Private equity’s laser focus on the value creation process was most certainly a result of increased margin pressure. Private equity (PE) firms started looking for ways to create value and drive
outsize returns at a time when achieving strong returns was becoming increasingly difficult.
No two value creation models work exactly the same way, but all models can be equally effective. Look no further than the stark differences between how The Carlyle Group and KKR create value. The venerable firms have many successful outcomes under their belts, but they generate returns using very different processes. (See what’s the right value creation model
As a byproduct of the increased focus on value creation, PE firms have been driving economic growth across the U.S. and in some cases globally. “There’s considerable evidence that private equity firms — in the middle market at least — are providing capital that’s productively invested in new technology, new plants and equipment, and other things that are good for growth,” says Thomas A. Stewart, executive director of the National Center for the Middle Market.
That said, while the largest brand-name deals usually grab the headlines, the middle market is unquestionably providing strong economic growth in the U.S. “The large deals, where a company is stripped for parts, get headlines, but most private equity investments in the middle market emphasize new investment, not financial engineering,” says Stewart.
There’s no question PE adds value beyond its intended beneficiaries. During 2017, private equity-owned middle-market companies are forecasted to increase revenues by 7.5% compared with an increase of 5.5% for non-private equity-owned companies. In 2016, employment at private equity-owned middle market companies increased by 8.1% compared with 5.4% at non-private equity owned companies, according to the National Center for the Middle Market’s Q4 2016 middle-market indicator.
Private equity as a whole makes positive contributions. According to the American Investment Council, 11.3 million Americans are employed by U.S.–based companies backed by private equity, and PE firms invested more than $122 billion in the first quarter of 2016.
“In many cases, private equity firms offer fresh money and fresh insight. They may come into a company when the owner is ready to retire and doesn’t have an heir or other successor,” says Stewart. “In those cases, private equity firms may increase investment and the company’s professionalization. It’s like pouring water on parched soil.”
What follows is a look at how a few of today’s most reputable PE firms have generated strong returns for their investors while they simultaneously acted as good citizens and positively contributed to the economy.
The Riverside Company
Assets under management: More than $5 billion
Case study company: YourMembership
In the first half of 2017 Riverside Company exited its stake in YourMembership. During Riverside’s five-year hold period, YourMembership flourished in multiple ways. When Riverside purchased the company in 2012, YourMembership was a software as a service-based membership company used by trade organizations, nonprofit professional organizations and affinity groups. Organizations such as the Ohio Nursing Association, the Florida Bar Association and the Association of Hispanic Lawyers would use YourMembership to reach out to its members.
“Organizations wanted to use the software to reach out to their members with educational news, updates and events,” says Joe Manning, a partner with Riverside. “It was also used as a social network that let the members be interactive with each other.”
When Riverside invested in it, YourMembership was a single product company with about 40 employees and $6 million in revenue. Over a five-year period, Riverside grew the company to a four-product company with $50 million in revenue and added more than 250 jobs. YourMembership’s revenues and earnings before interest, tax, depreciation and amortization had increased roughly eight fold and seven fold, respectively, since 2011 via a combination of organic growth and three add-on acquisitions.
“We invested in a great product and value proposition, but there was so much value YourMembership could have been providing to its members that it wasn’t. We recognized there was a lot of room for growth,” says Manning.
Soon after the initial investment, Riverside bought a direct competitor to YourMembership, which doubled the customer base and added career-board software. This add-on allowed YourMembership to sell ads for job opportunities while allowing users to see career opportunities in their industry. “This was a win-win. The employers wanted to reach these markets — members who are engaged on the site are trained professionals who are paying membership dues to an organization that keeps them up-to-date on their profession. This is whom you want to reach with new job opportunities. The users loved this feature because they were able to regularly access job opportunities in their field. The company also added an additional revenue stream,” says Manning.
