Best of LinkedIn: Private Equity: Value Creation CW 40/ 41

00:00:00: Provided by Thomas Algeyer and Frenes, based on the most relevant LinkedIn posts about private equity value creation in calendar weeks forty-and-forty one.

00:00:08: Frens supports PE backed manufacturers with market intelligence needed to unlock revenue from idle production capacity.

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00:00:17: And uh...to set stage for you today we are going dive into top private equity insights trends We're seeing across linkedin right

00:00:24: now.

00:00:24: Yeah, specifically looking at how the whole industry is aggressively pivoting away from financial engineering and moving toward hardcore factory floor operational execution.

00:00:34: This edition has brought to you together with our partner Private Equity Insights.

00:00:38: don't miss out on their upcoming conference private equity insights UK in London.

00:00:42: find a link of the conferences in the description.

00:00:45: So picture this You beat your operational budget?

00:00:52: And then...

00:00:53: Let me guess, something goes wrong.

00:00:54: Oh totally!

00:00:56: You find out from your lender on a Tuesday morning that you are actually bleeding cash like heavily?

00:01:00: Well

00:01:01: yeah

00:01:02: That's nightmare fuel right there.

00:01:03: Right.

00:01:04: and today we are tearing into why the classic private equity playbook is just mathematically broken at this point.

00:01:11: It really is.

00:01:11: I mean that disconnect between paper earnings an actual cash in the bank Is driving this huge reckoning.

00:01:18: Absolutely.

00:01:19: We're looking at a fundamentally altered landscape like the traditional lovers of value creation, cheap debt automatic multiple expansion.

00:01:28: they've just completely evaporated.

00:01:30: exactly so The burden has entirely shifted onto operations.

00:01:34: which brings us to our first major theme this idea Of the new math of PE returns.

00:01:38: Yeah, the financial engineering era is dead.

00:01:41: everyone in the industry knows that during the zero interest rate days of the twenty tens.

00:01:46: You could just underwrite a deal with what, five percent annual EBITDA growth target?

00:01:51: Yeah!

00:01:51: Five percent ride multiple expansion and you'd still deliver top quartile return.

00:01:56: But that baseline is gone.

00:01:58: Mario EF actually brought up this phrase coined by Bain.

00:02:01: That I think perfectly captures his shift.

00:02:03: He said twelve Is The New Five.

00:02:06: Twelve is the new five.

00:02:07: Wow

00:02:08: That's the new mandate To hit standard two-and-a half times return profile.

00:02:12: in todays environment PE firms need roughly twelve percent annual EBITDA growth.

00:02:17: So you're asking portfolio companies to more than double their historical growth rates.

00:02:23: in a macro environment that is arguably way tougher?

00:02:26: Way tougher, and the friction point here is severe.

00:02:29: over The past two years sixty five percent of value creation plans have not been fully realized.

00:02:34: wait really sixty-five percent

00:02:36: yeah

00:02:37: But these are multi-billion dollar buyout firms.

00:02:40: I mean, if they're failing to execute their plans sixty five percent of the time you'd naturally assume The macro environment is crushing demand or I don't know capital?

00:02:49: It's just too expensive?

00:02:50: well You think so but it's entirely something else.

00:02:53: a recent survey of two hundred PE professionals showed that forty one percent cite capacity constraints as Their number one barrier to value creation.

00:03:02: Capacity constraints like just not having people

00:03:05: exactly.

00:03:06: It's not a lack of capital or some flawed strategy.

00:03:09: Its simple execution bandwidth.

00:03:11: The strategic thesis that the deal team comes up with is radically outpacing the actual literal human capacity Of the operating team to implement it.

00:03:19: Okay, I have to push back on that a little bit.

00:03:21: How can a mega fund afford To buy a billion dollar platform but somehow they Can't afford to hire enough operators?

00:03:27: Actually execute the turnaround

00:03:29: right.

00:03:29: it sounds crazy.

00:03:30: are They just like artificially suppressing SG&A and make the initial model look better?

00:03:35: That is a massive part of it actually.

