Making Growth Net Free
Investing in organic growth often creates tension with the model of PE, which necessarily pushes general partners to be mindful of the debt they’ve taken on and the covenants they’ve signed. For this reason, it’s usually important that the funding for portfolio companies’ growth initiatives be net free, meaning the cash to invest must come from savings realized elsewhere within the portfolio company or from an “organic growth investment charge” that’s taken when the buyout is made. (See “A Different Way of Funding Organic Growth.”)
Headroom can help with this, too. At the very least — even with private equity owners that aren’t willing to increase the cash they’ve committed — a focus on headroom can make companies smarter about the organic growth initiatives they have in place. Take product development: A company looking to increase its market share would make sure that its product development efforts were aimed at customers that were likely to switch, and were built around needs-offer gaps that really needed to be closed. Or sales-force redesign: Although it wouldn’t necessarily spend more on its sales force, a headroom-conscious company would make sure that its salespeople were going after prospects that might actually switch.
Headroom can also help companies identify which costs they can cut in non-promising areas in order to reallocate them somewhere else. Here, the concept of “return on effort” is important.
Reinforcing PE’s Baseline Capabilities
Even as organic growth becomes a more explicit part of the private equity compact, the means of value creation that existed previously will remain important. Private equity firms will have to be best in class at financial and operational engineering; the organic growth imperative doesn’t change those requirements. It is, rather, a new way of gaining competitive advantage in an era when many private equity firms are still trying to utilize tactics that have become commoditized.
Indeed, part of the promise of organic growth enhancement, as a PE innovation, is the impact it will have on the two capabilities that most general partners would say are as important as adding value to their portfolio investments — fund raising and deal making.
Despite a few recent improvements, the fund-raising environment has deteriorated, and will likely remain depressed for the foreseeable future. There are several reasons for this. One is that limited partners of every kind have seen their non–private equity investments, including real estate, tank in the last few years, says one general partner. As a result, this partner says, “the denominator has gotten smaller.” U.S. state pension funds in particular — traditionally among the biggest backers of private equity — are facing “huge shortfalls in funding versus liabilities,” he adds.
The reduced pool of available capital is forcing senior managers of many private equity firms — including the firms’ boldface names — to spend more and more of their time on the road meeting with accounts and prospects. “Basically, you’re out there selling the brand,” says Apollo’s Silverman. “That’s a different step from traditional fund raising, which is actually asking for the order. The point is to make sure when you ask for the order — when you say, ‘We’ve got this great deal; why don’t you put up $400 million?’ — that it’s the 16th meeting, not the first.”
In the future, having demonstrable organic growth capabilities will be part of what general partners sell, and something that reinforces their fund-raising ability.
Likewise, having a successful approach to engineering organic growth will give firms an advantage in deal making. Just as private equity firms that were one step ahead in financial engineering in the 1980s or ahead in operational engineering in the late 1990s were able to pay more for available assets and still earn rich returns for their limited partners, so will the firms that master organic growth enhancement today succeed at winning more deals. That will cause the money to flow their way, bringing them more fee revenue and more opportunities for capital gains.