Private markets firms can be so focused on fundraising and investing that they overlook operational efficiency, which has the potential to reduce costs, make clients happier and even improve investment returns. A target operating model redresses this balance.

The private equity industry is guilty of its own irony. Successful firms are excellent at raising money; they often do extremely well at investing money in improving the operations of their portfolio companies, but some of these firms do not devote enough attention to improving their own operations. This can also be the case for other private markets firms, such as private debt or infrastructure investors.

Why general partners may underplay operational excellence

We see this happening for a number of reasons:

  • Management style and structure. Private markets firms are usually partnerships. That means they are run in a consensual way. Consensus-building has its virtues; it reduces rash investment decisions, for example. However, consensual decision-making can mean slow decision-making – particularly when the decision is about internal operations. That is because this is often not a priority for the partners who control the business. They usually come from either an investment or a fundraising background, so they sometimes overlook the importance of operations.
  • Operations as a background. Partners can assume that the operations side of the business will run like clockwork, without anyone senior having to pay much attention to it. This reflects their backgrounds – few come with operational expertise. The posts of chief operating officer and chief technology officer are relatively new in the private markets industry. Even where these posts do exist, such people may not be partners, who can speak up for operational issues at partner meetings.
  • Not keeping up with the times. Partners may be right in thinking that the operational side of the business can take care of itself – but right only about the firm as it was in the past. Private equity firms used to be able to run even their portfolio monitoring on Excel. These days, the rise of big data and the expansion of many firms into new markets and sectors makes this harder. The cost of not thinking about what good systems can do is much greater now that good systems can do more – and need to do more.

Why improve operations?

There are several compelling arguments for improving operational capability. Most importantly:

  • Limited partners – present and prospective – are more demanding. They are increasingly prone to ask highly specific, data-heavy questions, rather than passively waiting for the fund manager to produce standardized handouts for every investor. These questions are much harder to answer if operations are inefficient.
  • Regulators are more demanding. An example is the European Commission’s Sustainable Finance Disclosure Regulations. These rules, applicable since March 2021, require fund groups to provide information about the ESG risks in their portfolios for the first time.
  • Firms are under fee pressure. For this reason, they have to make their operations more efficient, to reduce costs and preserve margins. Failing to invest time or money into internal operations is a false economy.

A target operating model, or TOM, is a good solution to operational inefficiency.

What is a TOM?

A TOM starts with a firm’s vision for its business. It then looks at the operational setup needed to achieve that vision. Next, the firm compares this with current operations, to work out what needs to change and how.

For example, a $50 billion syndicated loans investor might have a vision to provide returns and customer service above what rivals offer – and at competitive fees. However, under its actual model, rather than its target model, this is far from the case. The investment professionals have chosen front and middle-office tools that are ideal for a syndicated loan investment manager, but do not connect seamlessly with the back-office systems chosen by the chief technology officer. A target operating model looks at how to create a more integrated set of systems, which would allow information to flow without friction between the investment professionals, limited partners and back office.

Why a TOM?

A TOM can provide the following benefits:

  • Lower cost. Implementing a TOM will probably require up-front technology costs, but over time these will be a fraction of the accumulated annual costs of inefficiency. Consider a moderately large private equity firm where systems do not marry up, allowing information to be passed automatically rather than manually between the fund accounting, investor reporting and deal teams. That might mean that at the end of each quarter, five people spend three days each in gathering, checking and collating the data. That could add up to 15 days’ worth of time – or a combined annual expense in remuneration and opportunity cost of perhaps $600,000. Alternatively, a TOM may be a catalyst for deciding to move some operations out of house, realizing cost savings from both lower annual costs and lower capital investment in IT.
  • Better investor relations. Long-term cost savings allow private markets firms to keep down fees to investors. Operational efficiency also makes it easier to respond to investor questions efficiently and comprehensively. TOMs will be particularly helpful for general partners with a new demand from investors (as well as regulators): better environmental, social and governance (ESG) information. Most private markets firms have not incorporated this relatively new investor priority very well into the way they do business.
  • Higher returns. Firms that build a TOM to make their use of data better should have better statistical information on current portfolio companies. This goes for past portfolio businesses – allowing them to analyze which investments tend to produce a higher return. They can make future investment decisions in the light of this information.

Conclusion: A TOM is a competitive tool

We do not mean to suggest the private markets industry is bereft of firms that manage their operations well. In many cases, each part of the business is managed very well, given the circumstance it finds itself in. However, because of the lack of a target operating model that takes a holistic view of the ideal future and the reality of the present, the firm’s operational effectiveness is less than the sum of its parts. In other cases, there are firms embracing TOMs and bringing operational and technology expertise into their business, as the industry matures. This is particularly the case, for example, for firms passing to a new generation of leaders, who want fresh thinking about how to conduct business.

But if some firms are already using a target operating model, this is all the more reason for those firms that have not yet adopted one to start doing so – before their competitors gain a greater edge in a competitive market.

Travis Broad
Executive Director, Private Markets UK and Europe
Giles Travers
Executive Director, Private Markets - Europe

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