00:03:37: The underwriting model assumes this incredibly lean, highly efficient integration.

00:03:42: but the reality is that changing a company's operational DNA takes immense human capital.

00:03:48: Yeah its messy.

00:03:49: Its very messy.

00:03:51: and when execution bandwidth falls short value creation plan stalls And with plant stalls well firm is forced to hold asset longer than standard five year time frame

00:04:01: Just to try and manufacture that missing growth.

00:04:04: Exactly, which triggers what Yuri Philip Chuck warned about he did this great breakdown of the math trap.

00:04:10: Oh The Math Trap.

00:04:11: yeah because like internal rate-of-return or IRR is just like hypersensitive time right?

00:04:16: The IRR decay is

00:04:17: brutal.

00:04:18: Yeah

00:04:19: Like Phillip Chuck maps it out so clearly if you underwrite a two and half times return over five years You yielded very healthy twenty percent IRR

00:04:27: Which everyone's happy with.

00:04:28: Right.

00:04:29: But if execution delays force you to hold that exact same asset for seven years, your IRR drops to fourteen percent.

00:04:36: Wow!

00:04:37: And nobody is raising a subsequent fund on a fourteen-percent gross IRR in this market?

00:04:41: Definitely

00:04:42: not.

00:04:42: So it'll maintain the target twenty percent IRR over a seven year old.

00:04:46: The firm doesn't just need an original two and half times return anymore.

00:04:51: What do they need?

00:04:52: They suddenly needed three point six times return

00:04:55: Are you kidding?

00:04:56: Nope You were something asking the management team to pull roughly forty-three percent more cash out of the exact same business.

00:05:02: Just to compensate for that fact you held it two years too long, That is wild!

00:05:07: Right?

00:05:08: I always found it crazy boards.

00:05:10: just accept these outdated underwriting models.

00:05:13: The original five year model rarely gets updated in board decks so have a management team being held on a ghost plan basically.

00:05:21: And this pressure is compounded by multiple traps.

00:05:25: Wayne Marhalski detailed this one.

00:05:27: We all know that if the market multiple drops from say, twelve times down to ten times The enterprise value obviously shrinks

00:05:34: But the debt load stays exactly the same.

00:05:36: Exactly!

00:05:38: The debt doesn't care about your multiple.

00:05:40: So...the real story isn't just that equity gets wiped out.

00:05:44: It's what it does with operational mandate

00:05:46: Because the operational mandate becomes basically impossible.

00:05:49: Marhelsky shows that if a seventeen percent drop in the market multiple, it raises over forty-percent of equity value.

00:05:55: just because of leverage structure then operations has to carry entire weight of recovery.

00:06:01: So...to get back into the original equity check and exit what had happened?

00:06:07: EBITDA has to grow by twenty per cent JUST TO BREAK EVEN!

00:06:10: Wow so operations is no longer like driving upside.

00:06:14: they are frantically bailing water to cover their multiple contraction.

00:06:18: Bailing water is the perfect way to put it, which really explains Lars R for his perspective.

00:06:23: He provocatively called adjusted EBITDA BS earnings

00:06:28: bs earnings.

00:06:29: I mean he's kind of right isn't

00:06:31: in this environment?

00:06:33: He's completely right when debt was basically free ignoring interest taxes and capex Which is what adjusted ebita does made sense.

00:06:41: sure there's a fine proxy

00:06:43: But today, you've got this highly leveraged capital structure draining cash so fast that adjusted EBITDA is essentially a fiction.

00:06:51: Yeah So the whole industry's focus is forcefully shifting away from who can engineer the highest-adjusted EBITTA to Who Can Actually Drive Real Cash Conversion?

00:07:01: Real economic earnings.

00:07:03: Because if Adjusted EBITA Is A Fiction In A High Interest Environment Well The Entire Architecture Of How These Companies Are Run Has To Change

00:07:11: Which naturally brings us to our second theme, redefining the operating model and the CFOC.

00:07:16: Because that structural change has to start with The Operating Model.

00:07:20: It has too!

00:07:21: Lee McCabe argued recently.

