Just because a fund can raise a lot of money doesn’t mean they’re good at investing it, operating the companies after acquisition, or making money through exits.

What is private equity?

Private equity (PE) investment strategies involve buying all, or portions of, privately-held businesses — those not available on the public markets — and unlocking their embedded value to sell later for a higher price. The overall goal of any fund is to identify private companies that are currently underpriced relative to the value of their future potential.

Usually, investors of funds (Limited Partners or LPs) commit capital for a substantial period of time. This can be 10 years or more. As the fund acquires more companies, they ask for more money from investors who’ve committed capital. When a PE fund buys companies, they do so usually with the target of flipping them in 3–5 years. Not always, but it’s a decent general guideline. Different funds have different objectives, and the world of private equity is large. So the facts I’m talking about above are super generalized.

Funds make money when they buy a brand, cut expenses, change headcount, replace the management team, merge with other brands, grow the top-line, and flip the company years later for a higher price.

You first have to identify solid companies worth buying.

There are a whole host of issues with buying private businesses that aren’t public. Part of the game is to identify those that might be unkempt on the outside but have solid bones on the inside. Because they’re private, they don’t have public reporting requirements. Sure, many might be audited or reviewed by an outside accounting firm, but this isn’t always a requirement, and I’ve seen some funds not require it either. These funds take way more risk investing in private companies than those funds that require rigorous diligence and audits before investment. Many funds won’t consider an investment if they haven’t had a financial audit — for obvious reasons… But I’ve also seen funds go right ahead and sink a ton of capital into a company without any financials to speak of.

In my experience, the funds that tend to succeed more often are the ones who have two things:

• Robust and refined diligence processes. They take deep dives into companies before investing and have a really good handle on where any skeletons are hiding within the company. Is there an impending lawsuit? Are they running out of cash? Is the founder maxing out the corporate credit card? Does the founder need to be replaced with a seasoned executive? Diligence lists can be hundreds and hundreds of lines long for bigger deals. Checking all of them off can be the difference between a massive return and an epic fail later down the road.
• Post-acquisition operating expertise. They have a team of seasoned, multi-function operators in-house or with a partner firm that can optimize the companies after acquisition. This portco ops team contains supply chain, marketing, sales, finance, HR, or other industry experts that are solely there to support and turn around the fund’s portcos.

I once worked for a company that had the same management team in place for 15 years before PE acquisition.

The interesting thing that happened once that company sold to PE?

Not one year after the deal closed, the company hit the first cash crisis they’d had in 15 years.

Why?

Not really any hands on the wheel.

The PE fund was not involved with the brand after the deal closed. They trusted the current management team to keep operating as efficiently as they did before the deal. The management team was mentally checked out. Spending was largely left unchecked. No one was really budgeting or forecasting. No new projects or growth initiatives were developing.

Things sort of fell off the rails.

I challenged the PE fund to reflect on this situation a bit when I stepped in mid-crisis. They actually told me, “We don’t have the resources or people to get into those weeds… nor do we want to.”

Their finance department suffered a lot of churn and was virtually non-existent. The fund didn’t have visibility into company profitability or cash forecasts. They weren’t getting monthly financials. I had to come in and rebuild the department, hire new staff, and create new communication lines between the fund and portco.

Portfolio company operating expertise can fix even the worst investments

The secret I’ve learned working for multiple family office, angel, private equity, venture capital, and other funds is this:

The more involvement the fund is allowed within their portfolio companies’ operations, the higher the probability of successful outcomes.

Now, I’m not talking “founder mode” or micromanaging the heck out of your portcos. Involvement can look very different depending on the style of fund. What’s most critical to take away is that the fund that has either partnered with an outside firm or built a team in-house to support their portfolio companies are the ones that win. These funds partner or hire folks in specific functional areas to create a group designed to lead their “portfolio operations” or “portco ops.” These people might be:

• Experienced CFOs or FP&A analysts
• HR and employment practice wizards
• Marketing experts
• Supply chain specialists
• Logistics coordinators
• The list is endless.

Funds that have a good portco ops team are the ones that can even get themselves out of a bad investment. Yes, bad investments happen. Maybe the diligence process didn’t catch some huge underlying supply chain breakdown, system issues, or an HR crisis. Without a portco ops team in place, these issues are hard to fix.

Having operating experts on staff or at a firm you trust that can step in and put a solution in place is key.

Honestly, this is a common thread in the PE world. Many funds don’t think they have to operate or shepherd their portcos after acquisition.

I’ve seen several funds believe (though they won’t admit it), that buying a company and successfully selling it for 2x, 3x, or 4x of purchase price in a few years is as easy as signing some paperwork, having a board meeting once per quarter, or replacing a CEO here and there.

Unfortunately for them, that’s really “dumb money” and not an effective or responsible approach to growing a company into a successful exit.

Unlocking the embedded value in a company in the private equity space means getting the people who founded the company on your side relationship-wise. This takes a lot of time earning their trust. It means playing politics and motivating founders after they’ve hit their big “cash out” milestone… or replacing them quickly after the deal closes if that’s not going to be possible. It means understanding the industry and where to make strategic growth investments.

How can PE funds take an active role in portco operations if they have a small internal team or lack the boots-on-the-ground operating expertise?

While some larger funds have the resources to build an in-house team of portco operators and support staff, some don’t want (or don’t have resources) to build an in-house team. It can zap fund resources that otherwise could go to buying more companies (or zaps fees that otherwise could go into the GP’s pockets).

Think about it this way — some of the best football analysts and coaches were once players at the highest level. They’ve played inside the game. They know the ins and outs. They know the team dynamics and what it’s like to be on the field in game-winning situations.

The same goes for PE. The funds that can build an internal team or partner with an external team of industry operators, finance leaders, or marketers are the ones who ultimately have the skill sets and best positioning to unlock the embedded value in their portcos. The funds that don’t may or may not get lucky when it comes time to sell. Some might not even sell if they’re really poorly managed. Relying on luck to make money is not a strategy.