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Harvard Business Review Recommends Private Equity Focus on Monopolization
All the easy profits are gone. Market power is the only piece left.
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Increasingly, I suspect private equity is in crisis. Apollo is facing investor demands over subpar returns, private equity PR campaigns are going south, and the industry is desperately trying to get retail investors to replace the money they would have gotten from pension funds. Moreover, the return of ‘club deals,’ in which PE funds band together to hold down prices of portfolio firms, suggests that the market is at its peak.
Two private equity industry executives, Karim Khairallah and François Mann Quirici, discussed this slow motion crisis in the Harvard Business Review, though in a pretty jargon-y way. Their basic theory is that private equity is 50 years old, and as it is now a mature industry, the easy money in financial engineering is gone.
That easy money, in their view, came from three basic levers. The first was layoffs. Buy a firm, lay off workers to generate cash, sell it and walk away. The second was gambling with other people’s money, or leverage. This means borrowing money to buy a firm, and then extracting dividends and selling that firm later on. By using leverage, PE firms radically amplify returns.
The third was taking advantage of the fact that small companies are willing to sell out for a lower price per dollar of revenue than bigger firms, or what is called multiple expansion. The strategy here is to buy a bunch of small family-owned companies that sell at a small multiple of revenue, and combine them into a bigger firm you can take public at a higher multiple.
After fifty years, Khairallah and Quirici argue, there’s just not much left in these levers. Target firms are hollowed out or bought up, and prices are too high at this point. So what’s left? Monopolization, or what they call building out an ‘ecosystem,’ to actually increase firm revenue. Here’s what they recommend.
We believe the next frontier of value creation is to design and manage PE portfolios as a business ecosystem. In this approach, which is largely unexploited, a PE firm orchestrates a network of relationships between some of its portfolio companies, linking previously unrelated goods and services across industries, and helping the companies unlock new value in each other. As a basic example, two businesses could coordinate the procurement of common services (such as employee health insurance) to reduce costs. The incremental value derived from leveraging the portfolio this way complements vertical value very well — the horizontal links between companies give PE firms more, and novel, options for increasing their portfolio’s worth.
This value is primarily created through revenue enhancements, cost efficiencies, higher valuation ratings, and some downside protection. In one basic area, procurement, a large PE fund has generated $550 million in cumulative savings over five years through coordination across its portfolio. Another player generated a 2.3x return on investment in three and a half years in a significantly declining sector, driven in large part by revenue relationships between interacting businesses. In sophisticated cross-portfolio arrangements, we find that operating profit can be increased by 15% or more.
Now, it’s hard to figure out exactly what they mean. Buying in common means combining bargaining power, which is clearly about monopolization. But I suspect that this is basically what happened in the late 1960s when conglomerate owners couldn’t figure out how to drive any efficiencies out of owning a line of business that made missiles and a different line of business that made, say, tennis rackets. Conglomerates were in the end all about playing accounting games, aka financial engineering, and thus made no sense if you see wealth as the ability to create goods and services.
Conglomerate managers back then put forward a lot of jargon-y nonsense back then similar to this HBR article to describe why their strategies made sense, how they weren’t just financial vultures. The difference is that in the 1960s and 1970s, we enforced antitrust laws, so they couldn’t monopolize even if they wanted to. This time, PE fund managers, who are basically just conglomerate managers reborn, can create monopolies, sorry, I mean ‘ecosystems,’ if they are able. It’s not entirely clear whether they will be able to do so. Some probably will, some won’t.
At any rate, get ready.