creation.

PE funds often have a ceiling built into the origination agreement that limits the total spend on operating functions and value creation plans. This makes right-sizing the PE operating team much more critical and difficult. Further, a focus of the operating team is not to go outside of the deal plan on what needs to be done to the portfolio company. If the changes needed go outside of the plan, then a cost discussion can occur around both what the firm absorbs versus the portco and what kind of value improvement the portco can expect to see as a result. There is no one-size-fits-all answer to any of these questions, but firms can often get bogged down in cost management and miss the bigger-picture opportunities. Industry leaders have a detailed understanding of the personnel and structure that helps make the most sense for their firm and are developing a network of advisors to help fill any remaining gaps.

How are leading PE firms finding success in improving their operating teams?

Focusing on your niche for growth and enhancing it

It’s almost impossible to be the best at everything. How you build out your team can be directly connected to how you want to generate value. Do you have a sector specialization focus? What about digital transformation? Sustainability? Emerging technology? Investing in your operating team’s niche and being top class in that field can lead to success.

Managing costs at a granular level

Industry leading firms target their spend to produce the highest value. Operating teams will always have a limit built into the fund origination agreement, so every dollar of spend needs to bring return on investment. A complete assessment at the top of the portco, including understanding management’s capabilities, can help avoid costly pitfalls and find the path forward with only the necessary capital outlay. Also, leaders in this space supplement their in-firm skill set by maintaining a pool of external advisors with a breadth of experience in various sectors and technical capabilities that can help assist in keeping costs down.

Building a culture of trust across the firm and into the portco level

Open communications and alignment between the deals team and the operating team are essential. Additionally, many firms are enhancing their communications by using industry leading technology to build real-time communication among the deal team, operating team and management. Further, bringing the teams together as one from pre-diligence to pre-exit can help both sides get a more complete picture of the potential of any portfolio company.

Collaborate with portco management on value creation opportunities

Management is an invaluable resource for perspectives on operations and opportunities for improvement. Many industry firms see the operating team role as a counselor, guiding management and the board of directors toward the end goal and receiving feedback in the process. A functioning collaboration between the firm and portco is essential to unlocking value.

Highlight your operating team’s strengths in the broader market

Whether it's fundraising with prospective LPs or demonstrating your firm’s strengths to future portcos, leading PE firms include the operating team’s capabilities as part of their marketing materials. Both LPs and portcos are looking to collaborate with firms that can help bring their returns to the next level, and you can use the investments you have made in building a world-class operating team to your advantage.

Build a strategy around combining the latest technologies with a subsector focus

Portcos that have found transformative growth use a combination of the right technologies for their needs and a focus on subsector strategy that allows them to quickly find opportunities in the market. Further, they plan out a leverage model to help determine where it makes sense to reach out to third parties for assistance.

Where do operating teams go next?

Ten years ago, a sophisticated operating team with knowledge on how technology can transform a portco’s operations was a niche capability. Now, it is table stakes. LPs are looking for teams that can help transform their underlying portcos for the better. They want the teams to produce the kind of high-value businesses that can generate the returns they come to private equity for in the first place. Firms that have built out the kinds of operating teams that can make these changes are already ahead of the game and will likely have a much easier time fundraising than their competitors.

Beyond fundraising, we are seeing more PE firms create individual deal thesis with a greater focus on operating improvements. Some firms have even included as part of their value creation plan an operations transformation built around a combination of strategy, tech and analytics to create value opportunities that may not have been available previously. This shows that industry leading firms have recognized the realities of this market and are treating their operating teams as a strategic differentiator to help enable the returns that their investors expect. Delaying investments in your operating team can put you behind other firms that can see the signs and move quickly. Now is the time to build the capabilities that will help your firm create value into the future.

^{_{1: Ted Bililies, “Private Equity Needs A New Talent Strategy,” Mondaq Business Review, October 26, 2023, accessed via Factiva, January 16, 2024.}}

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