317. Strategic re-underwriting in private equity

0:01Jason Phillips: My general assumption is that many of the insights from our diligence are stale by the time they close the transaction. So yes, absolutely, it is worth revisiting those assumptions.

0:13Manuel Fernandez Angulo: From McKinsey & Company, I'm Sean Brown and welcome to Inside the Strategy Room. That was Jason Phillips recalling a conversation he had with a client that sparked the research effort behind the recent McKinsey.com article he and his colleagues published titled Unlocking Full Potential, Five Practices Reshaping P.E. Value Creation. So in today's episode, we discuss how leading firms are using systematic re-underwriting in a new reality of longer hold times, evolving investment theses, and fundraising friction. Jason is a senior partner in our New York office and global leader of Portfolio Company Alpha, which helps P.E.

0:52Manuel Fernandez Angulo: owned portfolio companies transform their performance. Adi Bhatia is a senior partner in our New Jersey office, leader of our transformation client service across the private capital and consumer retail sectors. Hasedin Ahmed is a partner in our New York office and a leader in our transformation and private capital practices. And Manu Fernandez Angulo is an associate partner in our Madrid office and co-leads our private capital practice in Iberia. They are all guests on our episode today. So Jason, let's begin with you. What was the genesis of this concept of strategic re-underwriting and why is it so important in this particular moment?

1:30Manuel Fernandez Angulo: That's a great question, Sean.

1:32Jason Phillips: It actually goes back to a conversation that I was having with a client about a year ago when we were discussing the durability of insights from an initial commercial due diligence going into a hold period. and we were discussing the notion of whether or not those insights are still relevant mid-hold. And his comment, I remember vividly, which is, my general assumption is that many of the insights from our diligence are stale by the time they close the transaction. So yes, absolutely, it is worth revisiting those assumptions to understand how the market has changed, what disruptions there have been, any movement around the likely buyers.

2:15Jason Phillips: because, again, thinking about the exit from the point of entry is critical to driving desired returns. And that led to a broader discussion that evolved into a number of interviews that we had with over 20 recognizable private equity firms ranging from lower mid-market to megafunds, as well as CEOs of over 100 portfolio companies. So the insights that we're going to discuss today reflect those interviews, various surveys, conversations with clients of all sizes, and just the thinking about how to ensure that you have fresh insights through the hold period and the value creation isn't just a one-time thing that's focused at the beginning of your hold, but it comes a repetitive motion throughout the hold cycle through to your exit.

3:06Manuel Fernandez Angulo: Now, maybe you could talk us through some of the high-level themes that came out of the research and And what are we seeing in the current environment?

3:13Jason Phillips: When we think about the notion about capturing alpha is a continuous journey over the life cycle of the deal, there are three factors that stand out for us. The first is the reality of the hold period. The second, as I mentioned earlier, is the evolution of the investment thesis. And the third is expectations and pressures from LPs. So we talk about the hold period reality. what we've seen is that exit velocity is down by about a third from where it's been historically. You know, we would have seen 30 % of investments being exited within four years. If we look at investments that are from the 2021 vintage, only 19 % of those, less than 20 % have been exited by 2025.

3:55Jason Phillips: What that means is that today there are 16 ,000 portfolio companies that have been held four plus years. So there's a huge backlog of businesses that we would have expected to have transacted by now in the marketplace. The other thing that we've seen is that there is pretty dynamic evolution in terms of the investment thesis, because the market is arguably more dynamic than it's ever been. And if we go back to the interviews that we were having, we were hearing consistent feedback that there were probably three or more thesis-relevant changes that are taking place for any individual asset in the portfolio.

4:34Jason Phillips: And often those insights and changes are not being surfaced through the typical rhythm of quarterly interactions that you're having between management and the board. So is there an opportunity to go deeper and what would that look like and how could you leverage that for value creation? Those are all relevant questions. The third point around LP alignment is that LPs are frustrated. It's like the low DPI that they've been seeing is impacting fundraising and creating friction because it's hard to justify to your CIO additional investments in a new fund when you still haven't realized any returns from two funds previous.

5:11Jason Phillips: And what we're seeing that from a metrics perspective is that DPI today is about 6%. And historically, if you look from 2015 to 2024, that average is about 14%. So there's a lot of frustration and expectation mismanagement that needs to be addressed over the course of driving alpha in these investments.

5:33Manuel Fernandez Angulo: Thank you, Jason. And to explain DPI for our listeners, not in private equity, DPI stands for distributed to paid in capital. It's the actual cash a fund has returned to its investors or limited partners relative to the money that they put in. So now would be great if you could talk us through to what extent we expect good deal partners to already be looking at these things as a matter of course, regardless of any shifts in the environment.

