In the current market conditions, there’s ample opportunity for private equity (PE) leaders to substantially improve the value of the companies in their portfolios.
Supply chain challenges have made it a necessity to re-examine sourcing, planning, and other supply chain processes; and the rising prominence of environmental, social and governance (ESG) strategies and disclosures creates a chance for companies to differentiate themselves in this area.
The rapidly changing economic environment may dictate a refreshing of strategic objectives, and many portfolio companies can see immediate results through the transformation of their financial and operational business functions, particularly when they employ new technologies that are available.
Here’s what PE leaders need to consider as they seek to boost the value of the companies in their portfolios.
Building value for a portfolio company begins by analyzing and creating improvements around the same essential drivers as just about any other company. A portfolio company and its PE owners ultimately will want to build demand for their products and services.
At a basic level, this means evaluating:
- Products and services, and the product or service mix the company offers
- Markets and market sizes
- The sales force and how the company goes to market
- The internal enablement of the go-to-market strategy
That means immediately asking some key questions, according to Adam Bowen, a Managing Director in the Strategy & Transactions practice at Grant Thornton. These include:
- Who is our customer?
- What is our value proposition?
- Have we done the hard work to truly understand what makes our company great?
- Do we understand what our competitors are doing?
- Have we identified the patterns that are associated with this industry?
- Have we uncovered powerful data that can inform the growth of this business and what ultimately we should be looking at?
The goal is to distinguish your product or brand in an often competitive marketplace and reduce friction that stands in the way of growth.
“You have to position yourself so that you can ultimately stand for something that resonates with that customer, that allows you to stand out in the marketplace,” Bowen said. “That's the role of brand differentiation. But at the same time, that rolls up into customer experience, which builds value around whatever that entity is.”
But portfolio companies are somewhat different because the time horizons are much shorter. PE’s limited time horizon means that more differentiation is better, and is needed sooner in the enterprise lifecycle; it’s that much more important to stand out from the crowd to deliver rapid growth. A truly unique (and of course, useful) product or service can create an immediate edge, but that’s often not enough to stimulate growth. Delivering an outstanding customer experience is also important.
A sports bar can serve great wings covered with its own patented sauce and award-winning homebrewed beers on tap, but it won’t grow revenue if the giant screens only show HGTV, service is slow, and the HVAC system doesn’t work.
Finally, with the limited time horizon, it’s important for PE firms to keep growth plans simple. There’s no time to implement a complex strategy with dozens of objectives. The sports bar’s menu doesn’t have to be 10 pages along. If the homebrewed beers are great, there’s no need to add a juice bar and a milkshake stand to the facility.
“Compress it,” Bowen said. “Condense it. Don’t draw it out. These are the most important things you need to be thinking about.”
Improving the supply chain
A company’s supply chain strategy, processes, organization and operations provide fertile ground for improvement after any acquisition.
Which supply chain strategies a PE firm or a portfolio company chooses will depend on what’s happening in the environment and the unique circumstances at the individual portfolio company.
“There’s a long list of value creation plays, but you don’t use all the plays all the time in all companies,” said Ben YoKell, Managing Director and the National Sourcing & Supply Chain Management Leader for Grant Thornton. “You need to fit the value creation plays to the company and the internal and external context.”
Supply chain value creation plays generally fall into one of four categories:
- Revenue generation or acceleration: This can be accomplished by improving product availability, visibility or lead times; upping forecast accuracy, agility and responsibility; and enabling cross-functional synchronization.
- Cost reduction and margin expansion: Items that can be addressed include cost of goods sold, logistics expense, distribution costs, production costs, procurement costs, taxes, duties, tariffs, resourcing and talent.
- Improving asset efficiency: Companies can accomplish this through changes in product portfolio, inventory investment, asset utilization, equipment efficiency, labor productivity, order to cash speed, and digitization of the procure-to-pay process.
- Better managing risks to drive resilience: This goal can be met by improving supplier performance and compliance, developing operational excellence and resilience, and addressing third-party provider procurement and contracting.
Because PE has a limited time horizon for improving portfolio companies before sale, short- and medium-term changes often get implemented but long-term changes might not.
“When time allows, the classic bread and butter of value creation in a portco is usually top line first,” YoKell said. “Make the pie bigger through customer-centric growth strategies. Then bottom line is next. Drive efficiencies, reduce expense and expand the margin. Remember that you cannot cut your way to growth — but there are almost always opportunities to expand profitability in alignment with the growth strategy. And then address working capital, and begin to extract the cash as you ready for the next transaction.”