00:07:23: most private-equity operating models are built entirely backwards.

00:07:26: Backwards how?

00:07:27: Well he talks about the need to kill the theater.

00:07:30: Oh I love that phrase... it perfectly describes the dynamic in most boardrooms.

00:07:35: Right The theater he's referring to is that classic sprawling, thirty-seven initiative value creation plan.

00:07:41: Yes the massive spreadsheet

00:07:44: Exactly it's usually managed by some PMO or a reporting team That has zero actual authority over the P&L.

00:07:52: McCabe points out if you have thirty seven priorities You actually have no priorities.

00:07:57: Yeah It's a symptom of a board that lacks the conviction To just make the hard choices.

00:08:01: A Value Creation Plan should be the output Of a rigorous operating model right?

00:08:05: Not a substitute from one.

00:08:07: Precisely!

00:08:08: To build a real operating model, you need solid data spine where the board pack and management dashboard actually reconcile.

00:08:14: Imagine that...

00:08:15: I know And You Need A Diagnostic That Isolates Just The Three Or Four Specific Levers That Materially Move The Needle.

00:08:22: And Crucially, You Need Accountable Owners Who Can Actually Move Capital & Resources to Those Three or four levers which brings us into crisis in C-suite right now specifically finance function.

00:08:33: Oh Absolutely Brad Wolf observed this massive mismatch in how private equity recruits for the CFOC.

00:08:39: Yeah,

00:08:40: because CFO is basically treated as a catch-all title For what are frankly four completely different jobs.

00:08:47: break that down for us.

00:08:48: So you have the backward looking reporting controller.

00:08:51: You have the forward looking reporting FPNA lead.

00:08:55: then there's the backwards deciding deal CFO.

00:08:58: and finally The Ford Deciding Operating CFO.

00:09:01: And most portfolio companies who are staring down this mandate to double their historical growth rate, they desperately need that fourth archetype right?

00:09:09: Yes the operating CFO.

00:09:10: They need a strategic capital allocator Who actually owns The forward-looking plan.

00:09:15: but what actually happens?

00:09:17: well because of cost concerns or honestly just A total misunderstanding Of the role sponsors repeatedly hire the first archetype the controller

00:09:25: and then they sit in board meetings frustrated

00:09:27: exactly.

00:09:27: They sit there wondering why the presentation feels like a dry reading of ancient history.

00:09:31: instead Absolutely have to reverse diligence the value creation plan before they sign the contract.

00:10:01: They do.

00:10:02: car advises them to ask really hard questions like How much of this forecasted growth relies on aggressive revenue expansion versus realistic margin improvement?

00:10:11: Right, or is the leverage structure actually appropriate for the cash flow profile?

00:10:16: Or was it just going to suffocate operations

00:10:18: exactly because they are tying their entire professional reputation To a thesis constructed by a deal team that honestly might not understand the operational realities on the ground.

00:10:27: And when you combine impossible twelve percent growth mandates, a broken operating model and finance leaders who are acting as controllers when they need to be operators it completely explains the burnout crisis we're seeing.

00:10:38: The burnout is real?

00:10:41: Devin Matthews shared some data on this showing that seventy-five percent of PE backed CFO's do NOT survive the full hold period.

00:10:48: Seventy five percent

00:10:49: Yes.

00:10:50: Three out four.

00:10:51: That is systemic failure.

00:10:52: That's a staggering turnover rate,

00:10:54: it is

00:10:55: and just highlights how fragile these execution plans really are.

00:10:58: It does And Sergio or Makora shared a real-world story that Just perfectly illustrates How this mismatch destroys value?

00:11:06: It actually goes back to the disconnect between EBITDA & CASH that we were talking about earlier.

00:11:10: Oh!

00:11:10: Is this The thirty eight million dollar industrial manufacturer Story?

00:11:14: Thats

00:11:14: one.

00:11:15: So their monthly board package showed company beating its budget Reporting four point eight million in EBITTA.

00:11:21: So on paper, the thesis is tracking perfectly.

00:11:25: On paper?

00:11:25: Yeah they're heroes!

