How PE Operating Partners Are Paid, Hired Special Report: All About PE Operating Partners David Snow, Privcap: Today, we are joined by Joe Healey and Ben Sanders of Korn Ferry. Gentlemen, welcome to Privcap. Thanks for being here. Let's talk about the wide range of models by which private- equity firms integrate that operating talent into their investment activity, whether on a deal- by- deal basis or fully baked into the firm. What are some common models or a few models in the spectrum from occasional to full member of the firm? Ben Sanders, Korn Ferry: Yes. There are four that we see fairly regularly. One is for business development they may call them a senior advisor or an operating partner. But, the person is there for their industry contacts and to help evaluate the investment opportunity and help win the deal. Secondly, for functional expertise. Maybe it is an investment sector within a private- equity firm or a private- equity firm that realizes that, given their investment thesis, they need to focus on the commercial side of the business or the finance function. So, they will bring in someone focused on that. It may be more of a generalist, perhaps a former CEO or a business president, who will work with the management team. The fourth one is maybe a former portfolio- company CEO of the private- equity firms or someone from outside that they have gotten to know. But, the person is parked there, looking for deals. When they find the right deal, they will go run that. At the same time, they might get recruited to run a company for another private- equity firm. Those are four. Do you have additional? Joe Healey, Korn Ferry: To answer your question, this is an idiosyncratic industry and every firm has their own approach. It is hard to see a standard develop. I agree with the framework Ben described. Interestingly, you find you have a range as to whether they are full- time, permanent members of the investment team or they are brought in on an ad- hoc basis. Depending on the circumstance, the firm, and their approach, you could have senior advisors who are typically less than full- time and standard operating partners deeply embedded in the investment team. The pay structure is identical to the investment team members
and they are, in fact, members of a team. Those are the two ends of the spectrum: full- time member of the team and senior advisor and you have every possible permutation in between. Along the spectrum are different levels of expense and commitment from the original private- equity partners. Setting aside what is more effective, the part- time advisor will simply cost less and take up less of the economics of the firm than the full- time partner getting a piece of the carry person. Are you sensing reluctance or hesitation on the part of some firms to open up their partner economics and bring in these new people who may or may not have an impact on profits? There is little choice. There is an expense to be incurred. Sometimes, these expenses can be billed back to the portfolio companies directly and some large firms it would be sensitive to name names, but some firms underwrite the cost of a large group and, throughout the year, they bill back the costs of that group on a project- by- project basis as the functional expertise is brought to bear on individual companies. So, it is imperative that it happen. It is a key pressure on the profitability of the private- equity community now that additional resources are being expended in order to create a different staffing model inside many of these private- equity firms. It is always a challenge to get the investment side of the firm to share their economics, but they look at it as an investment decision: Is this operating partner we are bringing in going to create more value than he will cost over the life of the fund? Since both of you are human- capital experts, people probably come to you and say, How much do you think I would make if So, in the realm of the operating partner, again without necessarily setting figures, what are the ways an operating partner might get compensative, incentivized in working with a private- equity firm? There is a range. Generally speaking, they will probably make less current cash compensation within a private- equity firm than in an executive role at a corporation. That is because of the carry element of things, because the private- equity firms exist to create that value. But, they can earn income for sitting on boards of portfolio companies. They can be billed out on a project- by- project basis or, as Joe said, they can draw a salary that is billed back to the portfolio company or they are part of the infrastructure cost of the firm and that value is parceled out and paid for according to the value they create for the portfolio companies. Any additional thoughts?
