Speaking the Language of Private Equity Sponsors

August 24, 2020

Private equity insiders rely on a specific vocabulary that defines their technical and behavioral approach to value creation. In this Q&A, Falcon’s Rob Huxtable details how the distinct language of private equity can impact sponsor-operator dynamics.

How important is it for portfolio company operators to speak a common language with their private equity sponsor?

There’s a unique and specific vernacular associated with private equity. Management teams who are conversant in the language and the nuanced meanings of the vocabulary are better poised to effectively communicate upstream to sponsors and also tend to possess a deeper understanding of the LBO framework.

Sponsors feel a certain sense of comfort when communicating with individuals who understand their pain points and objectives as investors. As a portfolio company operator, intimately understanding your bosses’ lexicon is invaluable.

The private equity vernacular is grouped into two buckets: technical concepts and leadership behaviors. Achieving fluency is a twofold challenge. The first is learning the terminology and gaining at least a baseline understanding of how the vocabulary is used. The second, which is more difficult, is gaining a deep understanding of the true context of a term and why it’s of the upmost importance to sponsors. It’s not enough for a management team to simply ‘understand’ the definition of a given term – executives must immerse themselves in the essence of why it matters.

From a technical perspective, what are a few examples of vital terms PE-backed management teams must comprehend?

There are many. We should begin with the two most important metrics LP investors use to measure sponsor performance: Multiple on Invested Capital (MOIC), sometimes referred to as Cash on Cash (COC), and Internal Rate of Return (IRR).

If an executive doesn’t understand the fundamentals of how these metrics work, there’s going to be a problem.

From a portfolio company standpoint, EBITDA is the most important financial measure for most funds, followed closely by the Compounded Annual Growth Rate (CAGR) for both revenue and EBITDA. Most assets (portfolio companies) trade in an EBITDA multiple range that is influenced by scale and growth rate.

Executives often understand the gist of these terms but don’t always appreciate their contextual importance or why they can be an emotional flashpoint for sponsors. 

For example, Debt to EBITDA is another common metric. At its baseline, it’s very simple. Yet savvy executives know that the evolution of a company’s Debt to EBITDA ratio over time reveals invaluable insights to potential cash flow pressures, banking relationship dynamics, as well as sponsor appetite for reinvestment.

Most executives understand that Leading an Exit refers to the process of selling the company to a financial or strategic buyer. What they may not understand is most private equity firms view it as an arduous journey equivalent to a second full-time job for the six or more months it will take to sell the company.

What behavioral leadership terms frequently come up when sponsors discuss preferred traits in management teams?

There are certain terms sponsors frequently use when describing standards for portfolio company leadership. Most of these may seem self-evident, but many LBO leaders fail to comprehend their true context and vital importance to value creation. 

No LBO trait is more important than a leader’s ability to drive the speed and volume of decision making in a high-pressure and ambiguous backdrop. An adjacent trait that fuels decision making is an extreme sense of urgency. Most first-time PE-backed leaders believe they operate in the fast lane only to be shocked by the autobahn that is private equity. LBO pace moves so fast it requires an executive to accept that making mistakes is part of the winning equation. In the words of George Patton, “a good plan violently executed now is better than a perfect plan next week.”

Sponsors commonly articulate their desire for hands-on executives who embrace a player-coach mentality – in other words, LBO leaders who can balance a white-collar brain and a blue-collar style of engagement. These traits indicate a bias for action critical to world-class execution. Leaders often think they operate in this fashion, yet sponsors hold a higher bar. For example, many CEOs struggle in an LBO environment because they don’t realize 70-90% of their time must be spent on “President-level” tasks that drive execution, with only 10-30% spent on traditional CEO-related objectives such as setting strategy.

While many factors play a role in a PE-backed executive’s success, an in-depth understanding of the crux of the private equity vernacular is paramount. Mastery of the language often only occurs once a leader has spent time inside an LBO. The faster an executive can come up the learning curve, the greater their chance of a successful, winning tenure.

Falcon provides C-suite talent solutions for middle-market private equity firms across North America. Follow us on LinkedIn.