We recently surveyed 24 general partners (GPs) about
their internal operations.
The research produced
several surprises, none bigger than this: for private
equity (PE) firms, economies of scale start to kick
in at roughly $8 billion to $10 billion in assets under
management (AUM)—and that is also about where
they stop. For example, smaller firms tend to employ
22 to 30 people per $1 billion in AUM, while firms with
$5 billion to $10 billion employ just nine. But firms
with more than $50 billion under management employ
almost as many (eight per $1 billion in AUM). In some
functions, the expected efficiencies are not only absent
but even reversed: we found evidence of diseconomies
of scale across finance, operations, human resources,
and compliance. In PE, the largest firms are in many
ways less efficient than their smaller peers.
This complexity is a growing pain for the industry.
The first buyout firms were founded in the 1960s,
and an industry was born as many more followed in
the ’80s and ’90s. The PE industry, now more than
30 years old, is maturing in many ways. Historically,
GPs tended to tackle operational problems by adding
people; relatively high profit margins meant GPs did
not have to focus on efficiency or costs. Today, the
problems are more complex; yesterday’s bespoke
solutions have begun to create their own challenges,
and inefficiency not only adds considerably to costs
but also inhibits scalability .
As our colleagues have discussed, PE
firms and other private market managers are now
turning to digital tools to improve many parts of
their business. In this article, we will look at how
one of those parts—the back and middle office—has
grown increasingly complex, as well as the ways in
which digital and analytical capabilities can improve
operational efficiency.
Layer upon layer
The PE firm of the 1990s was a fairly simple operation,
with just a few products and a small number of
clients. Today’s PE firm offers an unprecedented
variety of products to a wide range of clients. On every
dimension—products, asset classes, legal entities,
jurisdictions—PE firms are doing more and interacting
with clients through a range of touch points, such as
investor relations staff, fund administrators, and
digital portals. To take just one example, in the 1990s
few GPs offered more than a couple of distinct products. Today, the larger firms manufacture dozens of types of
exposures, across many different asset classes around
the world, for an ever more diverse client base.
The result is extraordinary complexity.
Our survey
found several examples, starting with the number
of legal entities firms create to house their products,
assets, and operations (Exhibit 1). Compared with
smaller firms, the largest ones create many more
entities—thousands of them for the larger multiasset-class GPs. That complexity has a cost, as each
entity must be accounted for, put in compliance with
regulations, reported on to investors, and so on.
Exhibit 1
We strive to provide individuals with disabilities equal access to our website. If you would like information about this content we will be happy to work with you. Please email us at:
McKinsey_Website_Accessibility@mckinsey.com
One of the biggest sources of added complexity is
the growing number of ways firms interact with
clients. Commingled funds used to be virtually the
only method. Then, separately managed accounts
appeared (Exhibit 2). Today, firms regularly create all
manner of new relationships: not just blind pools and
separate accounts but also sidecars, co-investments,
and other structures with institutional clients—sometimes lumped together under the rubric of
strategic partnerships . At the same time, firms are also
experimenting with diverse vehicles aimed at the retail
market. To be sure, this has created opportunities
for more investors to access private markets with
greater precision, but it has also massively increased
complexity in the system, as each new arrangement is
incrementally reflected in firm systems and processes.
Exhibit 2
We strive to provide individuals with disabilities equal access to our website. If you would like information about this content we will be happy to work with you. Please email us at:
McKinsey_Website_Accessibility@mckinsey.com
In these and numerous other ways, complexity has
been growing rapidly in PE. Behind the scenes,
however, the modern PE firm still uses an outmoded
approach to keep up: adding people. This has proved
to be an expensive and inefficient solution, in many
cases. Our survey showed that in several functions,
including IT, finance, and fundraising, larger firms
must hire proportionally more people than smaller
firms do (Exhibit 3). Even where efficiencies show
up (investment professionals, for example), they
are much smaller than might be expected from a
linear extrapolation.
Exhibit 3
We strive to provide individuals with disabilities equal access to our website. If you would like information about this content we will be happy to work with you. Please email us at:
McKinsey_Website_Accessibility@mckinsey.com
This complexity (and the ability to control it) doesn’t
matter only for controlling costs. As the industry
matures, GPs are increasingly judged against
traditional asset managers and other large financial
institutions—organizations with a decades-long head
start in streamlining and scaling operations. As these
firms begin to shoulder their way into alternative
assets , GPs will need to become more competitive on
these dimensions.