6:01Jason Phillips: That's a fabulous question. And I think it goes to the notion of what is the highest and best use of a deal partner's time and energy. Certainly maintaining closeness to the assets and ownership of the performance of the asset end to end resides squarely with the deal partner. It's like that is almost an immutable truth in private equity or private capital more broadly. The reality of it is that if you look at the primary focus, which is identifying new investments, building relationships, negotiating those transactions, bringing more deals into the portfolio, deploying capital, you need to look beyond that deal partner to think about what is the right collaborative effort to ensure that the company is delivering on the investment thesis, management is getting the necessary support.

6:53Jason Phillips: and there's enough attention being focused on the surrounding environment to make sure that decisions are optimized. So I think a good deal partner recognizes that this is a collaborative team effort and bringing more people and more talent to the table, more structure and more process is only going to increase the likelihood of a strong exit.

7:15Manuel Fernandez Angulo: Sounds great, Jason. Thanks. And AD, any thoughts you'd like to add to build on that? Well, Sean, just the

7:22Hassen Ahmed: but just the facts of it as we talk to people and ask to what extent how many of these firms actually have a structured approach to the discipline that jason's talking about what they're telling us is that the majority of them do not and so while yes it absolutely is a part of being a good deal partner and a good steward of resources just the reality of where they are spending their time where they need to spend their time it is not as much on the type of activity that we're going to talk about today as it could be, and as it is in some places.

7:53Manuel Fernandez Angulo: Thanks, AD. And Jason, now let's talk a little bit more about what this process actually looks like in practice. Does it simply involve more frequent analyses?

8:03Jason Phillips: As AD was saying, most firms were not set up to do this in a structured way. So the firms that are navigating this most effectively are thinking about how can you build a process that's exhaustive without being exhausting. So it's how do you think about integrating the second look into your operating rhythm as an investment firm? And the goal is not about more analysis. It's about how do you focus on the most critical questions, assess them earlier, and think about the implications it has not only for operational value creation, but also for exit. So how those firms that have built processes have structured those processes, staffed those processes, and deployed those processes across the portfolio.

8:49Got it.

8:50Manuel Fernandez Angulo: And how do firms navigate the potential additional costs and efforts associated with doing this?

8:56Jason Phillips: i think the multiple effect is one factor that needs to be taken into account which is if i invest in this effort to effectively re-underwrite and make a decision of you know how i should adapt for the remainder of my whole any incremental value that you capture from that exercise is going to have your exit multiple applied to it so while the cost is kind of fixed going out you know the benefit on the exit is, you know, add a multiple and potentially a greater multiple if you find a way to unlock increased growth or performance. I think that's one consideration. But there's also a structural issue.

9:33Jason Phillips: And when you look at the way that firms are set up, you know, the diligence expenses are typically borne by the fund. And then everything going forward is supported by the company, its performance. If you look at doing a traditional re-underwriting where you bring in advisor to do it, it's a bit of a hot potato in terms of whose responsibility it is to pay for this work. So one of the ways that we've done this that I think speaks to the accretive value in doing this is not only thinking about how has the market evolved, which is essentially creating a preview of what your exit diligence or VDD would be, but also think about what are one or two or three additional levers that we can exercise mid-cycle that can drive incremental value creation.

10:22Jason Phillips: So in many cases, if it's not simply the exercise about doing the diligence, but understanding what more can we do in our value creation plan 2.0, it's like with an eye toward exit, there's definite value to be captured if you are showing up when you're ready to sell, not only with ideas of what you can do to drive the next wave of growth, but you've actually got points on the board already where it's like these are the things we identified 18 months ago to drive the next wave of growth. Here's our progress against our plan. This is what you can assume going forward and comfortably underwrite as the next owner.

11:00Jason Phillips: So there's a lot of value that can be unlocked beyond that initial value creation plan, and that's what makes this process particularly exciting.

11:08AD Bhatia: And maybe, Sean, just adding to Jason, And one thing I'd say, what we've seen recently in this research, AI has been a force multiplier and accelerator to this process. And what used to take weeks before now takes days. And therefore, you know, the cost of doing that exercise and the speed of doing that exercise has fundamentally shifted and changed in the past months. So that also helped a lot. And in some of the research we've done, some of the most compelling cases came from mid and lower mid cap funds rather than the larger funds when how they leverage AI to this process.

11:44Manuel Fernandez Angulo: Thank you both. And so this would make it more accessible for all kinds of funds. And maybe, Jason, you can share an example of a fund that has successfully taken a second look at their portfolio and what that looked like in terms of approach and impact. Great.

12:00Jason Phillips: Yeah, let's take a look at one example. So this is a European fund, again, a brand name, but not a mega cap fund. It's kind of a mid market firm that decided to take a very focused look at how to manage mid cycle re underwriting. and this is a fund that historically kind of capped out at five to six exit per year. They were able to drive 10 exits as their new baseline and that's on a portfolio of about 50 companies. So a meaningful size portfolio, but this emphasis led to a reduction in the number of companies in the portfolio from the 50s down to the 40s and the benefit of that is that you've got fewer companies in the portfolio demanding the attention of the investors of the operating partners, as you mentioned earlier, freeing up time and energy to focus on new transactions, new deals, but also on getting successful value creation launches for those companies that are coming into the portfolio.