00:11:26: But the reality was... They had negative four hundred thousand dollars in free cash flow and The operating partner only found out about that massive cash drain because the lender flagged it on a call.

00:11:36: That's insane.

00:11:37: How does finance team completely miss a multi-million dollar cash bridge?

00:11:40: Because the Finance Team Was literally just two people And generating that adjusted EBITDA figure took them fifteen days every month.

00:11:48: They just didn't have the bandwidth to run the cash flow analysis.

00:11:51: They were completely maxed out

00:11:53: Totally maxed-out.

00:11:54: and it turns out, The business was bleeding cash through working capital leaks that EBITDA completely ignores.

00:11:59: they had a one point six million dollar inventory bill.

00:12:02: Let me guess procurement Was buying raw materials based on some overly optimistic sales forecasts

00:12:08: Exactly

00:12:08: Instead of actual contracted orders.

00:12:10: Classic misallocation at Capital right there

00:12:13: Yeah, and then on top of that they had nearly a million dollars in CAPEX for new production line plus over one million dollars floating rate interest just eating into their reserves.

00:12:22: And the controller's CFO basically stops at the EBITDA Line?

00:12:25: Right

00:12:26: Whereas an operating CFO manages balance sheet They stop inventory build before it traps cash.

00:12:32: If your internal reporting stops at EBITTA Your lender ends up doing your cash report for you.

00:12:37: By then its too late.

00:12:38: You're already in covenant trouble Exactly.

00:12:41: Well, with finance leaders burning out at a seventy-five percent clip and execution bandwidth cited as the number one constraint it makes total sense that industry is desperate for some kind of technological rescue.

00:12:53: which leads us to our third theme AI & Technology.

00:12:57: The Magic Bullet

00:12:58: Supposedly.

00:13:00: But hey real quick before we unpack where AI actually working.

00:13:03: if you're enjoying this deep dive take second hit subscribe so catch all future additions.

00:13:09: Yeah please do So, the deployment of AI in private equity is just a fascinating study and the gap between expectation and reality right

00:13:18: now.

00:13:19: Sponsors definitely want AI to be this magic bullet that just manufactures execution band without a thin air?

00:13:25: Oh for sure!

00:13:26: But Steve Budd noted while seventy-one percent of PE firms have adopted some form of AI only eighteen percent can actually point it as competitive advantage.

00:13:37: Wait, seventy-one percent adoption but only eighteen percent success.

00:13:41: That means a lot of money is just being lit on fire.

00:13:44: Why?

00:13:45: Is the translation from adoption to advantage failing so spectacularly?

00:13:49: Scott Engler diagnosis The problem as dabbling Dabbling.

00:13:53: yeah individual productivity might be up like maybe an analyst is writing emails faster or summarizing documents in seconds, but overall EBIT hasn't moved a inch.

00:14:03: Right because companies are just using AI to perform the exact same legacy processes with slightly less effort.

00:14:09: Exactly They aren't doing hard work of fundamentally rebuilding their workflows around what technology can actually do.

00:14:16: Pernit Gill highlighted how this looks in the boardroom.

00:14:19: He says sponsors will just slap a vague deploy AI initiative on to like page six of The Value Creation Plan

00:14:25: with no designated owner, I bet

00:14:27: No owner?

00:14:28: No specific target.

00:14:29: it's totally performative.

00:14:31: To actually drive value AI deployment has to be tied to a specific p&l margin lever Like reducing the cost-to-serve or accelerating collections

00:14:40: and crucially It needs a named business owner who is not the IT director and not the software vendor.

00:14:45: Yes.

00:14:46: Rich Hemple provided a really brilliant framework for understanding this whole dynamic, he draws a hard line between what he calls efficiency margin and capability margin.

00:14:56: I loved his distinction.

00:14:58: it just cuts through so much of the vendor hype out there.

00:15:00: It really does So Efficiency Margin is doing today's work with less money using commercially available tools.

00:15:07: Right like anyone can go buy a co-pilot license.

00:15:09: Exactly It's everyone on the block buying the exact same high-tech oven to bake faster.

