By Paul Share, Conway MacKenzie
The operating partner’s role in private equity is a relatively new position. Industry firms differ about whether such a role should exist and, if so, whether an in-house operating partner (employee) or external operations professional (consultant) should be utilized.
Many PE firms need additional boots on the ground in some form during each operating company’s hold period. But they must consider a number of key issues, benefits and challenges before deciding to bring on that talent as an operating partner or external professional.
Expertise and Payment
When it comes to operations talent, expertise is one issue to consider. Specifically, limited partners may not see the need for operating partners. But those LPs may not understand that PE firms’ five highest values are finding the opportunity, negotiating the deal, pursuing bolt-on acquisitions, creating financial capitalization structures and finding the monetization strategy.
Using the theory that you should use the right tool for the job, PE firms should stay focused on their core strengths so they can add the most value. And that’s where operating partners or external professionals come in. PE firms recognize their core competencies and realize that experienced operations staff know what the firms’ investors, creditors and potential buyers will require to maximize value.
The harder question isn’t whether PE should use operating partners or external professionals, but who should pay the tab. If the PE firm pays an operating partner directly from its management fee, that immediately affects the general partner but also increases the LPs’ investment returns, of which the GP earns only the typical 20 percent carry. In this scenario, a return of 5x the cost gets the GP only to break even, and the LP is better off at any value accretion.
If the fee for an operating partner or external professional is paid directly by the portfolio company, any improvement over 1x the cost of the operations talent benefits both parties. But anything under 1x affects both the LP (direct) and GP (reduced carry). In this scenario, both the downside and the upside are shared.
In my opinion, utilizing either an operating partner or an external professional increases returns by supplementing management’s existing talent base, reduces the holding time of the investment and maximizes internal rates of return.
In a decade and a half of professional services I have learned that time in the PE world moves quickly. Work on non-prioritized issues wastes resources. The best PE firms think about more than cost; they think about value created and time saved (i.e., multiple of invested capital and IRR).
External Professionals: Pros and Cons
On the plus side, external professionals are not employees and, therefore, they are independent when they must speak to a bank or third party. The value of independence should not be minimized. As an external professional myself, my analysis has been used to help explain synergies and run rates for dividend recapitalizations and to increase financing available for acquisitions.
In addition, external professionals’ fees are clearly paid by the portfolio company, which is no different from the way other professional services, such as audit and legal, are paid. In addition, a portfolio company can reduce costs by using external consultants only when it needs them.
The challenge with external professionals is that they represent multiple clients. Typically, a PE firm wants to hire a certain individual from an outside consulting firm with whom it worked previously. But that professional may be on another engagement when the client wants their services.
When it comes to obtaining professional services, it’s not possible to compare outcomes on a case when only one person can be hired. Therefore, trust and prior relationships can be non-negotiable (and even limiting) factors in choosing whom a PE firm hires.
In-House Operating Partners: Pros and Cons
One benefit of choosing an operating partner is that it will cost LPs less than comparable external professionals because the PE firm removes some of the overhead (the consulting firm itself).
Another benefit is that the PE firm has control of operations talent it trusts and can move that individual internally when needed (i.e., during a merger, add-on opportunity, large project, due diligence and management turnover).
A potential downside of operating partners is that they typically are utility players — generalists without deep industry specialization. I have clients at PE firms who will never have an operating partner because they want an industry specialist for every client company.
Making the Choice
Operations-talent-related purchasing decisions are difficult because they come down to whom your PE firm trusts to make decisions on its behalf — and because it’s nearly impossible to determine later whether someone else could have done a better job.
Operating partners may be the right solution if your key concerns are limiting costs and having trusted resources available when you need them. But if it is more important for your firm to remove all conflicts, maintain independence or hire industry specialists for each engagement, engaging an external professional may be the better choice.
And if you find that you just can’t decide between the two, you may want to consider using both. I have seen operating partners and external professionals work side-by-side seamlessly. It comes down to what is truly best for your PE firm and the specific circumstances you’re managing.
Paul Share, CPA, CIRA, CGMA, is a managing director at Conway MacKenzie Inc., a national consulting and financial-advisory firm. Paul has 15 years of experience in restructuring and interim financial management positions. He can be reached at +1 678-596-8545 or [email protected].