13:01Jason Phillips: From a DPI perspective and a return to investors, they were able to return over 30 % of their AUM in that period, which amounted to about$2 billion in 12 to 15 months. So a very material shift in trajectory that also enabled more compelling conversations with LPs about bringing money into new funds that they're raising capital for right now. And the last point that resonated is that going through this process across all the relevant assets in the portfolio led to exits that did not require heavy sell side processes. They had a much better understanding of the buyer universe. They were clear on what the value proposition was.

13:46Jason Phillips: They knew what messages to bring to market and were able to have very focused, concise approaches that minimize drag and friction on the management team, on the firm, and ultimately optimize the exit valuation. So it's, you know, it's, you know, end of one in terms of this particular example, but pretty compelling if you look across all of the metrics of success, in our opinion.

14:12Manuel Fernandez Angulo: Thanks, Jason. In your experience with clients, what are some of the more common value creation assumptions that might have been overlooked in the original deal phase that maybe then surface in the rediligence? Are there any specific things that tend to pop up?

14:27Jason Phillips: Well, I'll start with one that Hassan alluded to on earlier in the conversation, and that's AI. I mean, realistically, it has changed the game for almost everybody. And not only having at this point, firms understand whether this poses an existential risk or not to the business. there's another issue where they've concluded it doesn't pose an existential risk but investors might not appreciate the fact that it doesn't and that's leading to a lot of these you know assets that you know theoretically should have received the warm welcome in in the market for a sale where they're just holding back and waiting for the story to flesh itself out more and then there also is an expectation on the ai front that you are doing things that demonstrate you understand the opportunity.

15:17Jason Phillips: You know how to mobilize against it. And importantly, you're actually capturing value from it. So while there's been a lot of noise in the market that nobody's capturing value from AI, that's actually not true. There are many portfolio companies that are capturing value. It's not about massively reducing workforce. It's about accelerating sales. You can process this more efficiently and self-funding growth. So that would be one point, but I'd love to open it up to my colleagues to see what their thoughts are as well.

15:48AD Bhatia: One thing I just, I think when I people with my clients, some of the pieces was built in the 21s, and this was the vintage that Jason was alluding to, and the market assumption have changed there in a K-shaped manner where certain portfolio companies, it's become a fundamental headwind and revisiting the value creation thesis with the new market reality has had a fundamental impact on the asset. Others has been a fundamental upside for them. And therefore, looking at the market assumption, the impact on the asset was one of the biggest things we've seen in the writing.

16:25Hassen Ahmed: Ijan, I think it's a combo of macro and micro factors. We've talked about some macro things. There's also geopolitical fragility that's had all kinds of impact over the last few years. And then micro and specific to the company, I think about some of the consumer retail portfolio companies I work with, consumer CPG that loses a major customer gets delisted. Private label competition emerges that didn't exist in the past. That's of much higher quality now. You could imagine a bunch of things on the retail side. So it could be macro. It could be very specific to that individual company. You could choose to take that as sort of business as usual.

17:02Hassen Ahmed: We deal with these bumps and we move on. In some cases, that's underestimating the impact that that particular shift is actually going to have.

17:09Manuel Fernandez Angulo: Thank you both. Manu, anything you'd like to add?

17:13AD Bhatia: Yeah, one last comment I was going to make is that also during the research, some of the funds, they were telling us that this was a way for them to really extract the market momentum from the management performance. So in reality, when you look at the portfolio, it's all together. So only once you run these type of exercises, you are really able to extract all of the things that we were talking about. What is tailwinds, what is headwinds versus what is actually management performance and how the company is performing.

17:37Manuel Fernandez Angulo: Thanks, Manu. And AD, now let's turn to re-underwriting and what it really looks like in practice. How do you do it?

17:46Hassen Ahmed: Sounds good. So moving from concept to practice, in talking to private equity leaders and portfolio company management teams that had gone through this sort of thing, we split this conversation across three aspects. The what, the when, and the who. The what is a set of choices about the substance of the re-underwriting. So that's things like how expansive is it? What's the breadth of the effort? How detailed is it? What's the depth of the effort? Is it explicitly tied to exit? So you're working backwards from what a buyer might scrutinize. Does it go beyond financials? So is it more realistic in the sense of assessing leadership and talent and culture and the implications of that on performance?

18:25Hassen Ahmed: So as you think about those, you can imagine the amount of effort that's involved spans a pretty broad range. And so it needs to be fit for purpose. it needs to be a high ROI use of the time of the people that are involved. It also means being intentional about when in the investment lifecycle you do this and how frequently you do it. So again, on that dimension, a few different options emerged. There are firms that will have an annual or periodic assessment for all of the assets in the portfolio, sort of an annual maintenance, oil change, that kind of thing. There are some that are oriented around fixed milestones.