00:15:15: it's a race to the bottom because your competitors are buying The exact same tools.

00:15:19: so, just shows up as a temporary bump in cost savings before the whole market prices it in

00:15:24: yep But capability margin that is what you're competitors cannot buy?

00:15:29: It's like owning this secret family recipe That makes people actually line up around the block.

00:15:34: So capability margin is built on what proprietary data

00:15:38: Proprietary data, unique customer relationships and completely redesigned workflows built around them.

00:15:44: That is what actually shows up in the exit valuation.

00:15:47: So how are elite operating CFOs driving this capability margin with AI?

00:15:53: Mark Jansen argues that top sponsors do not want CFO's using chat GPT to summarize earnings calls Exactly.

00:16:02: They want CFOs leveraging AI to collapse the monthly close cycle, like taking it from fifteen days down three days.

00:16:08: Oh

00:16:08: wow Think about this strategic bandwidth that unlocks.

00:16:12: If a finance team isn't spending half their month looking backward to generate A stale EBDOT number

00:16:17: they suddenly have twelve extra days To actually analyze The business

00:16:21: exactly.

00:16:22: Janssen notes they Want ai running predictive models to spot working capital leaks Like That inventory build we talked About earlier Spotting it weeks before, it threatens debt covenants.

00:16:32: Right They want AI optimizing pricing dynamically so they can scale portfolio revenue by forty percent without having to linearly inflate the back office headcount.

00:16:41: It's about fundamentally changing the physics of the finance department So they could actually execute that twelve-percent growth mandate.

00:16:48: But you know whether a firm is trying to rebuild workflows around AI or execute this highly demanding operating model?

00:16:56: Ultimately all comes down to talent which is our final theme today.

00:16:59: Talent, leadership and the reality of buy-and-build

00:17:02: Because the pressure on talent is compounding.

00:17:05: organic growth alone is rarely enough to hit these new return thresholds anymore.

00:17:09: so sponsors are increasingly turning too aggressive M&A to artificially manufacture the scale they need.

00:17:15: Chris Barber highlighted just how dominant this strategy has become.

00:17:19: In twenty twenty five almost three out every four buyouts were actually bolted onto acquisitions for existing platforms not standalone platform deals Three

00:17:27: out of four.

00:17:29: So the serial buy and build playbook is essentially at the industry standard right now?

00:17:34: It is, and Nicola Ebbmeyer shared the data on why platforms that execute over five add-on acquisitions see a median margin expansion of two hundred basis points

00:17:45: Compared to what

00:17:46: compared to just one hundred twenty basis points for platforms without an active M&A strategy.

00:17:51: Okay so the math works but integration is notoriously messy.

00:17:55: The conventional wisdom, as always that when you merge two companies the larger company just dictates operating model to culture or chart everything

00:18:04: right which actually exposes the flaw in how a lot of sponsors handle integration.

00:18:08: Deanor Michelle shared this brilliant case study of Apollo's recent acquisitions.

00:18:13: it completely upends.

00:18:16: Oh, this is the Emerald and Questex deal.

00:18:18: Yeah!

00:18:19: So Apollo acquired two companies in the same space — Emerald which was a massive one point five billion dollar public company—and Questex…which was a significantly smaller private company...

00:18:29: ...So by The Standard Playbook, Emerald's leadership should have swallowed QuestEx whole?

00:18:33: Exactly but they didn't.

00:18:35: Apollo actually gave that combined CEO-C to the leadership of the Smaller Company – Questex.

00:18:40: Wait really

00:18:41: why?!

00:18:42: Because when they looked under the hood, they realized Emerald had strong revenue scales.

00:18:46: Sure But almost all of it was acquired.

00:18:48: They didn't actually have an organic growth engine.

00:18:51: Oh interesting

00:18:52: Apollo understood that they were buying The massive audience from a larger company but they were by the Engine to actually monetize That audience from the smaller Company.

00:19:00: so they put the engines leadership in charge Of the combined entity.

00:19:03: exactly Michelle's takeaway there is profound.

00:19:06: the org chart Is the integration plan?

