Operating Partner Model Insights
“Deal partners were the kids who traded baseball cards. Operating partners ran the lemonade stand.”
And let’s be clear, lemonade is having its moment. LPs and management have gotten wise to the importance of operational capabilities as a means to add value beyond the table stakes of sourcing and traditional deal structuring techniques. What’s more, value creation has been given greater prioritization by investors who believe that they have ridden the market roller coaster close to the peak of its ascent and are awaiting its inevitable downturn. While the value of an operations group is universally understood, its firm-to firm implementation is anything but. Now, maybe that’s because the role of the operating partner is still in its relative infancy, but the truth is that the private equity industry doesn’t yet have agreement on who an operating partner is, nor what he or she does. And that has far-reaching consequences…including the SEC’s relatively recent insistence on ‘spreading sunshine’ on portfolio operations.
So, we have devoted our most recent Accordion event to doing just that. On a recent Thursday night in downtown San Francisco, 30-some private equity professionals gathered at the Silicon Foundry to eat and drink…. but mostly to discuss and debate the operating partner paradigm. What we learned, via panelists from FFL Partners, The Carlyle Group and Permira plus participants from TPG, Terroir Capital, H.I.G Capital, and many others is that the role of the operating partner is: Difficult to Define, Critical to Deal Diligence, Half Portfolio Advisor and Half Portfolio Boss, and Part of a Push-Pull Dynamic.
Difficult to Define (and…difficult to structure)
Of course, the devil (when not in the details) can be found between the ellipses. Nearly a decade into its existence, defining the role of operating partner remains tricky, particularly because so many firms see it as meaning vastly different things. The role can range from in-house consultant, to CEO of portfolio companies, to peer of the deal team sourcing the next transaction. In the industry’s most noteworthy attempt to make sense of various operating structures, research by INSEAD described three main models:
THE INDUSTRY EXPERT MODEL: Operating partners are sector-specific former senior executives, typically CEO or CFO; High-level general managers.
THE FUNCTIONAL MODEL: Operating partners are former executives, consultants, accountants or lawyers with a deep expertise in a functional area, such as procurement, sales & marketing, or lean manufacturing.
THE GENERAL MODEL: Operating partners are former consultants, often complemented with a few years of industry experience.
What we know (and was ultimately confirmed by our discussion) is that in modern practice, very few firm structures fall neatly into these buckets. Instead, most firms employ some sort of hybrid model — but those hybrids vary wildly in their composition and reliance on staffed generalists (who deep dive into specific portfolio companies), functional experts (human capital, strategy, pricing and marketing executives who work across the portfolio) and sector specialists (who have fallen into recent favor, particularly in the growing intersection between tech and PE).
The universal designation of ‘operating partner’ doesn’t help unify this diverse crew. In fact, it adds to the confusion. Some PE stakeholders use the term operating partner to refer, almost exclusively, to executives serving in interim management positions. Some with a more modern approach to the role, use the term to refer to functional/sector-specific partners whose skills are leveraged across the portfolio. Some use variations of the term in deference to their firm moniker for the role (operating partners, operating executives, operating advisors, senior advisors, etc.). And still others won’t use the term at all.
“We intentionally reject the operating partner title in favor of principle, which gives equal weight to those of us who specialize in deals and those of us who are leveraged for portfolio management and value creation.”
The difference in verbiage and structure aside, there is one important commonality: the direction of the operating footprint. “We have a relatively small circle of full time operating partners who participate in the carry, and then we have a larger, informal network of supplemental executives who we call in as needed, per deal.” This represents somewhat of a retraction from the post-2009 operational era, which saw the creation of an all-encompassing captive model— with its large footprint and fixed costs. It also represents a new responsibility for operating partners on staff: talent collectors. “I constantly collect people to add to our broader network so that we can tap the right person for a bespoke deal.” And there is value in that network of ‘single shingle executives’ who have done repeated operating work with the sponsor. “We are all looking for that perfect network of people who are somewhat unique to our firm (albeit not totally captive or exclusive).”
Critical to Deal Diligence (but…not in critical mass)
Then there is the question of when to call in the operating cavalry. “Having the operating team in as part of deal diligence provides you with a running start. The time invested prior to close means hitting go quickly – and speed is everything. “ That said, operating partner time spent on the deal is time taken away from something else. “And, as we all know well, most deals die.” Finding the right balance for early operating partner investment is critical.
“Would I be a wise addition to the first management meeting? No, I don’t think so. Perhaps the second, but certainly once the investment committee determines there are real legs underneath the deal.” Of course, it’s not just a question of when, but a question of who. The early involvement of a functional human capital partner who can assess the management of the team, or a sector specific specialist who can provide industry context and inform valuation is where early operational investments can yield real returns. Whether or not there is significant investment of time during diligence, the real operational heavy lifting will come post close. The specter of Vista has caused some to speculate that the evolution of the post-close operations team will lean toward a more prescriptive playbook-style approach. But that evolution has yet to happen.
