Move over dealmakers: Portfolio-company operators are the rising stars of private equity

But in the current climate, portfolio-operations professionals are gaining esteem. Firms are bringing them into the deal room to assess the technological transformation potential of acquisition targets before signing deals — even though it can create conflict when operations teams poke holes in a deal team’s plan.

It’s part of a larger shift that Desai describes as private equity 3.0, which has firms relying more on company management — and even total transformation of the companies — to generate returns for investors. Under this model, portfolio-operations jobs are more important than ever before, said Desai, who spoke to BI about private equity 3.0, how we got here, and what it all means for the traditional private-equity hierarchy.

Making money used to be easier

Private equity began as a “cottage industry” in the 1980s before evolving into a “much more sophisticated portion of our economy,” Desai said. In the early days, buyout funds took corporate conglomerates private and then sold off parts of the companies at a profit.

This era, which Desai calls private equity 1.0, was focused on using debt to stretch the returns that an investor could get on their equity, borrowing from the theorems of the University of Chicago economic school to become maniacally focused on efficiency.

But early success led to more competition and fewer acquisition targets. Suddenly, it became a lot harder to generate massive returns through financial magic alone. Instead, firms had to focus on reducing costs and beating industry peers.

This led to private equity 2.0. In this era, efficiency was king, as firms turned to cost-cutting strategies like layoffs, consolidating businesses, and moving corporate headquarters. The goal was revenue at the lowest possible cost.

“Can we extract more value or get more return on investments on our capital spend to really drive that cash on cash return,” Desai said, explaining the mindset of the firms of this era.

But competition only continued to increase, leading to what Desai calls private equity 2.5, or using the money generated by a business to buy more growth. One example is the classic roll-up strategy, where an operator of a chain of small businesses, like a carwash, uses cash flow to purchase more of these businesses, growing the size of the business and the return on the investor’s original equity.

Private equity 3.0

Rising interest rates nearly two and a half years ago ushered in a new economic reality that hit private equity firms right in the pocket. Cash flow that previously could have been reinvested into a business or dispersed to investors now had to be used to cover the debt that financed the deal in the first place.

Stubbornly high business valuations have compounded the problem, making it harder than ever to find a lucrative target.

“If I’m a private-equity investor, I’ve got a problem because I’ve got a mom-and-pop seller who’s looking at their stock portfolio, and the price earning ratio of the S&P 500 hasn’t really moderated all that much,” Desai said. “Why would I sell my business for a lower EBITDA multiple? Because the stock market is telling me that the economy is doing great.”

This leaves the industry with two options, Desai said: reduce debt or “do something different to generate outsized cash returns.” Since private equity relies on debt to boost returns, the first option is off the table.

What’s left over is the new model that Desai calls private equity 3.0, which forces buyout companies to build new revenue streams to generate investor returns.

He said this model tends to start with technology to lower costs and then use the cost savings to find ways to expand a business’s ability to make money.

Desai used the example of a carwash chain that previously would have used its earnings to purchase more locations. With extra cash flow eaten up by high debt costs, ownership now has to bring in labor-saving back-office technologies, including generative AI or even chatbots.

Those savings would then be used to roll out new money-making opportunities, like an app that could drive more loyal business or selling other adjacent services at your carwash locations.

It’s one reason private-equity firms have been increasingly focusing on blue-collar businesses, like pest control or cleaning.

“A lot of clients will tell me, ‘We have to now start thinking about taking old-economy businesses and bringing them forward to the new economy,'” Desai said.

Enter the portfolio-operations pro

The rising star of this new investing paradigm is the portfolio operations pro. Instead of just minding companies between their purchase and eventual sale, they’re now helping transform them into revenue-generating machines.

“We are now surrounding our financial-minded quants, who are the historical engine of private equity, with really smart operators, some of who’ve done digital transformation at large-scale corporations,” Desai said.

Historically, portfolio operations partners were former CEOs and CFOs with a demonstrated history of successfully managing companies. They’ve grown to include professionals of all major business functions from HR and marketing to procurement, and especially CTOs and those who have driven major digital transformations.

Desai said this is increasing demand for operations talent, including people who might have launched an e-commerce platform for Walmart or run digital for Nike, for example. These people are taking their talents to private equity firms to manage smaller companies using an already proven playbook for technological transformation.

They are adding value at the shopping stage by assessing how long a transformation might take and what it might cost. If the deal goes forward, they’re the ones who actually help run the day-to-day changes at those companies, along with the management team at the companies themselves.

“With unlimited capital, a lot of things sound like a great idea,” Desai said. “In a capital-constrained world, we’ve got to see what is achievable.”

Culture clash

The importance of portfolio-operations pros is already taking hold.

A study cited by the Harvard Business Review found that operations (increasing revenue and reducing costs) contributed to 47% of all private-equity value creation since 2010, compared to the 25% of value provided by financial engineering. This is a reversal from the 1980s, when operations made up only 18% of private-equity value creation, and financial engineering was responsible for more than half, at 51%.

Of course, Desai warned, the operations pro’s rising status could lead to more potential conflicts in the deal room.

“As portfolio-operating teams get under the hood of the portfolio companies, they uncover challenges to the value creation agenda or perhaps obstacles not known at the time of diligence,” Desai said. “This can create conflict within the fund; deals teams and operating teams may not see eye-to-eye on how appropriately one can realize the PE firm’s investment thesis.”