19:01Hassen Ahmed: So we do this X years in, we do this Y months prior to exit, we do this upon completion of a platform build or acquisition X, that sort of thing. And then some are triggered by specific and typically highly disruptive events. So all the sorts of things we just talked about a couple of minutes ago, when that happens, that'll trigger this re-underwriting effort. So that's the what, that's the when and then the who. There are several stakeholders involved in actually conducting this re-underwriting. It's actually a growing set of stakeholders. We've seen in our other research that the size of operating groups in private equity has doubled over the last few years.

19:43Hassen Ahmed: So there are more people that are involved in that have a role in this sort of process. And then there's more complexity. As Jason said, longer hold periods have led to portfolios that are simply larger. There are more companies across which to think about this sort of thing. So this dimension, the who can actually be the trickiest of all three of these.

20:03Manuel Fernandez Angulo: I can't help but wonder, how do you get the deal partner to actually align on this and to engage with a process that might actually reveal that the original deal thesis is now very different?

20:15Hassen Ahmed: Look, let's not be naive about it. That is the reality. That is attention. There's no getting around that, right? You've made a claim, you've staked your credibility at times on the investment, not at times, always on the investment. And it can be hard on multiple fronts to do a piece of work that comes back and says, hey, the thesis has changed, the value creation potential has changed, the amount of time that we need to have this company in our portfolio has changed. um so you know a few things that we have seen one at a firm level establishing that this is simply a thing that will be done consistently across every deal and for every deal partner so it's not an indictment of the specific deal it's not an indictment of the specific deal partner it is simply a good practice for us to do and that could be the periodic archetype I talked about.

21:09Hassen Ahmed: It could be the milestone-based. A firm that we talked to said, it is now simply our practice that three years into an investment, we will conduct this exercise. There's another firm that said, tied to exit, but not just from a timing perspective, they actually established, they called it an exit squad. But it's a practice of doing this X months before exit, which I also say in quotes, right? It's hard to predict exactly when an exit is going to happen. But when that starts to appear on the horizon, there is a set of folks that is actually going to take responsibility for doing this. And the firm embraces that that group by design is meant to create some constructive tension with the deal partner.

21:53Hassen Ahmed: By the way, that also then leads to something Jason said earlier, which is the amount of effort that's involved in the sell-side process down the road actually changes quite meaningfully because you've done this. So I offer up a couple of things there, but again, I come back to we don't want to be naive or Pollyanna-ish about this. There is that tension. That tension will continue to exist. And the deal partners will obviously retain accountability for the deal and the investment. But there are some of these practices and there's some of the roles that the investment committees can play in making this a bit more the norm.

22:24Manuel Fernandez Angulo: Sure. And just continuing on the how, A.D., I imagine this is going to look different depending on the deal, the asset, the proximity to exit, and so on. Is that right? So the reality is that this is not yet a common process.

22:40Hassen Ahmed: Just to be clear, it's not common. And when it does happen, there isn't a ton of consistency across the board. So we're not suggesting that. But we did start to see three archetypes start to emerge through the haze. and these archetypes are about the what is being done and when is it being done so kind of combinations of those two things the first is a lighter touch sort of diligence refresh you know this is applied to companies that are generally on track to the original thesis this is done periodically it can look like a check-in on the 10 to 15 metrics and kpis that are most critical to the business's health to sort of place this in context it is more intensive than a monthly or quarterly operating review.

23:21Hassen Ahmed: So that's the first. The second archetype is what we call the buyer backward audit. So this is for assets that do have a potential exit appearing on the horizon, and it's focused on the elements that a potential buyer would likely look at, which will go beyond the day-to-day performance of the business, the broader market context, the competitive situation, for example. It's sort of a VDD before the VDD, and it can guide the value creation efforts that take place in the home stretch of the investment's life cycle. And then the third archetype is a clean sheet re-underwriting, or what we sometimes call a full potential assessment.

23:58Hassen Ahmed: This is similar to the sort of ECP that would potentially be done when an investment is first made. So where significant changes in context have led to a real shift in the value creation efforts, in the equity narrative, in the exit story, so much so that it merits a more fulsome re-underwriting. So there's clearly a trade-off between the timing of the frequency of doing this and then the depth at which you do it. So there's a role for each of these types, but it does require being clear-eyed about which one is most appropriate.

24:31Manuel Fernandez Angulo: And are these hard and fast archetypes? And how difficult is it to differentiate and determine which one best applies to a given portfolio company? There are a number of companies in portfolios today that are not troubled enough where they

24:47Hassen Ahmed: obviously fall into the third bucket. They're sort of idling along, they're doing fine, but they don't have a clear path to exit at a return that would suffice. And so, you know, those might end up getting put into the first bucket, especially in a world where a deal partner is going to have a bias towards optimism. So they might end up in the first bucket quite frequently, where I'd say, I think we'd say, more of those actually need the treatment in the second bucket or even the third bucket. And so a clinical assessment of what is the true momentum of the business and what could its actual full potential be between now and a presumed exit.

