Upgrading Operating Partners to First-Class Citizens

Market forces have put pressure on private equity firms to grow their businesses significantly to achieve target returns. “Private equity firms have to create real value, not just bet on interest rates being low,” says Zorian Rotenberg, an operating partner at Charlesbank Capital Partners. “Top-performing PE firms know how to create real value to generate superior risk-adjusted returns.”

Private equity firms used to have external advisors who helped them run the companies they acquire. Most experts say that model is outdated and dedicated operating partners are necessary. Some firms now employ full-time operating partners, while others hire contract workers who report payments on a 1099 tax form. Some large firms have separate subsidiaries where they house their operating partners. Across these arrangements, a multitude of models and compensation structures has emerged. Headhunters say there is no “one size fits all” approach. Instead, PE firms employ different methods based on what they need and can afford.

“We’re seeing less of the consulting approach,” says Laurie Canepa, managing director at executive search firm StevenDouglas, who adds that operating partners tend to fill a variety of roles depending on the firm. Some help find portfolio companies to buy, while others occupy a temporary C-suite role to help “stand the company up” in the first few months post-acquisition. Still others are deployed as functional experts across portfolio companies.

The Evolution of the Operating Partner Role

Headhunters say the operating partner role has gone through several iterations since the beginning years of the private equity industry in the 1980s. At that time, most firms had senior advisors who were typically retired C-suite executives from major corporations, says John Rubinetti, partner at Heidrick & Struggles. Eventually, some of the larger firms began bringing advisors on staff who typically had consulting backgrounds and were often younger than the retired advisors.

Now, in the second, third or fourth iteration of the operating partner role, most firms have dedicated on-staff operating partners who are involved in the latter stage of diligence and come in with a value-creation and execution plan for the portfolio company. Many are also functional experts in areas like finance, IT, human capital, go-to-market/sales and supply chain/procurement, Rubinetti says. He estimates that the trend of hiring dedicated operating partners began about 10-12 years ago and ramped up in the past five.

“The old model was that a handful of former CEOs or CFOs who were semiretired would help out on a part-time project basis as needed,” says Bill Matthews, partner at executive search firm BraddockMatthewsBarrett. “Over time it has evolved into a recognized function as the need for specialization grew.”

Charlesbank’s Rotenberg recalls talking to LPs at a recent private equity conference who said  limited partners today are looking for full-time operating partners, not just “curated lists of advisors.” Investors want to see operating partners who are fully committed to the PE firm and have unique expertise to tangibly impact portfolio companies, where they lose sleep over the same issues and are focused on the same priorities. The LPs at that conference mentioned that they want operating partners to pass the so-call “the shower test,” meaning that they think about their job and priorities every day in the shower.

The old model was that a handful of former CEOs or CFOs who were semiretired would help out on a part-time project basis as needed. Over time it has evolved into a recognized function as the need for specialization grew.

Bill Matthews

BraddockMatthewsBarrett

Experts credit some large firms like Bain Capital, KKR and Vista Equity Partners on being ahead of the curve in building dedicated operating partner benches.

Olivia Howard, a partner in the Portfolio Group at Bain Capital, says her firm has been focused on partnering with management teams with an eye toward organic growth since its launch in 1984, when the firm spun out of consulting firm Bain & Co. “Our approach has always been about improving companies through operating performance, not financial engineering,” Howard says.

Since the firm’s founding, Bain Capital has dedicated resources to working closely with management teams in driving strategic and operational performance. The firm’s Portfolio Group, which split operating responsibilities from deal teams in the 1990s, has evolved to include functional specialists. Bain Capital also leverages management consulting firms and other third-party resources for advice, and to help diagnose problems at portfolio companies and come up with solutions, Howard says. “We want to always be learning about what works and what doesn’t from a wide variety of sources.”

Employment Structures

Korn Ferry’s Auzerais says that the “independent contractor” model for operating partners has been popular among private equity firms and still is in some places. These types of advisors are often hired on a project basis and report income using a 1099 form. Usually they aren’t exclusive with the private equity firm or portfolio company.

