A great new book recently hit the shelves by Jason Scharfman. While the topic is operations due diligence – this is the first book of its kind to get beyond financial due diligence into the risk in the operations of the business. What is uncovered in due diligence gives the eventual buyers an edge assuming operational value creation is in their arsenal beyond selecting good management and holding them accountable with proper incentives.
The book itself addresses many topics that cross over to value creation and portfolio management including:
– difference between operational due diligence and ongoing portfolio management needs
– using operational data in deal negotiations and ongoing operations
– creating ongoing monitoring of operations as part of board governance
– leveraging generalist and specialist operational advisors
While the book caters somewhat to both GPs and LPs, it sets the stage to provide a framework on how DD and ongoing value creation should be discussed in the industry.
James Grebey’s Operations Due Diligence is out almost at the same time. The book has a very similar holistic treatment of the various aspects of Ops DD including sales, personnel, financial, manufacturing, IT etc. There is limited discussion of using the findings in ongoing operation so slightly less relevant for our topic.
When it comes to value creation itself, very few titles are emerging since Orit Gadiesh’s broad review of the impact PE firms make.
Many times value creation strategies are specific to a particular company; they can be based on industry dynamics or take advantage of market changes for example. PE firms are excellent at identifying these strategies and creating value based on them, the PE business model depends on it and so does their carry. What about the opportunities for creating value across a portfolio of companies and how can a PE firm take advantage of them.
There are a few ways to look at cross portfolio value creation. The key is to identify the common denominator across the companies and to leverage that denominator so it generates value. Many firms do this already in a single source model that is dependent on internal resources and bandwidth. A distributed model is more effective at scaling however I’ve only seen a few firms use it and only in one area. Depending on the portfolio of companies the common denominator could be based on the following.
– A line of business like manufacturing, procurement, or supply chain
– A business area like CEO, CFO, or CIO
Industry and line of business are very similar. They have obvious common denominators and strategies. This is also where most PE firms are focused and leveraging a single source model. PE firms predominantly have deal teams and/or operating partners with extensive industry or functional expertise that are responsible for transferring knowledge across the portfolio. Simplistically, they dive into a company, build the 100 day plan with management, monitor execution to the plan, and then leverage that knowledge into the next portfolio company. The significant downfall of this approach is that only the current engaged company is benefiting from the PE firm’s input. Why not leverage a distributed model where there is a common denominator and drive value by spreading the learnings and challenges across the portfolio.
I’ve seen only a few clients take a distributed approach and only in one area, the office of the CIO. The CIO is a natural selection; they share similar challenges regardless of industry and when leveraged strategically can drive significant value for the business. For example, consumerization of IT, bid data, and social media are just as relevant challenges and opportunities for retail and consumer businesses as they are for an oil & gas, healthcare, or technology company. By effectively connecting the CIOs across a portfolio they can share learnings, best practices, and challenges while building a network that can yield a significant competitive advantage. The firms I’ve worked with that do this well and see a benefit connect their CIOs in person bi-annually in a forum with thought leaders to share their insight. They also take time during the sessions to present case studies within the portfolio to engage the CIOs in relevant discussions.
So what are the other areas that can benefit from a distributed knowledge sharing approach? There are obvious ones like procurement and lean. What about innovation or sustainability? Which areas are more effectively driven directly by the PE firm vs the portfolio companies themselves?
While talking about refining business models is very common in Venture Capital discourse it is rarely discussed in PE literature. Bigger companies can benefit just as much from a structured review of the business model that leaves the world of spreadsheets and LBO models and brings management to the fundamental question – how do we make money and what alternatives are possible.
All operationally focused firms have exceptional tools at work to address many aspects of working capital, pricing, procurement and other operational improvements and all great PE firms have fantastic eye for talent and the outstanding way to motivate management. One tool that recently resurfaced from Europe on Business Modeling could help make the 100-day plans or GP/Management alignment discussions even more productive.
What started as a Ph.D. thesis on Business Models by Alex Osterwalder is now a global phenomenon. Not since the late 80s business process reengineering has there been a similar holistic methodology for looking at the business beyond figures and KPIs into structure and end-to-end alignment.
Business Model Generation analyzes all businesses, departments and teams in 9 categories:
– key partners
– key activities
– key resources
– value propositions
– customer relationships
– key channels
– customer segmentations
which results in a certain
– cost structure and
– revenue model
The final outcome of a business model is represented on a “Canvas” somewhat similar to a value chain model. What I found unique about the approach is the visual mapping that allows teams to reach consensus, tradeoffs and specific strategies based on the insight gained. The method which is now a major book series was developed in an open source fashion and many private and PE-owned businesses seemed to be active on their forums.
