What value do PE investors add to portfolios beyond investing money?

Popular media spreads diverse and often even conflicting views on private equity investors. In the more extreme cases like the example above, PE is portrayed as a force of evil and, from the perspective of entrepreneurs or managers, something to be avoided at all cost.

Yet, academic research is more nuanced: PE investors generally advance sales efficiency and growth of the companies they back, and — in times of financial crisis — contribute to their financial stability. Part of this confusion around how value-adding PE investors truly are may be due to the fact we know relatively little about what they actually do — beyond investing money. 

PE investors as active investors

PE investors typically acquire majority stakes in mature businesses, take on board seats and actively try to steer their portfolio companies towards shareholder value creation, striving to sell their stakes at much higher valuations five years after they entered the firms.

While in the past, the PE model was often portrayed as focusing on enhancing efficiency, for example, by streamlining operations and cost-cutting, PE investors are increasingly recognised for the entrepreneurial spirit they activate in their portfolio companies.

This means they now contribute more to growth as well. Such growth can be achieved internally, for example, through capital investments, or externally, such as through acquisitions. Yet, that does not mean PE investors push for internal or external growth equally nor in any circumstance.

Performance matters

Based on a study we conducted with a mid-sized, pan-European PE company, we showed that in the case of portfolio firms performing worse compared with their targets, PE investors were much more likely to push for capital investments, but yet against acquisitions.

Companies thus double down on improving existing operations when faced with significant performance shortfalls. As one of the PE investors we talked to put it: “If your company is in distress, the last thing you want to do is put another M&A target on top and add complexity and stress for the management team.” Acquisitions are not a great way to buy yourself out of trouble. 

If your company is in distress, the last thing you want to do is put another M&A target on top and add complexity and stress for the management team PE investor

So what happens when portfolio companies over-perform? PE investors might intuitively think, “push for growth, regardless the type, no time for slacking”.

 With returns in mind, this would indeed make sense – at least, at first sight. Value-creating internal capital investment opportunities are not endless, and capital investments take a significant amount of time to really materialise and yield increased sales, economies of scale or cost reductions.

Acquisitions, however, bring immediate sales and cash flows, together with an influx of resources which will help deal with any potential adjustment costs due to integrating the newly acquired firm. Hence acquisitions may boost shareholder value creation in the short term. So, PE investors should be more likely to push for acquisitions than capital investments in case of over-performance.

No portfolio company is the same

While most PE investors are no vampires like in the quote from Warren, they are still people. That means they are limited in what they can spend their time and attention on.

As a result of the carried interest incentive scheme PE investors rely on for their compensation, they are particularly incentivised to monitor and add value to their relatively larger investments because those have a disproportionate impact on their overall portfolio return and their personal compensation. Therefore, they will spend more of their time and effort on their relatively larger investments.

Additionally, while PE investors generally have board seats, having a seat does not equal having influence or being listened to. Typically, more experienced board members can weigh more on a conversation and can hence more easily influence the decisions taken compared with more junior board members. Our research shows that both aspects, incentives and influence, matter in terms of how PE investors steer the growth strategies of their portfolio firms. 

Specifically, when a PE portfolio company is underperforming, its investors are especially more likely to push for capital investments, and against acquisitions when the PE has invested more money and has more experienced non-executive directors.

On the other hand, when a company is over-performing, we found that investors push for acquisitions and against capital investments when they have put in more money and when they have less experienced people on the board. This latter might come as a surprise to many PE investment managers — as it did to us.

Overall, PE investors should be aware that their impact is constrained by their willingness to exert effort, as well as by their influence.

While PE investors generally have board seats, having a seat does not equal having influence or being listened to

Getting more influence is something they can achieve through appointing board members with sufficient experience; appointing too junior investment managers may harm influence, especially in underperforming portfolio companies.

However, senior investment managers may become somewhat risk-averse or complacent when portfolio firms perform above aspirations, and as such this might deter acquisitions. This may therefore be another factor to be considered. 

A buyout puts a PE investor in the driving seat; management typically takes a minority stake. As such, managers might have to accept decisions they would not have taken themselves. Nevertheless, these decisions can enhance value creation in their company as this active involvement is also what entails the added value of PE investors.

Through their investing experience, PE investors assist their portfolio companies to help them grow, either through internal investments or acquisitions, and depending on the company’s over or underperformance.

Management should understand that the impact they exert also depends on their money at stake and on the specific representative on the board.

Veroniek Collewaert is a professor of entrepreneurship and director of the Centre for Excellence in Scale-Ups, and Sophie Manigart is a professor of corporate finance and faculty dean, both at Vlerick Business School