Investing in a newly acquired business presents unique challenges, notably the infamous “J-curve” effect—a phenomenon where businesses see a decline in value before rebounding one to three years after the acquisition. At a recent private equity conference, in all my discussions this issue seems to be completely accepted by almost all the PE firms as a fact. Candidly my head exploded. It doesn’t have to be this way. I have worked with countless owner-founders and helped many with 10x growth and even a few to reach near billion-dollar market caps. We to tend achieve what we tolerate and, in my opinion, people in the PE space seem to think it is ok to lose money. As an occasional LP, I do not agree with this.
The Problem with the J-Curve
It’s widely accepted among private equity and VC firms that 60-70% of newly acquired businesses underperform in the first three years post-acquisition and lose money. This statistic is startling and, frankly, unacceptable. The root causes are typically attributed to the structuring of acquisition fees and substantial front-loading of debt. However, these factors alone don’t paint the full picture of the underlying issues.
Bridging the Gap Between Founders and Firms
I have seen the core issue often boils down to a fundamental disconnect in common language, communication, and collaboration. Owner-founders of businesses are typically passionate, hardworking, intelligent, and highly entrepreneurial smart, but they may lack sophistication in corporate finance and operations. Meanwhile, private equity professionals—often clad in patterned suites and no socks and are MBAs minted from Harvard, Stanford, or Wharton, bring a different set of skills and are often very smart, incredibly hardworking, and extremely sophisticated but they are often not very entrepreneurial smart. This is where the rub starts.
The disconnect arises when these two worlds collide. Private equity firms, with their vast resources and academic pedigrees, tend to impose structured, metrics-driven approaches without fully engaging with the entrepreneurial spirit and operational knowledge of the founders. For many owner-founders, this is one time they will experience this process so they abdicate leadership and do the best they can with their existing tools and sophistication. Within a couple of months, sometimes sooner this top-down imposition can lead to frustration and misalignment on both sides resulting in an us and them feel rather than a single team, single voice, and single direction.
A Collaborative Approach to Value Creation
To mitigate the J-curve and propel quicker returns, a collaborative approach is essential. Here are a few strategies that can help bridge the gap:
- Foster Open Communication: Encourage the spirit of genuine curiosity and regular, open dialogues between the private equity team and the business founders. The entrepreneurial ‘legacy knowledge’ is often just as valuable and needed as the financial sophistication. This can help each party understand the other’s perspectives and operational logic.
- Develop A Common Language: I can’t tell you how often I have seen the disconnect in understanding that is a direct result of language miscommunication. Remember, very few owner-founders have an MBA and many PE operators have not been entrepreneurs but have built businesses. Creating a space where people can respectfully let the other know that they do not understand what or why they are asking for something is critical. When done well both sides will begin to understand they are closer than they think and they can collaborate.
- Cultivate Mutual Respect: Let’s face it, most Harvard MBA folks may have an initial challenge with the blue-collar owner founder who started in the trenches and built a company. But there are a lot of those types of founders who have built amazing companies and make a lot more than most MBAs. Both parties need to be curious and respect each other’s unique expertise. Founders should appreciate the financial acumen and strategic foresight of their PE counterparts, while PE professionals should value the operational experience and customer relationships that founders bring.
- Joint Decision-Making: The more both sides can collaborate to clearly define the root issue they are solving and the reason behind the need to make the decision the better the outcomes. Implement a decision-making process that involves leaders from both sides. Encourage a curious but heated debate and then make a call. This inclusive approach ensures that strategies are both financially sound and operationally viable and maximize the outcomes.
- Implement Strategic Planning: Arrange for these teams to collaboratively define success and build a plan to achieve it. If you don’t have a targeted destination, that everyone understands, how will you ever get there? I have worked with hundreds of companies to achieve more than they ever thought possible. When people begin to create clarity on what they want and then build a plan to go after it, anything becomes possible.
Conclusion
The path to profitability in private equity involves more than just financial investment and sophisticated financial acumen. These are both 100% critical and will contribute to success. However truly exceptional growth requires a genuine partnership between investors and founders. By fostering a culture of collaboration and mutual respect, firms can navigate past the initial downturns of the J-curve more effectively, leading to more sustainable, long-term growth. This approach doesn’t just benefit the bottom line—it also builds a foundation for enduring success and innovation in the newly acquired business.
If you’re a PE firm or owner-founder who is not happy with your current IRR and want to see if one of our advisors can help. Feel free to reach out for a no-obligation discussion.