Riverside then bought a company that gave them a learning management software (LMS) solution. “You can envision the linkages. Someone finishes taking an online course on the YourMembership LMS portal, and immediately they are directed to job opportunities relevant to what they just learned about. Conversely, if you are looking at job opportunities in pediatric nursing, for example, the site would then know to show you educational courses for pediatric nurses,” says Manning.
By the end of Riverside’s ownership, YourMembership had 4,000 customers and more than 20 million individual users. Riverside also grew YourMembership from a single location in St. Petersburg, Fla., to a six-office company with offices and staff in Connecticut, Illinois, Texas, the Philippines and UK, in addition to its original office in Florida.
“YourMembership wanted to interact and connect its customers with their membership, we helped them find the best way to do that by investing in the businesses, adding employees and using technology. We saw an opportunity to connect people in a better way and worked to make that a reality,” says Manning.
In early 2017, Riverside sold YourMembership to Insight Venture Partners, which plans to focus on growing the company internationally.
The Carlyle Group
Private equity assets under management: $51 billion
Case study company: Axalta Coating Systems
Look no further than Carlyle’s 2013 $4.9 billion investment in Axalta Coating Systems, a carve-out from DuPont, to see a company achieve unprecedented growth with the help of private equity. The company makes paint for many purposes, including for companies such as Volkswagen AG, Ford Motor Company, General Motors and the NASCAR.
The buyout was the focus of a hotly contested auction process. Carlyle paid $4.9 billion for the company, the highest offer. Many felt Carlyle overpaid for the asset, but Carlyle had conviction around the company, and experience in purchasing companies from corporate parents and transitioning them into successful standalone businesses. Carlyle had done this in the past with Allison Transmission, which came out of General Motors; HD Supply, which was owned by Home Depot; and Hertz, which was once part of Ford.
“Despite the price tag, we felt this was a good deal for us because we had a process that had already been tested. We have some pattern recognition at this point. We knew we could make Axalta a strong independent company and make money for our investors at the same time,” says Chris Ullman, a managing director with The Carlyle Group.
The deal turned out to be Carlyle’s second-best deal ever in terms of return despite the high price it paid. In 2016, Carlyle sold Axalta for $5.8 billion.
Axalta had been losing market share to larger operators, which resulted in layoffs and poor performance results. Under Carlyle’s ownership Axalta was able to achieve wide-ranging positive economic benefits. Carlyle reinvested $700 million into the business over three years, which allowed the company to grow considerably.
“We worked hard on our value creation process to grow Axalta. As a free-standing company, Axalta was able to innovate and thrive,” says Ullman.
Carlyle worked with Axalta to increase senior leadership by 12 people and repositioned the company to serve more multi shop operators. The company also launched four key products in Brazil, China, Germany and Mexico. At the same time the company targeted and won new business in emerging markets and launched new product lines to address market needs. Carlyle also invested in IT systems to increase efficiency.
By the time Axalta went public, it had grown substantially. Carlyle also enhanced the company’s corporate citizenship through a change in its coating system to one that reduced the emissions of volatile organic compounds for clients by 70%. The company also planted 30,000 new trees in China to help with the pollution issues in the country and partnered with Ducks Unlimited to support the restoration of the Anahuac National Wildlife Refuge along the Texas Gulf Coast, which is close to the company’s Houston manufacturing facility.
KKR & Co.
Assets under management: $129 billion
Case study company: Sedgwick Claims Management Services Inc.
Large corporations tend to have high insurance deductibles so instead of paying those high premiums, they fund their insurance coverage themselves and hire Sedgwick Claims Management Services Inc. to administer the claims. The company’s clients are employers in the U.S., Canada and Europe that self-insure. Sedgwick has had a long history of being owned by private equity firms. In 2014, KKR bought the company for $2.4 billion. David North, Sedgwick’s CEO who has been with the firm for 22 years, is a fan of working with PE firms. “At first I was prejudiced against private equity. I thought they were going to talk to us about procurement and minor things, but good investors bring discipline. It’s a model aligned with what we do,” says North. “Private equity understands our business — when we need to invest and how we need to grow.”