25:31Jason Phillips: And that, if I can build on AD's point there from another conversation I was having with the operating group leader of a client, And his concern was that everybody storms the beach during the value creation plan. There's a meaningful uplift in performance. And he said quite candidly, he's like, my concern is that by the end of year two, getting into year three, we've plateaued. And that's just kind of it. And you're like, okay, this feels like it's okay. I'm going to shift my focus to the next deal and try to focus on deploying capital, bringing new investments into the portfolio. So just be more thoughtful about how do you make value creation or process that occurs over time versus a one and done at the beginning of the hold.

26:23Jason Phillips: I think it's a mindset shift that enables a lot of the structural changes that AD was talking to. And I think that's a good reflection conversation for firms to have, because if they look at value creation as a one-time thing, as opposed to an all-of-a-time thing, to quote Vince Lombardi, that leads to very different outcomes.

26:46Manuel Fernandez Angulo: I would imagine it would. So I'm now interested in touching on how the funds that are doing this are also communicating the benefits of this activity to their LPs. Jason, maybe you could take us through that.

27:01Jason Phillips: So I'll take a crack at opening on that, but then we'll be interested in what my colleagues have to share. There's long been a tension of how engaged slash interventionist private equity investors should be because so many of them open with the statement of, you know, we're not operators. Like, yes, you're not operators, but you have been active investors for decades and you have pattern recognition. You actually understand a lot of what can be done here. I think across the LP universe, there has been an embrace of the idea that active value creation is going to be essential for realizing alpha in investments.

27:44Jason Phillips: And from our surveys of LPs, what we've learned is that when you can go down to an additional level of granularity beyond saying we have an operating group, they help the company's management teams realize value and say, here are the structured processes we've put in place. Let me talk to you about some of the impact that it's had in individual situations. I think a typical LP is going to be comforted by the fact that you're not just presenting this as window dressing, but you're actually going into depth about how you partner with the management team, with your operating group, with outside advisors to continue driving the performance of those businesses.

28:26Jason Phillips: So I think it's just giving them comfort that the firm has realized that they just can't bank on low interest rates, tuck in acquisitions, multiple arbitrage and multiple expansion to drive returns. I think we are all at a place where we understand that that model no longer works. So creating conviction and appreciation amongst the LP base that what you're doing is different from what they've seen in the past and is driving incremental value and performance is a very compelling conversation to have. I'll open it up to my colleagues.

29:00Hassen Ahmed: Yeah, just to pile on, Sean, we've talked to LPs. We have an LP survey. We've asked them, what is most important to you when you think about manager selection? and you know over the years you've seen value creation operational value creation ability move up that list i think in the most recent version it was top two maybe a top three factor which by the way on one hand you could say that sounds intuitive on the other you think about the world of factors that investors have typically been assessed on it's a whole bunch of things outside of value creation and investment selection etc um so lps are telling us and they're telling these firms that your ability to drive value creation is increasingly important as we think about where to put our money.

29:43Hassen Ahmed: And as you think about how firms can demonstrate that, you could talk about building up an operating team. You could talk about the hires that you're making. That's a part of it. There's a part of it that's what we're talking about here, which is actually having a structured approach that you can point to. And then over time, results that have come from that structured approach. As an aside, we are seeing more firms actually collect and cultivate the results of their value creation efforts and include those more explicitly in conversations with LPs. But anyway, for the purpose of today, it's that second part, using this as a way to substantiate something that LPs are increasingly looking for.

30:24AD Bhatia: Let me compliment with two comments that we heard from the interviews, from the fans that I think are relevant. So the first would be that one way to convince that some of the fans were telling us that they used to convince the LPs to run this process and have an established process, is that when you say by mandate that you have this structure, this framework, the portfolio management and everybody feels more open about it. So it's not like you are being tested. It's not like you have an exam, but it's actually something that every single portfolio is going to pass through at the year three, which is going to help you open a lot of doors without being painful, saying this way.

30:56AD Bhatia: The second one is also other fans that were telling us that when you talk about exit readiness, is not just about preparing the financials and running some KPIs, but it's also about thinking about where are the synergies, where are the lines of growth that you're going to push on the next 15 months, 18 months, and which are the ones that you're going to let for the next one. So that reflection, when you have this structurally, it actually helps you gain momentum and to really focus on those synergies that are going to have value for you when you do the selling. So this is part of reasons and ways that we have heard from GPs, how they convince LPs.

31:31Great.

31:31Manuel Fernandez Angulo: And so AD, you've talked about the three archetypes of approaches to re-underwriting. Who's deciding whether the asset is on track? Or we're 12 months pre-exit, or there's a major disruption or performance issue. How is this archetype approach typically being selected or determined?

