The capabilities-driven approach by the PE firms

Public companies, for ages, have looked up to the PE (private Equity) sector and their amazing ability to crack deals, hoping to take lessons in improving the success rates they have in carrying out M&A (Mergers and Acquisitions). Today, however, around 6000 PE companies having about US$1.2 trillion in cash reserve at hand for investment (showing a hike of 200% in over the last decade) are looking in vain for deals. The competition is influencing the increase of prices and it might prove tougher for the PE sector to enjoy profit, especially if the bull market slows down in the long run.

In this highly competitive environment, the PE companies can take a leaf out of the books of the public ones which have succeeded thoroughly in M&A. It has been discovered that companies like Abbott laboratories, Danaher and Disney have seen success having mastered something called the capabilities-driven approach which would lead to inorganic growth. They take into account the distinct strong points of their businesses in terms of optimum capacities, the basic pillars which include knowledge, process, skills, tolls, organisation, etc.

This comprehensive perception leads them towards astounding returns in terms of finance and successful deals. Analyses of over 500 cases from nine industries over a decade (2001-2012) showed that around 14 percentage points in average are added to shareholder returns of two years by such deals, beating those of other public companies following different methods. The same approach may work for PE firms as well if they use it while looking for and filtering targets for acquisition and for performance driving after the completion of deals at portfolio companies.

Value creation by PE firms happen in the follow four main ways which if dipped in a capabilities driven approach bucket can maximise its value creation, while accelerating the rate of growth at the same time:

Operational improvements made on the top-line and the bottom-line: Value created by the PE companies, often involve the optimisation of cost; it focuses on acquiring resources, and realignment of the workforce. The capabilities – driven approach can boost value by identifying the exact capability the cost program is affecting and by making sure its most important strengths are not watered down just to suit cost optimisation.

Simultaneously firms can accelerate growth at the top line, by focusing on particular capabilities, bringing about improvements in innovation, R&D (research and development), and sales force effectiveness. The Blackstone Group’s investment in the Hilton group of hotels and the eventual hike in returns in 2013 after the crisis in 2009, is an excellent example of application of the capabilities driven approach.

Investment in high growth rate industries: Value creation is done by PE firms by investing in companies which are growing fast and well in the industry, or in situations in which growth opportunities are created even if there are disruptions in the market. In these cases, the possibility of all assets rising; however, even here the companies trying to fortify their capabilities systems are likely to create greater values.

This smart approach assists in driving better performance by pinpointing and strengthening the particular capabilities or assets. Just like Apex Partners collaborated with the TriZetto Group which provides integrated healthcare management software in 2008, in face of the intensifying debate about healthcare reform and managed to make a separate place in the market for themselves by the distinctive capabilities.

Rolling up and consolidation of assets and creation of synergies: Value is created by PE firms by compiling assets that are related so that more scale can be gained, creating alliances, and building up market share to facilitate better pricing. What the capabilities driven approach does is, value creation by concentrating on the unique capabilities and manoeuvring or leveraging them all across a massive base. As an example the investment made by Apollo Global Management in 2007 by buying and combining Oceania Cruises and Regent Seven seas Cruises, can be sited.

Restructuring the financial element: PE companies create value by coaxing those who lend to them to rethink and negotiate interest rates, and/ or by exercising perseverance to set up the application of operational improvements. By utilising the capabilities approach, value can be enhanced by creating the restructuring of debt in accordance with the firm’s capabilities system, while emphasising at the same time, how the company’s distinctive capabilities will help its case in the market. Apollo did this kind of thing with Lyndellbasell.

Taking into account the dry powder available in the Private Equity sector, and its highly competitive nature, that prices will rise is a given possibility. PE firms have to keep in mind that in such a scenario, irrespective of the price they pay, they will have to find a way to use acquisitions as a major source of creating value to gain success in the long run. And to attain this target, they have to learn from the methodology that the best public sector companies have used to maximize returns from M&A, and that is the capabilities driven approach.…