Sedgwick, which has been owned by five different PE firms over the past 11 years, has grown from $103 million in revenues to $1.8 billion in that time.
When it came time to part ways with Sedgwick’s last owners, North specifically wanted to work with KKR because he was interested in working with KKR’s in-house consulting arm Capstone. “The KKR Capstone story made sense to us. Sedgwick was already an industry leader, and we have had a view on additional growth opportunities, but needed support,” says North.
The company had been insuring Fortune 500 companies like Coca-Cola, Pepsi and Target, but wanted to expand internationally and into smaller markets. “Their vision was very exciting to us,” says Anne Arlinghaus, a director on the KKR Capstone team. “They were very innovative, and we are happy to spend the time supporting their vision. In addition to the expansion, they also implemented new technology to help with handling the claims process.”
After experiencing so many different private equity owners, North says the Capstone model has been superior. “It’s beyond comforting to know you can work with them on a wide range of things because I have to deal with a wide range of things every day. It was also easy to hit the ground running, there was no getting outside consultants up to speed and there was no third party generating fees. Capstone’s and Sedgwick’s interests are totally aligned,” says North.
Sedgwick has experienced substantial growth since KKR’s investment. The company has added 4,257 jobs in three years and opened about 80 new locations. While this type of growth is great for the company and the economy, what excites North is how many more people Sedgwick is able to help every day. “Today 17,500 people got up to do whatever they were going to do and they got hurt or found out they were pregnant — something happened that changed their life; and when they were looking for support, Sedgwick helped them through that event. We pay out about $35 billion in claims annually, and I am happy that we are able to help so many people through life events in a professional and timely manner. This is what’s important to Sedgwick,” says North.
Grant Thornton’s perspective
The Carlyle Group is arguably one of the biggest and best private equity firms in the U.S. Most would likely believe the firm has a whole team of people on staff all the time to help them with the value creation process. They don’t. Instead they have a cadre of go-to consultants they will tap at any given time to come into a situation. Their value creation process focuses on four things: their investment professionals, deep industry knowledge, a stable of C-suite consultants and data. Carlyle used these facets to create value with Axalta. They were able to expand internationally using their investment professionals, and they relied on their deep knowledge of how to successfully carve companies out of larger entities. They also used consultants to help them plan next steps. This resulted in a great outcome for the firm. Carlyle is obviously larger than most firms, but their method is applicable to smaller firms. Smaller firms can learn from the laser focus Carlyle uses and apply some of the methods they use on a smaller scale. For example, a smaller firm can and should have very deep industry knowledge or transactional knowledge that can help it differentiate itself to win the deal or make a company a success.
The Riverside Company also uses a consistent value creation method, which ultimately paid off with its YourMembership investment. Buying YourMembership, then applying a roll-up strategy, is something that Riverside has expertise in. Additionally, Riverside relied on a network of outside consultants to help identify complementary acquisition targets. Additionally, Riverside aligns itself by industry verticals and relies on a group of consultants to be operators at their portfolio companies, ensuring they are always pairing the right experts with the right companies. YourMembership benefited from this strategy.
KKR actually has an entire team at its fingertips to help with the value creation process. Founded in 2000, KKR Capstone now has 50 full-time employees and has helped KKR transform many portfolio companies. The in-house model is difficult for most smaller firms to implement, but some firms are trying to emulate it and having success. Comvest Partners, a middle-market private equity firm that raised $893 billion in 2015, has developed what they dubbed the Operating Advisory Group. More firms likely will follow suit as they look for concrete repeatable strategies to create value at portfolio companies.
The bottom line is using a very well thought out and executed value creation process will not only ensure successful exits, but it will also make institutional investors happy and companies stronger while creating growth in the economy.