31:50Hassen Ahmed: So there are several stakeholders that get involved here. To share a little bit from the research that we did, when a strategic re-underwriting effort takes place, deal partners are involved nearly all the time, as you might expect and as is appropriate. Operating partners and their teams are involved about two-thirds of the time. And of course, not every firm has a full operating team, and so that influences that a little bit, but about two thirds of the time, the operating group is involved as well. The investment committee is involved in the process about a third of the time, which is actually quite interesting.

32:25Hassen Ahmed: You might think, well, why wouldn't they be involved 100 % of the time? And so I think that, again, speaks a little bit to the fact that this isn't something that is consistently done and applied. It is emerging sometimes in ad hoc fashion. And then a small percentage of respondents in single digit percentages said they have people actually dedicated to exit assessments, It's a sort of exit function, if you will. So when you think about these stakeholders and the baggage that they bring to the party, just to be a little blunt about it, for a deal partner, as we've talked about, there's a tension here.

33:00Hassen Ahmed: There's a tendency to give the benefit of the doubt to the portfolio company and its performance, whether that's justified or because it's simply hard to acknowledge that a deal might be off the original track. for an operating partner who's trying to deliver impact while being spread across multiple portfolio companies, taking the time to lead a potentially multi-week re-underwriting process, they might laugh or cry if you were to suggest this to them. We've done a lot of research, we've talked to a lot of operating partners, Jason has in particular, and the question of how to have sufficient impact when you might be spending 10 or 15 % of your time with a company is very real.

33:39Hassen Ahmed: And this would just make that even more complex, would exacerbate it. As we talked about a few minutes ago, there are some practices that can help here, right? The team that's focused on exit, the establishment that this will just be a thing that we do and it is not a criticism. Those things help. And there are firms that are doing this more consistently now, even if a minority. But for the more intensive re-underwrites, there does tend to be a motivating reason. Just to be very frank about it. Exit is approaching or exit, there is no line of sight to exit and we need to find that performance is flat or degrading that it's not really a judgment call anymore.

34:23Hassen Ahmed: In a lot of cases, it just sort of almost becomes obvious. One other factor we didn't talk about is, you know, we've also shared research on just how frequently CEO changes take place in this universe. That's actually another moment where it can just be completely natural and organic to conduct something like this. And then it's no longer about how is the company doing? How is the deal partner doing? Just you have a new leader coming in and they're going to have a mandate and it's within the context of the deal thesis, but it can be a perfect moment to trigger something like this. So putting all that together in practice, we see a combination of deal team, operating team, quite often some third-party support to get something like this done, increasingly the use of AI to try and compress this process, and then some involvement of the management team that varies a lot as well.

35:14Hassen Ahmed: And all of that is with the deal partner obviously retaining ultimate accountability and the investment committee retaining its decision-making role as needed.

35:22Manuel Fernandez Angulo: That sounds great, AD. And I'd love to talk a little bit more now about funding and how you fund this activity? Are there new models emerging for resourcing this as a regular discipline? Maybe, Hassan, you can take first pass. I think funding is a real issue

35:39AD Bhatia: and comes one of the most common, I would say, constraints in deploying this as folks are systematizing this approach. What I found exciting in our research is that some of the most compelling example of deploying the systematic re-underwriting wasn't coming from the largest funds. It was coming from the mid and lower market funds. And those funds, you know, on one hand side, for example, deployed AI as a force multiplier, as we discussed before. This was like an example where there's a private equity, mostly operating in Asia, and a two-person team basically ran through diligence on 14 markets in a week's time, what would usually take four or five weeks.

36:21AD Bhatia: and that compression and ability to look at such a large amount of data, do the diligence in such a fast manner was something that we found exciting. And then the other piece I'd say is that as firms continue to see how doing this is important and this will be the fundamental element in driving alpha, they're also thinking about enlarging their operating groups, right? And we've seen this in the survey. So I think there's an element where AI is helping, accelerating, creating leverage. And at the same time, there's a recognition by leaders in this space in different sizes around the importance to invest in this.

37:06AD Bhatia: Because what will drive ROI and exit value is not the same that was in the past few years.

37:16Manuel Fernandez Angulo: And Jason, you work a lot with operating teams. how do you get them excited about this? How does one get them excited about this? Do they really have the bandwidth to take this on?

37:27Jason Phillips: I think the operating team bandwidth one point highlights a necessary mindset shift, if I were to frame it that way. And there are two ways I would think about that. One is, again, what is the best and highest use of your operating team resources? And two, how are you thinking about the value that your operating team brings to the performance of the fund? So if you think about highest and best use, I mean, the reality of mid-cycle re-underwriting is that you know the company much, much better than you did when you bought into it. And getting clarity on what needs to be done to drive the next cycle of value creation to position the company optimally for exit, potentially, you've got a better, you've got more clarity going into that than you ever have had over the life cycle, the hold.