For portfolio companies that need to demonstrate improvement within six months, YoKell said, the shortest-term strategies are often related to sourcing and transportation. Manufacturing and/or distribution assets and strategies may take longer to impact, and inventory can be improved somewhat quickly but still requires some time to drive onto an optimal glide path. However, renegotiating agreements, rationalizing or expanding suppliers, and procuring materials, services, transportation and warehousing from lower cost and/or higher service providers can provide a return in three months if the market conditions are right, he said.
It’s not unusual for a company in a PE portfolio to have a finance function that needs at least some updating, and perhaps even a complete overhaul.
The four basic elements that lead to increasing value through finance transformation are:
From leadership in the finance department to the entry level employees, having the right people in place is critical. A company’s talent base should include people who:
- Understand accounting rules, particularly GAAP requirements. Some smaller companies in PE portfolios may have prepared financial statements strictly on a cash basis in the past.
- Know how to close the books and book journal entries.
- Can successfully use whatever technology is being implemented. As a company moves from manual processes to a digital workflow, new tech-savvy skills may be necessary.
Manual processes are slow and tedious, but many portfolio companies still rely on them.
Moving to digital processes can improve efficiency and enable improved reporting and forecasting. When processes such as payments and invoicing are particularly cumbersome, the whole organization can suffer.
Sometimes even modest tweaks to processes can lead to significant improvement, but it may take a deep dive into a company’s business practices to discover them.
Many times, there’s a mismatch between the systems of the acquired company and others in the PE portfolio.
It may be possible to integrate the acquired company’s data with that of other companies. It’s also possible that an acquired company’s QuickBooks system will work just fine. But the bottom line is that having some sort of system for basic reporting is critical.
PE firm management will want to see dashboards that track certain metrics; without them, a portfolio company’s value is diminished.
When private or family-owned companies are acquired, they might lack basic financial controls such as segregation of duties. Some aren’t preparing GAAP-based financial statements, and some even need help putting basic reporting, budgeting and forecasting processes in place.
“If they've got stronger processes and better ways to produce reporting, that is going to create value,” said Lisa Heacock a Partner and West Coast Market Leader with Grant Thornton’s Finance Transformation Practice. “That makes [portfolio companies] so much more attractive when [private equity] wants to sell.”
PE firms can protect the value they’ve created in a portfolio company by demonstrating a commitment to ESG and reporting on progress of ESG initiatives during the life of the investment.
An overwhelming majority (86%) of M&A professionals said in a recent Grant Thornton survey that a target’s ESG program and reporting capabilities mattered when considering a deal.
Because the world of ESG has expanded to cover a very wide range of issues (GHG emissions, biodiversity, working conditions, data privacy, and many more), not all ESG topics are equally material to all organizations. As such, PE firms should guide their portfolio companies to anchor their ESG programs only around those ESG issues that are most material to that company’s business. By narrowing the focus of the ESG program to those most material issues, portfolio companies can investigate value creation opportunities for those key issues.
“We think about things like raw material reduction initiatives, energy usage, water and waste management,” said Mark Zavodnyik, ESG lead for Grant Thornton’s Private Equity and Asset Management practice. “These initiatives all help support the bottom line of the portfolio company itself.”
Those hoping to increase the value of a portfolio company may seek opportunities across the “E”, the “S” and the “G” of ESG. Examples:
- Environmental: Lowering greenhouse gas emissions and pursuing net zero carbon goals can reduce operational costs and improve the long-term sustainability of the business model amid a fast-changing climate risk environment.
- Social: Investment in business resource groups, employee training, and employee mentorship can result in improved retention and engagement metrics. Diversity, equity and inclusion (DEI) initiatives can improve company performance by pursuing a wider range of backgrounds and experiences at all levels of the organization.
- Governance: Fostering a strong, independent board, developing a succession plan for key leadership positions, and strengthening internal controls can show a potential buyer that a portfolio company has all the right core business functions in place.
“Fund managers should encourage their portfolio companies to develop their own ESG strategy and oversight structures tailored to their business,” Zavodnyik said. “Portfolio companies can create an ESG committee and then within that context define, ‘OK, what are our ambitions?’ That allows you to do some goal setting.”
Once portfolio companies establish the foundation of their ESG programs, Zavodnyik said PE firms can establish expectations, defining which ESG-related KPIs will be reported and tracked. Whether it be GHG emissions, energy usage, health and safety incidences, etc., firms should work with their portfolio companies to developing a reporting plan to establish a baseline metric, identify areas for improvement, and track progress towards goals defined by the company’s ESG committee.
Then the PE firm can track improvement on these ESG issues throughout the life of the investment and report progress to their investors and potential buyers.
“If you’re not doing that, you’re risking being dinged at sale,” Zavodnyik said. “You’re potentially diminishing the value you’ve brought to that investment during the time you’ve had it.”
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