“I always say it’s a spectrum. On one end, you have the firms, like Vista, that employ a ‘thou shalt’ operational model. Then you have the purely bespoke model. Somewhere in the middle is the bulk of firms — those who marry a prescriptive menu of operational tools with a customized plan per investment.”
The thou shalt model, arguably, is more suited to a sector-specific firm. The dynamics of software and healthcare, for example, are such that firms tend to see frequently reoccurring challenges and opportunities. By contrast, “when you are investing in a building products company, a beer company, a healthcare roll-up, there are consistent threads, but you do very different things with each investment.” That said, “there’s a place for a more institutionalized and programmatic approach to operations. Most firms haven’t gotten there yet, but some will, and will likely benefit from the approach.”
Half Portfolio Advisor, Half Portfolio Boss (with…all the conflicting dynamics that implies)
Should an operating partner sit on the portfolio company board? If the answer to the playbook question is a spectrum with a critical mass somewhere in the middle, then the answer to the board question proves far more varied. Some firms believe that operating partners must have a board seat and have it as an indoctrinated part of an institutional operations strategy. Though, that argument can be matched by an equally emphatic argument to the contrary. On the affirmative side of the board debate are those that believe operating partners must be intimately familiar with portfolio company operations to effectively serve as a communications conduit.
“Us deal people are finance geeks, whereas the operations people are the necessary translators between sponsors and portfolio management.”
Beyond the functional importance, some firms see its symbolic benefits as well. “There are firms that mandate one deal partner alongside one ops partners on every portfolio board. It’s important to the firm ethos to demonstrate the equal ownership that deal teams and operating teams share over an investment.” The presumptive debate side, however, likes to point out the subtle but critical downside to operating partners holding board seats: it creates a different, and difficult, dynamic between operating partners and management.
“Are you advising me as an advisor or are you advising me as my boss? That’s the tension.”
For that reason, some firms insist that operating partners do not take board seats, arguing that the advising relationship is better than the reporting relationship, particularly when it involves more sensitive discussions over compensation structure and talent evaluation. And, of course, there are also the firms that fall somewhere in between, varying their operational approach to the board per investment. “I’m on some boards and not others. My role is to be a confidante of the CEO. While I like the insight the board role provides me, I know that I’m a closer confidante to the CEOs on whose boards I don’t sit.”
Part of a Push-Pull Dynamic (that… creates compensation tension)
The lemonade sellers are here to stay. LPs now view financial engineering levers and transaction skills as commodities; skills that, alone, are no longer viewed as sufficient to generate consistent, targeted returns on investments. So, the kids who built the lemonade stand are the ones LPs are also looking to in order to drive value.
“But there are the economics to figure out.” And those economics are more in play, and in doubt, than ever before.
In 2014, Andrew Bowden, director of the SEC’s Office of Compliance Inspections and Examinations, gave his now infamous ‘Spreading Sunshine in Private Equity’ speech. Bowden argued that although operating partners generally work exclusively for the fund manager, have offices at the private equity firm and appear as full members of the team, they are often not paid by the firm itself. Instead, their compensation is expensed either to the fund or the portfolio companies they advise. For the SEC, this is fundamentally a disclosure issue. For the private equity firms, it’s a window into the real value placed on operations.
“The GP dollars come out of somebody’s pocket. In mid-market or smaller funds those are real economics. The firm needs to have real conviction that they want to pay YOU, the operating partner, out of the GP dollars and cut you into carry pool.”
Firms have typically dealt with this push-pull dynamic by varying operating partner compensation according to firm structure. Where there are operating partners that are leveraged across the portfolio, they are paid for from the GP management fee, get base, bonus and participate in the carry pool. (Again, these full time, on-staff partners are now decidedly fewer in number than in years past.)
The extended network sees a wider range of compensatory arrangements including retainers, fee-free co-invest relationships and, at times, equity within the companies for which they provide deep dive services. “Though, cutting in on equity for the outside network is the exception, rather than the rule.” Operating partners serving in interim management positions are employees of the portfolio company and are paid for by them accordingly.
But the money conversation here isn’t just about the cash going out. The role the operating partner plays with cash coming in is also worthy of discussion.
“We are in the market raising a growth fund now and at least one out of every three LP meetings includes a conversation, and follow-up meeting, on value creation.”
The operational value creation plan discussion in fundraising is no longer an outlier, it’s the standard. Period. Private equity stakeholders, on all sides of the industry, have drunk the operational lemonade. But the questions surrounding how best to serve it have only begun to be asked (and are, thus far, inadequately answered):
- How can firms develop their own bespoke operating partner organizational strategy?
- How can fund sponsors define and execute effective, customized playbooks to employ across their portfolios?
- How can a firm leverage industry best practices to create an institutionalized portfolio operations strategy?
We are looking forward to working with our clients and partners, leveraging our industry insights to help define the right answers to these questions.