38:26Jason Phillips: So the question there is, does the operating group need to be responsible for driving this? Or is this support that I can look elsewhere for? And the reality is, because this tends to be accretive when it's done right, You can often find partners who are willing to go on an at-risk or performance-based basis for this. So it's not requiring an outlay of capital. It's that the increased impact is actually funding that directly. So finding outside parties who are willing to put skin in the game, that becomes an unlock that doesn't require your operating group to go in and do twice as much as they were set to do before.

39:08Jason Phillips: In terms of thinking of the value that your operating group brings to the table, we've worked with dozens of firms trying to quantify this. It is a fool's errand. I think you need to think about this as a holistic effort to deliver the investment thesis and create alpha that includes deal team and operating group. Because when you try to atomize what is the contribution made by individual operating group members, it's just too difficult in most cases to isolate that. You know, if you have somebody who's focused on upgrading procurement and driving incremental value capture, something that that that's that functionally focused, you can do it.

39:50Jason Phillips: But when you look at models where the operating partners responsibilities are more diverse, it's really best to think about how that collective team delivers results as a team versus trying to disaggregate the contribution of one member or the other. Got it.

40:08Manuel Fernandez Angulo: And AD, do you think that the nature or makeup of operating teams is shifting, or perhaps will need to, based on some of the recent research that you completed?

40:17Hassen Ahmed: The nature and construction of operating teams is evolving quite rapidly, you know, in response to a bunch of the things that we've talked about here. So the idea of, you know, functionally focused professionals versus more, you know, integrative change leaders and the backgrounds that folks are recruiting for. You know, it is an important consideration as well. If you start to do something like this more, the profiles of the folks that you have on your teams might actually start to look quite different or evolve and expand.

40:49Manuel Fernandez Angulo: Hassan, anything you would add here?

40:52AD Bhatia: Maybe one last thing, Shad. I say more looking from the portfolio company side. And I think, you know, in the management team, driving the VCP, you know, getting all the reviews and the questions that get asked from the sponsors. How do you do this at the same time? I think two thoughts there. One, making sure that you have the right archetype in terms of the underwriting comes back to the governing thought that Jason shared at the beginning. We want this to be exhaustive without being exhausting, both for the portfolio company as well as the sponsors. And two, how can the fund productize this?

41:27AD Bhatia: How do you make sure this is repeatable? How do you make sure there's a playbook where when we go in, we know exactly what we want to look at. We know what data we need to ask, how to leverage AI. And we're not reinventing the wheel with every portfolio company to go and look after. So I think just two thoughts on how we can, you know, we've seen some of the leaders that are addressing this point about management bandwidth, which is something to be recognized.

41:50Manuel Fernandez Angulo: Right. And Hassan, how doable is this for different funds? Any examples that you could share?

41:57AD Bhatia: Yeah, absolutely happy to. And I think we've touched on some of these in the questions before. The reality is there are constraints. We need to recognize them. And, you know, we've seen the leading firms there and some of the most exciting example coming from this mid and lower mid cap, you know, firms where interestingly, when we need to do something, you know, resources are constrained, innovation and creativity kicks in and, you know, folks think through ways to get this done. So just a few examples for folks to think around there as food for thought. I think, one, there was this example where we had a two-person team run the diligence around 14 markets in days instead of weeks.

42:34AD Bhatia: And there, they leverage AI to run this in multiple markets. Second comes back to what A.D. mentioned earlier, that you have a squad that will come together to leverage resources both from the operating team, the deal team, the management, and sometimes external parties to make this happen at the right level depending on are we doing the light version or are we doing the full re-underwriting. So making sure that we leverage the right resources and there's an expectation that this is part of the role to be part of that re-underwriting exercise. And the third, and this is stayed with me, where doing this exercise, speaking to a client, there was a portfolio company where close to exit and the exit story was more of a cost story.

43:21AD Bhatia: And we know that's not the same as a growth story. and by doing this exercise, they discovered that there's an untapped opportunity in terms of margin upside and that completely changed the way, you know, they frame the exit story. So there's also a bit of this can tackle where things are underperforming, yes, but it can also look at the upside and we have the bias and tendency sometimes to look at assets that are underperforming and how we can fix them. There's also the opportunity to look at assets that are doing good, great and make them exceptional by doing this exercise.

43:54Manuel Fernandez Angulo: And it's really good to see that this is within reach for every fund. So now before we end, let's talk a little bit about where we start. Hassan?

44:04AD Bhatia: Awesome. So we wanted to leave you with two thoughts here. One, I'd say, think about an asset where you'd like to run a buyer backward analysis where you feel there's high conviction as a great exit candidate. Take that asset, spend a week mapping the gaps you see and think through what will be the question that a buyer will likely ask during the diligence. Second piece is more, if you see there's a real portfolio company that is struggling and has drifted against its original thesis, put together a proposal, a perspective on why you think a real re-underwriting would be appropriate and take it to the RIC.