In the last five years, Auzerais says he’s seen that model recede in favor of full-time staff positions, where operating partners are paid a base salary and bonus with some type of equity participation in the PE management company, at the portfolio companies they work with or both.

“From a candidate’s perspective, most prefer to be an employee rather than a contract worker. There is symbolic value in that,” says Matthews. “But there are a lot of good firms that make the 1099 thing work.”

Some larger firms have affiliates where they house operating partners or other consultants. For example, Lone Star Funds, Vista Equity Partners and KKR have affiliates called Hudson Advisors, the Vista Value Creation Team and Capstone, respectively.

The slow exit environment and market headwinds make it costlier to hire more operating partners, and some firms juggle the cost-benefit analysis by cutting corners. Operating partners who are hired as contract workers on a 1099, for example, tend not to have benefits or paid time off. StevenDouglas’ Canepa says the lack of exclusivity in these arrangements raises issues with confidentiality, especially since private equity firms like to keep their strategies close to the vest.

Compensation structures can vary widely. In two recent operating partner searches for similarly sized firms, Canepa saw very different offers. One had a $200,000 base salary, a $100,000 bonus and a small equity component. The other offer included a $325,000 base salary, a $150,000 bonus and equity participation in multiple portfolio companies.

Heidrick & Struggles’ Rubinetti says some compensation structures are heavier on equity stakes and profit sharing on exit, while others have larger base salaries and bonuses. His firm’s Operating Professional Compensation Survey this year shows that most respondents are seeing base salaries increase while bonuses decrease. The sources of cash compensation for operating partners are primarily fund management fees, portfolio company oversight fees and time billed directly to portfolio companies. The breakdown of where compensation comes from has remained relatively unchanged compared to prior years, according to the survey, with 49% of respondents getting paid solely from fund management fees, 14% solely from time billed to portfolio companies, and another 14% from portfolio company oversight fees and time billed directly to companies.

Canepa points out that some firms are very intentional and specific about how they structure equity plans for their employees, so as not to overly dilute the value of that equity. The affiliate structure sometimes allows firms to avoid paying equity shares to operating partners housed within the subsidiary, experts say. In some cases, firms will give operating partners equity but don’t put it in the offer letter up front.

Operating Partner Hiring Trends 

Headhunters say they’re seeing more functional specialization in the operating partner benches at private equity firms. Some are experienced in human capital, for example, while others might specialize in finance, transformation, commercial excellence or supply chain. “The big trend today is operating partners in AI and technology applications, where they can streamline data and analytics,” Auzerais says.

“Firms have become more specialized, where they compartmentalize their approach. They have dedicated business development teams, deal teams, operations teams,” Rubinetti adds. “Private equity 3.0 involves very specialized operations. You have to adapt to survive.”

“More firms are moving toward functional expertise and going narrow on specialization, whether it’s AI, talent, go-to-market or something else,” says Erin Carroll, partner at BraddockMatthewsBarrett. She notes that her firm’s clients have been hiring more people at junior- or mid-level experience, some of whom have a few years of consulting under their belt, in addition to seasoned former executives.

Private credit and special situations firms are also starting to add to their operations teams as restructuring and turnarounds become more prevalent, according to Rubinetti and Auzerais. Private equity firms that are more “deep value in nature” are actively seeking out operating partners, where they might be dealing with broken capital structures and need to transform businesses, Auzerais says.

The popularity of operating partners in recent years stems in part from the slow pace of exits and longer holding times. Those, in turn, require operating improvements over a lengthier period. Asked whether the trend would reverse once interest rates go down and financial engineering becomes easier, Howard says she expects this to be a lasting need: “Our experience over the long term is that you have to grow businesses in a sustainable way to achieve top-decile returns.”

Anastasia Donde is Middle Market Growth’s senior editor.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.