00:19:10: You cannot wait until after the close to figure out who is running what.

00:19:13: you have To decide whose operating model wins before the ink has even dry.

00:19:17: Matt level of intentionality really changes The kind of talent.

00:19:19: You need as these platforms scale up.

00:19:22: Zara Sanduk pointed out that as a buy-and-build platform grows and begins, you know centralizing back office functions like HR and finance

00:19:30: the requirements for regional leadership shift Dramatically

00:19:33: completely.

00:19:34: you no longer need these chief Rainmakers in those regional seats who are solely focused on top-line revenue at any cost

00:19:41: Completely

00:19:41: because top line growth that doesn't convert to cash is totally useless and high interest environment.

00:19:46: exactly You need true operators.

00:19:49: You need leaders Who obsess over labor utilization job costing?

00:19:52: And what she calls the messy middle of margins?

00:19:55: I like that.

00:19:56: yeah, the messy metal?

00:19:57: Yeah

00:19:57: i mean integrating five different regional add-ons means navigating Five different ways of tracking labor efficiency.

00:20:02: And Dan Kremen's noted that finding operators who can navigate that messy middle requires a massive shift in how private equity even approaches talent.

00:20:10: Right, moving away from the old model of hire and hope?

00:20:14: Yeah, that idea of just competing in a red ocean to poach expensive outside talent.

00:20:19: at the exact moment a gap appears it leads to incredibly high mishire rates...and every mishire completely derails that tight hundred-day value creation plan.

00:20:28: So he advocates for a draft and develop strategy, right?

00:20:32: Building a bench of operational talent internally before the crisis actually hits.

00:20:36: Precisely but you know there is a darker side to talent management in private equity too which is knowing when to cut your losses.

00:20:44: we always hear about PE being this ruthless cutthroat industry that will just fire a management team on day one if the numbers slip.

00:20:51: Oh absolutely.

00:20:52: But Brian Cascarano argues the exact opposite.

00:20:57: He has a very unpopular opinion that private equity firms actually hold onto underperforming CEOs for far too long.

00:21:04: I find it hard to believe.

00:21:05: given the insane pressure on returns, why would they hesitate?

00:21:09: Because of the sunk cost fallacy.

00:21:11: The deal team backed this founder really back this CEO.

00:21:14: So when execution slips the sponsors instinct is to change everything around the CEO first.

00:21:20: Oh, I see They'll fire the CFO.

00:21:23: Yep, they'll fire the CFO.

00:21:25: They'll bring in a new chief revenue officer that will restructure the entire reporting cadence...they do everything humanly possible to avoid admitting core leadership

00:21:34: is flawed Because the CEO sets culture and drives operating model.

00:21:38: Changing a CEO is undeniably expensive It's highly disruptive And it risks alienating employee base.

00:21:44: True

00:21:45: But Cascarano points out That waiting too long To make change Is simply fatal to equity return.

00:21:51: Wow So we have an environment where execution bandwidth is the number one constraint.

00:21:57: The margin for error on debt structures has totally vanished, and sponsors are struggling to field the right operational talent.

00:22:04: It really forces a conversation about that future architecture of private equity firms themselves.

00:22:10: it does And I want to leave you with this final provocative thought to mull over.

00:22:14: Paul Press shared some data showing that the median deal-to-operator ratio at large PE firms Is currently three two one?

00:22:21: Three Two One.

00:22:22: Yeah You have three deal professionals engineering spreadsheets for every one operating professional who is actually tasked with executing the transformation.

00:22:31: Wow, so knowing that operational execution.

00:22:34: Is now the sole driver of returns will The next era of private equity see the traditional deal partner becomes subordinate to the Operating Partner or taking it a step further as Aaron G suggested If AI execution becomes the ultimate capability margin, will elite data engineers become the celebrated persona at major buyout firms completely replacing traditional financial engineer?

00:22:59: The industry is basically facing a fundamental identity crisis.

00:23:02: It absolutely

00:23:04: is!

00:23:15: Thanks so much for diving deep with us today.

00:23:17: Make sure you are subscribed and we will catch on the next one!