A digital path forward
Digital is remaking ways of doing business. McKinsey
research finds that, on average, companies around the
world have digitized nearly 40 percent of their work.
That research did not include the private investing
industry, but in our experience GPs have thus far
stayed mostly on the digital sidelines, even as they
have ensured that their portfolio companies are
digitally competitive.
Digital offers GPs an escape from their productivity
trap. Across back- and middle-office functions, a
digital transformation holds the promise of creating
expected economies of scale, so GPs can grow more
profitably. More firms are willing to acknowledge that
goal today than during what for many GPs was the
stick-to-your-knitting times of the past.
A digital transformation certainly harnesses the power
of cutting-edge digital tools but encompasses so much
more, including client-experience and design-thinking
principles. Firms that successfully digitize their
operations apply five core levers, in combination.
Client-journey redesign
Firms are looking at their functions through a
new lens, the client journey: a progression of touch
points (personal, digital, paper, events, and so on)
that together constitute the limited partner’s (LP’s)
experience of its GP. Seeing the world as clients do and
reshaping interactions into sequences of activities
that cut across traditional functions can help firms
organize and mobilize their employees around their
clients’ needs. Some firms, for example, have improved
the client experience and their internal productivity
by redesigning the way they deliver investment and
market insights to LPs.
The rise and rise of private equity
Intelligent process automation
Firms find significant efficiencies by investing in
robotics to perform common, repetitive, and low-value
tasks—for instance, using advanced optical
character recognition to scan the reporting packages
of portfolio companies and bots to upload them to
a portfolio-management system. Smart work-flow
tools are used to streamline and systematize complex
activities, such as the money in/money out process,
which requires numerous lookups, validations,
and approvals across segregated functional roles
in the treasury and accounting functions. This
kind of intelligent process automation frees valued
employees from burdensome work so they can focus
on value-adding activities. That helps firms to retain
top talent and to perform well overall.
Business process outsourcing
Outsourcing to third parties allows firms to focus on
their core value-adding work while enabling scale and
supplementing in-house capabilities. While this is old
hat for public-market managers, many PE firms find
that business process outsourcing can help break the
linear relationship between costs and scale, although
ease and efficiency often dip initially as functions
are outsourced. This change has been enabled by the
transparency into providers that digital and work-flow
tools make possible and by the growing capabilities
of companies that provide PE services. Many PE
firms are examining strategic partnerships with fund
administrators, for example. Fundamental to this
evolution is the dawning recognition among many
GPs that even if they are quite singular, some of their
business processes are becoming commoditized.
Advanced analytics
A new breed of advanced analytics (AA) is providing
the intelligence to improve the speed and quality
of decision making across middle- and back-office
functions—a development that will grow in
prominence over the coming years. Although AA in
PE is in the early stages, it has gained considerable
traction in sales-force management. GPs are beginning
to build data reservoirs of client characteristics, and
they use AA to design more personalized distribution
and service models centered on an understanding of
their clients’ needs. Another area with much promise is
the generation of insights for client reporting through
the application of artificial-intelligence techniques
such as natural-language processing.
To succeed, AA must be coupled with strong data
management, governance, and architecture—which,
by and large, are new to private markets. Managers
will also need both proprietary and third-party data
to deliver benefits at scale. Firms that do this well
focus on a few applications (typically, three to five)
and ensure that these deliver an ROI before moving on
to others.
Digital sprints
Leading GPs that transform their operations are not
tweaking steps here and there but instead examining
processes end to end and reimagining what they could
look like with a new digital tool kit. Likely targets for
digitization include tax reporting for thousands of
entities, and bank-account reconciliations.
Firms are executing these digital transformations not
as traditional “waterfall” projects, many of which fail
to deliver their full promised impact. Instead, they
rely on short digital sprints : 12- to 16-week cycles
when cross-functional business and technology teams
use agile principles to tackle a tightly scoped set of
problems and to give users working functionality.
Through an iterative sequence of such digital sprints,
leading PE firms find that they can deliver higher
returns on their IT investments, and at lower risk—a trade worth making.
Digital effectiveness is a rare competitive advantage
for GPs today. We expect that before long, it will
be a competitive necessity. Initiating a digital
transformation is therefore increasingly a top-of-house
priority for many GPs—critical to maintaining
their distinctiveness and improving their ability to
serve clients.
About the author(s)
Sudeep Doshi and Nikhil Sudan are associate partners in McKinsey’s New York office, and Bryce Klempner is a partner in the Boston office.
The authors wish to thank Connor Mangan for his contributions to this article.