"I create nothing. I own." - Gordon Gekko, Wall Street, 1987
Gordon Gekko, the fictional poster-child of private equity in the 1980s, got rich through financial engineering; fracturing companies and selling them off for more than the sum of their parts. Oh, and there was also that insider trading thing he had going. The movie, Wall Street, and its main antagonist were emblematic of the destruction, not innovation, which was the order of the day on the Wall Street of 1987. Thirty years later, the question remains, “Do private equity firms provoke innovation or prevent it?”
On the one hand, if you are looking for uncommon innovation…the world changing, balls-to-the-wall, transformational kind…you probably won’t go searching in a private equity buyout fund’s portfolio of companies.
On the other hand, these days you might be missing something if you don’t.
LBOs and Oreos
On the heels of the movie, Wall Street, my impression of Private Equity was further shaped by the gargantuan buyout of RJR Nabisco by Kohlberg, Kravis, Roberts & Company (KKR) in 1988. The fate of Nabisco’s “Double Stuf Oreos” was at stake, so naturally the deal had my full attention.
The way I actually learned the salacious innards of the $24 billion buyout was through the gripping chronicle, Barbarians at the Gate: The Fall of RJR Nabisco. Still hailed as one of the best business books of all time, Barbarians was penned by two Wall Street Journal writers, Bryan Burrough and John Helyar. The book indelibly branded the LBO realm as a greed-fueled frenzy of over-leveraged alpha dogs. The RJR Nabisco deal marked not only the biggest private equity deal at the time, it marked the beginning of the end of RJR Nabisco.
Fast-forward thirty years and shift the scene from New York to a greasy spoon in Atlanta. John Helyar and I chase scrambled eggs around slippery plates as he recounts the KKR|RJR LBO and its impact on the company’s innovation. Helyar says, “The enormous pressure to service debt forced the company to slash and streamline. The focus wasn’t on innovation. Much of that was stopped – like the smokeless cigarette project they had was gone right away. In the 90s they were doing work on finding helpful pharmaceutical uses of nicotine but that R&D got spun out as a separate business. The main focus was on cost cutting and tightening operations. Meanwhile, arch competitor Philip Morris used that time to stretch its market share lead while the price of RJR stock dropped.”
A decade after the storming Barbarians, the reign of RJR Nabisco ceased for good. “End Of An Empire: The Overview; RJR Nabisco Splits Tobacco Ventures And Food Business,” read the March 1999 New York Times article announcing the break-up. Another ten years later, Burrough and Helyar wrote this in the afterward to the re-released version of their iconic book: “Be assured, that the Barbarians are (still) out there just beyond the gate, licking their wounds, biding their time, waiting for their next chance to storm the gates.”
Private Equity is a Buy-to-Sell Game
Firms mostly prefer to hold the companies they buy for five to six years (maybe up to ten years for the very patient) before hopefully exiting them for a tidy profit. That time compressed resale requirement might provoke think-fast innovation but too much pressure on management to perform under high debt anxiety may also fatigue a team and cripple new ideas.
“Since investment performance as measured by internal rate of return decreases with time, there is an urgency created that brings growth to the forefront and spurs innovation,” says Alex Mammen, founder of the PE firm, Heritage Growth Partners. “While all this sounds great, that same pressure for speed of innovation and rapid growth can also lead to short-term thinking and squelching innovation that requires big upfront or multi-year investment or may have a longer-term payoff beyond the investment window.”
Ira Genser is a Partner at Operating Advisory Group providing hands-on consulting and leadership support to Comvest Partners' portfolio companies. “Private equity may stimulate innovation immediately after the initial investment is made,” Genser says. “That’s when they are most likely to support new ideas, new markets, and new products. Once the hold period reaches three years or more, the appetite diminishes significantly as they prepare for an exit,” he says.
Is The Proof In The Patents?
Proponents of private equity say that time pressure provokes innovation. There is some relatively recent research that may corroborate the claim - that is, if you consider patents to be a proxy for innovation. Several European academics studied the quantity and quality of patents produced by PE-backed companies compared to others. They found that PE portfolio companies produced more high quality patents in the same time period relative to their non-PE peers. The researchers didn't draw direct conclusions as to what it was about PE investment that led to the profusion of patents. Correlation doesn't imply causality, as they say. But it doesn't NOT imply it either.
It is possible that the right amount of time pressure may just cause individual inventors in PE portfolio companies to produce more...because intelligent constraints can drive creativity. It is also possible that there's a different explanation. John Bacon is Chairman of the innovation consultancy IP2Biz and a faculty member for I-Corps, a national science foundation initiative which prepares scientists and engineers to extend their focus beyond the laboratory and into the commercial marketplace. "Private equity backed companies may file more patents, but they are not of high quality," Bacon says. "They are ammunition for litigation borne from culling through development efforts before the deal closed."
What happens to innovation when private equity firms hold their investments longer? We’re finding out now. Since the Great Recession, private equity firms are keeping their portfolio companies for longer periods. Middle market PE firms’ average holding periods rose to 6+ years following the Great Recession – up from a pre-downturn length of under 4 years. And, while hold times have dropped a bit recently, they remain much higher than pre-2008 numbers.
It is possible that longer PE holding periods will be the new normal. Actually, “Several big firms are raising new buyout funds that can invest in companies for up to 20 years — more than twice the period they've typically held onto investments in the past,” according to a recent Business Insider report. If you set aside the patent research (above) and assume that extreme time pressure is an innovation depressant, this trend bodes well since longer retention periods provide more opportunity for PE firms to provoke new ideas, products and processes in their portfolio companies.