Yes. We have seen the whole range. Some firms feel strongly that there is no distinction between the investment professionals and the operating professionals and that there is one team, one common pay structure and there is a salary, a bonus and carry participation. Some firms see that in an extreme way and whether there is parity or not is a firm- specific decision. Some firms pay their operating partners a salary and bonus and, if an operating executive is chairman of a portfolio company, which often happens, they might have dedicated economics in that company where they have the opportunity to add value. So, you are creating an alignment of interest with that operating partner. Some eschew that model because it does not lead to the type of behaviors that are across the fund. If several operating partners have economics only in the companies in which they have an interest, you create the incentive to have less cross- collateralization of insight, information, and sharing. So, it is hard to generalize. Another example: in the case where it is someone within the private- equity firm to find a deal to go do, they will be incented based on finding a successful deal and how instrumental they were in sourcing that. Generally, they will be paid a percentage of the equity that gets invested in that. So, a big question is the degree to which the operating executive has his or her economics tied to the specific deal they have been assigned to or they found, versus the health of the whole fund. Is there a standard emerging there? Is there a perception among limited partners that you are a real operating partner if you are incentivized by the whole fund, versus a hired gun with the deal you hunted? The limited partners care about the outcome and the individual firms leave it to themselves to determine what is optimal. To think about it in a theoretical sense, the idea that you have a group of very smart people some with an investment background, some with an operating background whose interests are completely aligned to a common outcome across a portfolio, theoretically, it stands to reason that might make the most sense. But, some firms we know well, as pointed out earlier, think they are backing great CEOs and do not feel they need an operating partner to oversee the activities of the CEO. Their objective is to let the CEO do what he or she does well. So, it is hard to draw a fine line there. One distinction is that the large- cap firms probably would have an operating partner for a specific industry sector rather than going across five or six industry sectors. But, for a mid- market firm, that
operating partner would focus probably more firm- wide, especially someone with a finance background who is there to help the CFOs. Yes. There is one other relevant profile worth pointing out. Some feel the need to build the operating partner capability and make it an in- house capability. And there are models (enough to merit inclusion) where one senior operating partner is hired who is, effectively, a general contractor or the architect of the operating partner thinking within the firm. This individual creates an outsource network of operating partners that can be drawn in on a one- off basis, a truly virtual team. But, it is led by a senior operating partner who has broad command over all the portfolio companies and the associated issues. He or she then must have that network in place, live and dynamic, so they can pull in the resources as needed. Without holding you to a statistic, what percentage of operating partners get carried interest based on negotiations you have seen? Can I rephrase the question? Yes. What percentage of the operating partners have a direct interest in the incentive, whether portfolio- wide or with specific companies? Yes. The answer is probably very high. As we said, some firms have specific economics and a specific deal, while some have carry in the broader pool. Of those who have direct participation, that might be more 50/50. If you go back six, eight or 10 years ago, it was probably a much lower percentage, more people being paid on a project- by- project basis and being paid cash rather than carry, much to their chagrin. But it has become a more highly- valued function; the best people will want carry, with the distinctions Joe drew about whether that is firm- wide or deal- specific. In many cases, a private firm needs to pay carry to get that person. We should not overlook that some operating partners are not pursuing these types of roles purely for W- 2 cash income or even carry participation. They may be in a position to seek attractive co- investment opportunities with the private- equity firms. They might find that more valuable, so they can make their own direct investment in these companies with the benefit of having done their
own due diligence on these deals because they are working side- by- side with the private- equity firm. We are highlighting the fact that it is idiosyncratic, depending on the firm, the circumstance and even the individuals in an operating- partner capacity. Final question, which has to do with how an operating executive might find his or her way to private equity. Many executives probably have read about other executives or even known their friends to go work for a private- equity firm and they think, That sounds cool, I wonder how I can do that? In your experience, how has operating talent found its way into a private- equity role? Yes. There are two immediate distinctions: one is where, over time, perhaps by being directly involved with the private- equity firm, an executive has gotten to know that firm. For instance, this is current news: Dave Cody just joined Blackstone in what is probably an operating partner role. He had run Nielson and probably came out of that. They took it public a couple years ago. So, he is someone who is known to them, who came in- house and we will see what his role is in the future. But, that is someone who is known to the firm and that is what they do. The other example is where a firm says, We need to hire an operating partner to do the specific thing. So, they go and find them it may be someone they know, or someone they do not know. But, they recruit them for that reason. And, that person needs to figure out whether it is the right private- equity firm for them. Yes. Private- equity firms tend to hire people they know. So, it sounds like a Catch- 22, but how do you become someone who private- equity firms know? Sometimes, it is because you are an operating executive inside one of their portfolio companies. Sometimes, it is because you found an opportunity to work with them on a project or perhaps you know all there is to know about one narrow sector or function that might be of relevance to that firm. You find a way to be introduced and maybe work on an isolated project that gives you the platform to have them develop a broader understanding of your capabilities. It is tricky, but the good news is, the demand for this function is increasing. Thankfully for us, not every private- equity firm knows, in their own ranks, all the people they want to hire. There are either formal or informal searches done on a regular basis for private- equity firms to expand the network of people they know. So, it is not out of the question that you could have a nonexistent relationship with a private- equity firm but end up in some capacity that might lead you to a role like this.