44:47AD Bhatia: So just two thoughts on how you can get started. I think a lot of this, and by the way, through the research we've done, I think no two firms do this exactly the same way. And there's different flavors of doing this. We've seen the leaders deploying some of the practices we discussed here today and all comes to just, you know, taking a sample and going after it.

45:09Manuel Fernandez Angulo: Super. And thank you all. This has been a really insightful and practical conversation. Before we wrap up, I just want to remind our listeners that they can read about all five practices for reshaping PE value creation by clicking on the article link in our show notes. Now, as we close, I'd love to ask you each, what excites you most about this concept of re-underwriting and the potential that it can unlock? Hasan, maybe we start with you.

45:34AD Bhatia: Yeah, absolutely. I think this is a, you know, our macro environment today is rapidly shifting. I see this as an opportunity to go and uncover and tap potential. And I think that is an exciting story for everyone to think through what is the next story. how can we use this as an opportunity to relook at the assets and unlock its full potential?

45:58Hassen Ahmed: Super. AD? Yeah, I'll bring some optimism to this. Having done a bunch of these with investors and operating groups, as well as with management teams involved, there's a version of it that feels daunting, that feels like a criticism. And there is a version of it that actually feels cleansing and exciting. It's a load lifted for the deal team and the operating team to say, hey, we now know what the right things are to focus on. We're going to talk about those things. And for a management team and actually even cascading down below the management team, the the re-underwriting and if it's done in the right way, the work that that leads to the ownership that can be given to folks in the portfolio company to actually go and drive that.

46:39Hassen Ahmed: It can be a source of renewal and excitement. So I said a few minutes ago, I didn't want to be naive about this. And I'm sure there are folks saying, well, you are being naive now, but I've seen it. And so I think that's what I get excited about is there's a positive version of this that can be energizing for people at a bunch of different levels when it's done.

46:58AD Bhatia: Great. Thank you, AD. And Manu? Look, I think from my side, running the interviews and speaking with all the fans, I think 100 % of them were excited about this topic. It wasn't like something that was not top of their minds. So for those that they were not doing this, they were like thinking about, hey, we got to launch it. There's no reason why not to launch it. And even for those that were even launching them, they were telling us, hey, we need to professionalize it even more. We need to make it look like something common for everyone. So making this to the next level, bringing this to the IC, bringing the operating partnership.

47:29AD Bhatia: So that impressed me. That is something that is a topic that is actually happening, that is in the mouth of everyone. And that professionalizing this is the right momentum right now.

47:38Manuel Fernandez Angulo: Thank you, Manu. And Jason, you get the last word.

47:41Jason Phillips: Okay. Thank you, Sean. So when I think about conversations over the last decade plus around topics of value creation and alpha in portfolio companies, there's always been a bit of a hesitation amongst funds to push their highest performing management teams to do even more. and you know that's you know embodied in the dynamic of well we set targets for them they're achieving their targets they were ambitious targets i feel like we can't ask for more from them than that and where the conversation ultimately goes from there is if you have a portfolio where you have some portfolio companies that are kind of achieving the targets you've set for them and others that are falling short the performance of your fund is going to fall short So you really need to shift the frame to how do we work with those management teams that are doing the best amongst the portfolio and give them the insights and the tools and the support to allow them to continue to exceed expectations and maybe do that at an accelerated rate.

48:53Jason Phillips: Because at the end of the day, the difference between a two and a half and a 3x Moic is materia. And often, as we've worked through this with different clients, that's the magnitude of the opportunity here. So if you want to have more 3x situations driving the performance of your portfolio overall, this is a way to do it. And if your management incentive plans are set up correctly, the management team should be on board to do this with you. So don't think about it as a not pushing them, but think about it more as how do we have a conversation that highlights the art of the possible and encourages them to build on strength to do even more and rewards them accordingly for it.

49:37Jason Phillips: Because at the end of the day, that is what your investors are looking for from you.

49:41Manuel Fernandez Angulo: Jason, that's a really inspiring note to end on. Many thanks to you, Manu, Hassan, and AD. Really appreciate you taking the time with us today. Thank you, Sean. Thanks, John. And thank you to all of our listeners for joining us. We hope you enjoyed the conversation and we welcome your feedback and ideas for future episodes. Our email is itsr at mckinsey.com. You can also share your ratings and reviews on any podcast player with many thanks to all who've already done so. We really appreciate the comments and feedback we receive every week and encourage you to keep them coming. And if you enjoyed the episode and you'd like to subscribe, you can easily follow our weekly series on any podcast player, where you can also access our entire library of more than 300 episodes.

50:25Manuel Fernandez Angulo: Finally, if you'd like to automatically receive our latest publications and insights, we encourage you to visit our private capital practice at mckinsey.com slash PC and our transformation practice at mckinsey.com slash MT. You can also connect with us on LinkedIn and we've included links for all of those in the show notes today. Thanks again for listening. We look forward to having you join us again next week inside the strategy room.