top of page

Management Control Systems from a Private Equity Perspective

Private equity financing enables portfolio companies to experience significant growth, benefiting both the investor and the company through the value creation achieved. Private equity (PE) firms buy, improve, and sell businesses. But how exactly do they do this? During my study in the Executive Master of Finance & Control (EMFC) at TIAS Business School in 2023, I researched how private equity firms assess management control systems (MCS) when acquiring a company and how they influence these systems during the holding period. For this research, I interviewed 10 general partners and investment managers from PE firms.


In this blog, I will discuss how PE firms select targets and improve performance after acquisition. Before presenting the research results, it is important to briefly review the definition of private equity and how this model works.


What is Private Equity?

According to the Dutch Private Equity & Venture Capital Association (NVP), private equity refers to investments in non-listed companies. Private equity strictly includes both investments in young, fast-growing (technology) companies, also known as venture capital, and investments in mature companies, although the term is usually associated with investments in mature businesses.


A key characteristic of private equity is value creation, which results from executing a plan by the management on behalf of the investors. Investors analyze companies to evaluate their plans for development (or restructuring in specific cases) (Demaria, 2020). To execute this plan efficiently, the company benefits from being privately held. The common and defining feature of these investments is their long holding period—typically 3 to 7 years—during which the company remains in the hands of the private equity investor. This time is needed to execute the value creation plan (Demaria, 2020).


How Does the Private Equity Model Work?

A private equity firm creates an investment fund, from which investments are made in a company. The fund is composed of contributions from the private equity firm as the "general partner" and capital raised from "limited partners," primarily institutional investors such as pension funds and high-net-worth individuals. This capital is used to make multiple acquisitions (buyouts) of companies, under the leadership of the general partner.

These acquisitions often involve substantial debt financing in addition to the equity contributions from the general and limited partners. Debt financing primarily helps to leverage returns on the partners' equity through a multiplier effect when company performance improves (Ligterink, Martin, Boot, Cools, & Phalippou, 2017).


The use of a high degree of leverage (bank financing) provides strong incentives for equity providers to drive improvements in the company. Furthermore, leverage creates a sense of urgency within the company to implement improvements. Additionally, performance-related compensation structures are used both within the private equity investment fund and the acquired company. As a result, the level of involvement in the company is high. The general partner of the private equity fund also actively engages with the company (Ligterink, Martin, Boot, Cools, & Phalippou, 2017). The general partner is compensated through a management fee and a performance-related fee known as "carried interest."


After the acquisition, investors manage their equity stake, which can take on more active or passive forms, depending on the investor, the size of the company, and the size of the equity stake. Active investors also contribute to value creation, for instance, by influencing the composition of management, strategy, internationalization, professionalization, digitalization, acquisitions, divestitures, (debt) financing, financial management, reporting, and improvement areas identified in due diligence (Rietveld, 2022).


Who Were the Participants in the Research?

The participating PE firms exhibited a range of common characteristics:

  • Investment horizon of three to ten years.

  • Predominantly majority stakes in portfolio companies.

  • Alignment between management and shareholders.

  • Use of financial leverage.

  • Exit-oriented approach.

  • Thorough due diligence before acquisition.

  • Collaboration with M&A boutiques.


How Do PE Firms Select Target Companies?

Profitability is a critical factor when identifying potential targets. PE firms focus on companies that meet certain financial criteria, often based on EBITDA. Additionally, the management team plays a crucial role. PE firms generally prefer to work with the existing management if it is capable. The specific sector and the company’s market position are also essential considerations. The ideal target? A market leader in a niche market with clear growth potential.


How Is Performance Improved After Acquisition?

Once a company has been acquired, PE firms focus on value creation. This is often done through a detailed value creation plan, which outlines strategic objectives. These objectives may be identified during the due diligence phase but usually take more concrete form after the acquisition.


Some key steps in the value creation process include:

  • Professionalizing the organization, for example, by improving financial reporting or implementing new systems.

  • Additional acquisitions, often as part of a "buy-and-build" strategy.

  • Appointing financial professionals such as a CFO or controller to elevate the company's financial management.

  • Aligning interests with management, often through stock options or variable bonuses.

  • Implementing performance bonuses for employees below management level.


Moreover, PE firms emphasize the importance of measurable goals and regular updates on financial progress, ensuring that both the PE firm and the management stay aligned with the set objectives.


Sources:

  • Demaria, C. (2020). Introduction to Private Equity, Debt and Real Assets: From Venture Capital to LBO, Senior to Distressed Debt, Immaterial to Fixed Assets. Hoboken: John Wiley & Sons.

  • NVP. (2023). About Private Equity Firms. Retrieved from NVP: https://nvp.nl/over-participatiemaatschappijen/woordenlijst/

  • Ligterink, J., Martin, J., Boot, A., Cools, K., & Phalippou, L. (2017). Private Equity in the Netherlands: A Stakeholder Perspective. The Hague: Ministry of Finance.

  • Rietveld, T. (2022). Handbook on Investing & Financing. Amsterdam: Boom Uitgevers

  • Niezink, R. (2023). Evaluation and Influence of Management Control Systems by Private Equity Firms.

bottom of page