"Our favorite holding period is forever." - Warren Buffett
Extra holding time may provide Private Equity firms with the opportunity to invest in portfolio company innovation, but it doesn’t mean they’ll do so. Fortunately, a lack of other return-accelerating options may provide them with the motive to act.
“The "low-hanging fruit" of the early private equity days is gone,” says Jason Kelly, New York Bureau Chief at Bloomberg and author of The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything. “Competition for deals is much more intense and getting easy returns is far more difficult,” Kelly adds. “Private equity managers really have to look at their portfolio companies more holistically, before and during their ownership. In its best cases, that means hiring smart people to crawl all over an asset and really engage on how to make the company better for the long term.”
Masters of the Innovation Universe
To score the home run financial performance that Limited Partner investors demand, private equity firms must now be experts at enhancing organic growth in their portfolio companies. But just because there is increased opportunity and motivation to innovate doesn’t mean PE firms and their companies are equipped to do so.
Many of the inherent traits of private equity executives and their businesses are antithetical to innovation. Historically, PE firms have been built for risk minimization and IRR optimization not for product experimentation and market transformation. They favor analytical skill over creative competence. Several of the biggest PE firms - like TPG, for instance - have built large internal teams of operating-executives. However, they seem to address more incremental, process-focused and cost-centric matters than issues of step-function innovation.
So, how is a PE firm to realize the growth “pop” that comes from successful innovation if they don't build it from within? One increasingly popular answer is to outsource it.
“Creativity is a lot like looking at the world through a kaleidoscope. You look at a set of elements, the same ones everyone else sees, but then reassemble those floating bits and pieces into an enticing new possibility. “ - Rosabeth Moss Kanter
Contrarians At The Gate
Not all contrarians are innovators. But most innovators know how to create like a contrarian. If you want to find value that others can’t see, try adopting the opposite viewpoint from everyone else.
Mark Payne is a lateral thinker, a likeable contrarian, and a very successful innovator. That’s why private equity firms hire Payne and his colleagues at the innovation strategy and design firm, Fahrenheit 212. Bain, Catterton and Carlyle are just a few of the major private equity firms that engage Fahrenheit 212 as a third party outsider to evaluate and activate innovation potential through each stage of the investment cycle: from due diligence to the hold period and including the exit/transaction.
“Growth has gone from interesting to becoming an imperative. But many PE firms are stuck,” Payne says. “These are guys who spend careers trying to push out the uncertainty. Their orientation is toward the known and the measurable so as owners they don’t necessarily understand why they should write big R&D checks without a return one can readily model before taking that risk.”
Payne’s 2014 book, How to Kill a Unicorn describes Fahrenheit 212’s Money & Magic approach to providing innovation capabilities that speak the language of Private Equity. “You need exceptional creativity to develop real leaps of value for customers or you can’t grow. That’s the magic. But, you also have to manage risk and demonstrate ROI. That’s the money,” Payne says. “When we come up with an innovation, we make sure that it is both interesting to the consumer and valuable to the business and its investors. We assess not just the upside potential but also the risk and we navigate how to make intelligent trade-offs and choices.”
Perhaps more essential to the success Payne and his colleagues have with Private Equity innovation is their deep awareness of how the holding period impacts innovation opportunity. For instance, when Catterton Partners bought Nature’s Variety – a leader in Raw Pet Food (which, I’m not sure, may be like putting your dog on the Paleo Diet) – Fahrenheit 212 was tasked with driving much faster adoption of the company’s products. Fahrenheit focused on new offerings that would reduce cost and increase convenience for customers…but they knew it was essential to concentrate on approaches that could be executed with lightening speed. Within 16 months, the firm developed two new Nature’s Variety offerings. One – Raw Daily Boost – is a simple-to-serve supplement which lets pet owners take an easy step toward adding raw nutrition to their pets’ diets. The other – Raw Bites – is a frozen raw kibble product that combines the benefits of raw nutrition with the convenience of kibble. The result was 34% revenue growth for the business since the products’ introduction.
Using outside firms like Fahrenheit that are purpose-built for the nuances of driving organic growth in Private Equity backed companies is another sign of the growing role of PE firms in innovation. “Private Equity was the place that innovation forgot. Or, maybe it was the place that forgot innovation. It is neither anymore,” says Payne.
The Barbarians Have Left The Building
Now thirty years after the RJR Nabisco LBO deal of the century, Barbarians at the Gate co-author John Helyar gets his coffee topped-off and continues, “After the first private equity epoch and, in part, because of how badly some of those LBO deals wound up and, in part, due to the disastrous end of the junk bond era, buyout funds went into a fallow period. Then they resurfaced. Only the term LBO didn’t sound so great anymore, so they had rebranded as “private equity” firms. Private equity just sounds so much more prestigious than LBO,” Helyar says with tongue firmly implanted in cheek…although, upon further reflection, it could have been an overly ambitious forkful of scrambled egg stuck in his cheek – not a tongue. But, I digress.
Private equity’s impact on RJR Nabisco’s innovation capabilities may still be at play. Nabisco’s product development reputation, for example, was impugned in 2013 when a rogue high school math class from upstate New York revealed that Double Stuf cookies were not actually “double” the “stuf” of regular Oreos after all. Having run the numbers, the students discovered that Double Stufs were a mere 1.86 times the size of Oreo classics. Could this have been the result of remnant cost-cutting left over from the KKR days? Or was it simply a case of some sophomore scraping off some of the stuffing for himself before official measurements were taken?
Some Oreo loyalists (and by “some” I mean me) have suggested that the humiliating revelation led directly to the 2015 new product introduction of Oreo Thins…with even LESS STUF than the originals…now, that’s just innovation moving in the wrong direction. Maybe they should have brought in Fahrenheit 212? But, again, I digress.