The private equity operating partner model – namely the appointment by private equity firms of a dedicated expert to work with their portfolio companies to increase value – is enjoying exponential growth but is this structure an effective one? Marie Fitzpatrick examines the pros and cons of this approach.
Demand for the operating partner model accelerates
Private equity dealmaking continues to break records. According to White & Case, private equity transactions accounted for 27% – or $2.1 trillion – of all global M&A in 2021, which is more than double the amount of activity seen in 2020. However, private equity firms are facing some difficult headwinds.
An abundance of dry powder, unspent investor capital, means the dealmaking market is incredibly crowded. In parallel with the wider inflationary pressures, private equity managers are increasingly paying very high multiples on deals, which in turn is putting pressure on investment returns. In order to enhance their EBIDTA (earnings before interest, taxes, depreciation, amortisation), private equity firms are looking to obtain value creation from portfolio companies through operational improvements. This is driving up demand for private equity operating partners.
The operating partner model is diverse in nature. Whereas some private equity firms are happy to let their portfolio companies function independently as is with limited intervention, others will appoint specialist operators to oversee the day to day running of the underlying businesses.
Similarly, GPs may work very closely with these operators in driving operational improvements at companies, in what is known as the joint leadership model. Elsewhere, some firms may choose to leverage dedicated in-house expertise or a network of industry experts to support them with portfolio companies’ operations.
But under what circumstances should private equity managers utilise operating partners?
A model with mixed blessings
Operating partners provide a degree of knowledge and proficiency in certain sectors or processes which may not necessarily be immediately available at most private equity managers. When acquiring companies in heavily regulated industries (i.e. consumer finance), it is well advised that private equity firms work closely with operating partners well-versed in those particular sectors. The same rings true for managers building up their exposures to digital industries, a trend which has been fuelled by the pandemic.
As investors increasingly prioritise issues like ESG (environment, social, governance) and D&I (diversity and inclusion), it is vital that operating partners understand these dynamics as well. Some may choose to engage with independent parties with ESG expertise that provide or help implement aligned practices within the portfolios companies. With many private equity firms looking to ensure their resources and personnel are deployed as efficiently as possible – the use of operating partners is one way in which synergies can be obtained.
Despite this, the operating partner model is not for everyone. While it is prudent for GPs investing in specialist sectors to engage with operating partners, it is less clear cut as to whether this is applicable for generalist managers. Furthermore, some LPs are unhappy about how certain operating partner models are structured – especially in terms of where accountability is apportioned. It is essential that GPs are fully accountable for all of the investments. Similarly, there are also concerns about potential conflicts of interest, mainly because operating partners will typically receive compensation from either the fund or the portfolio company as opposed to the manager. This is something which the US Securities and Exchange Commission (SEC) is closely reviewing, having recent confirmed that it wants details about private equity fees and expenses to be fully disclosed to clients, including charges related to consulting, legal support and monitoring which are billed to portfolio companies and/or investors.
Effective implementation and where to begin
The operating partner model does carry a number of benefits, especially for managers investing into heavily regulated, specialised (such as ESG) or technology-orientated industries. However, it is vital these partnerships are subject to robust governance as LPs and regulators increasingly scrutinise conflicts of interest at GPs.
If you would like to find out more about JTC’s private equity services, please contact Marie directly.
For our innovative ESG solutions, please get in touch with Victoria Gillespie, Head of ESG Services.
 White & Case (January 13, 2022) Global private equity delivers ground-breaking 2021
 Private Equity International (October 1, 2020) The operating partner of tomorrow
 Financial Times (February 17, 2022) Investment industry welcomes SEC efforts to reform private equity fees