How to build better partnerships: 3 lessons from private equity

When we hear the words private equity, how many of us immediately think of Barbarians at the Gate, a brilliant book describing the hostile takeover of RJR Nabisco in 1988? It’s a gripping tale of raw aggression, hard-nosed competition and viewing the world as a zero-sum game. It’s an apt caricature of the Mergers and Acquisitions (M&A) climate in years past and could just as easily apply to some of the current prevailing populist and nationalistic views about the world.

Yet this is not how private equity operates today and need not be the way we view the world at large, either. For evidence, look no further than the steadily declining share of hostile M&A deals in the last two decades. What has happened?

The likely answer is that, just like the world at large, the private equity landscape is not (and never really has been) a zero-sum game that rewards the most ruthless, scorched-earth behaviour. In reality, many private equity firms have always understood the need to navigate a complex web of conflicting interests and multiple stakeholders to achieve a successful outcome. The sellers of a company play for the highest price; buyers want the opposite. The employees and management of the company understandably worry about their future under new ownership. Advisors on all sides must balance their own interests with those of their clients, and crucially, a private equity firm engages in repeated transactions, so reputation matters.

What strategies do private equity firms use to achieve beneficial outcomes, and what lessons might this hold for other actors in the financial world and beyond?

This is helped by the nature of their funds, which often have lifetimes approaching a decade. In practice, this means that a disagreement over the price of a company can be resolved with a mechanism called an earn-out. A lower price than the seller wants is paid at the point of sale, but if the business performs according to the seller’s projections one or two years later, a second payment is made to bridge the gap. This way, a potentially acrimonious short-term negotiation is turned into a trust-building relationship.

A similar thought is embedded in roll-over equity, where sellers retain a significant stake in the company – and thus can profit from a “second bite at the apple”. This offers a significant upside, particularly where the new owners can scale the business to new heights. At our firm, Brightstar Capital Partners, we use this concept extensively and benefit from the long-term relationships it creates with previous owners. Beyond the shared economic incentives, the previous owners, with all their business experience and knowledge, are available as sounding boards to aid decision-making.

A great recent example is Ownership Works, which aims to make large parts of the workforce shareholders. This helps overcome the natural suspicion of rank-and-file workers and aligns interests in creating economic value. There have been high-profile success stories of this approach, creating significant wealth for lower-level employees and not just management. Alignment with employees is, of course, only one aspect of a wider ESG (environmental, social and governance) commitment and in this respect, private equity firms have also been proactive in recent years. An example of this is the ESG data convergence initiative, where private equity firms and their institutional investors are working to create a set of standards for ESG-related reporting in the industry. This has momentum: more than 42% of assets in private markets are managed under an active ESG policy.

At our firm, we will advise families, founders and entrepreneurs about when a deal with private equity makes sense, regardless of whether we actually benefit. There are official rankings that document the enthusiasm with which private equity firms partner with management and founders. Those partnerships create economic value, but they also create mutual respect and referrals, which leads to a better deal pipeline in years to come. The final proof point of how private equity firms are happy to collaborate, even with competitors, lies in the approximately 20% of transactions that are “club deals”, where several private equity firms pool together to buy a company. They share in the investment but, more importantly, complement each other with their expertise. It is this pooling of expertise rather than just capital that has likely allowed club deals for large companies to significantly outperform sole-sponsor deals in recent years.

To conclude, if an industry historically perceived as cut-throat can embrace collaboration and partnership and achieve results through this approach, this should be of interest globally. Like the world at large, the private equity landscape is full of competing actors and interests, and many decades ago, some firms thought the answer was often a zero-sum game approach. But the industry has learned that building partnerships and consistently collaborating are not only more satisfying but also more successful. I sincerely hope the three approaches outlined here can transcend our industry and make a difference in the wider world.