Here is a little video overview of the method and a “canvas” we created mapping some value creation strategies to their model.
Since 2008 there has been increasing focus on operational value creation and even firms that traditionally shunned operating groups established a role for portfolio support or a resources team. While PE organizations may be shifting to seeking more of the alpha in improved sales and operations, PE conferences and associations still seem to be primarily about dealmaking, deal structuring and networking.
Reviewing the 2012 industry conference agendas it is clear that operational value creation is still considered more of a special interest group in these events than the major thrust of the value.
- In the DowJones PE Analyst Conference only 1 out of 20 sessions address value creation and operational improvement.
- In BRIC countries where growth equity and minority holdings dominate a similar story emerges in the regional events like PE Latin America forum where no such sessions are planned. China’s International Private Equity Forum was a major event with over 40 session and again no discussion on operational value creation.
- IFC and EMPEC’s joint conference on Global Private Equity had a great plenary session dedicated to value creation in emerging markets raising the profile of the discussion in such a great forum.
- Increasingly PEI Media emerges as the though leader in value creation with their repeated commitment to the operating partner focused event.
- The Wharton Private Equity Conference in February dedicated only 1 out of 10 sessions to value creation
- Harvard’s VC and PE Conference the same month had no discussion on the topic
- Kellogg’s PE conference dedicated 1 of 6 panels to value creation.
There still seems to be a great opportunity to learn and share more for the operating professionals on the topic.
Last week I posted on the general value creation levers PE firms focus on to create value in their portfolio companies. While the levers will differ by company and industry I believe there is a playbook out there PE firms are following. I discussed this with one of our PE clients this week and got an interesting response. He is a PE operating partner focused on technology initiatives in the portfolio. Below is his ranked response to the question “what do you think are the top value creation levers you typically focus on”:
– Technology infrastructure
– Security – technology as well as people and processes
– Sales force effectiveness
What I found most interesting about the discussion was the focus on top line growth related levers, they’re not the standard process efficiency, cost cutting, or shared service initiatives you would expect from an IT professional. He said the focus on technology infrastructure as the number one priority is to ensure the business has the foundation for growth.
This discussion reminded me of another paper by Booz on what PE firms are doing for top line value creation and organic growth. The paper mentions similar levers like category evaluation and expansion, sales force effectiveness, and pricing. According to the paper, “The Next Winning Move in Private Equity” PE Firms will need to do three things to capture additional value from organic growth; add new growth capabilities, rebalance how they engage with portfolio companies, and lastly find ways to make growth net free.
How a firm attacks these three areas will depend on the size and focus of the firm and is similar to the considerations for how a firm would build out its operating team. So how does/should a PE firm balance its operating team to focus on growth and operating strategies? At what size and number of portfolio companies can a firm afford to invest in these capabilities internally vs outsource? Does a KKR Capstone approach, with dedicated operating partners that focus on growth and operational improvement, feasible for a mid market firm like Riverside? The market is becoming more and more competitive for deals and firms are also being forced to differentiate for LP investment while also needing to drive real value and generate the super returns LP’s expect. Figuring out the unique balance and focus of the operating team will be more and more critical to a firm’s survival.
Value creation from a minority position has always been more difficult. Beyond the obvious reasons (minority vote and marginal board presence) there are several other challenges. Markets with dominant minority positions like MENA, India and Brazil for example have other similar characteristics:
– The owners / promoters want to retain control of the business and yield little in corporate governance
– Limited debt/leverage in deals also means more limited upside incentives for management
– Focus primarily on growth and limited tools or desire for operational performance improvement
The report published by Booz&Co jointly with the MENA PE Association highlight some of these difficulties in value creation specifically in MENA. I found their insight fairly universal in minority investments. In many ways minority investors are limited both in their tools (few strategic and operational improvement levers) and their multipliers (no leverage). The report offers a couple of prescriptions:
- Retain or hire managers with track record in value creation and operations improvement methods
- Do not compromise in governance. Make sure you have the necessary board and management influence on value creation
- Agree in writing to a 100-day plan and even an exit plan prior to the investment and make it a condition of the deal
- Implement effective KPI / performance monitoring systems
There are also great examples of global buyout firms successfully adapting their operating models into non-leveraged, non-control makers like India. Blackstone has been featured as one such firm in the India Economic Times. Blackstone successfully created synergies (cross-sell, collaboration) between their portfolio companies as a way to increased value.
In my last post I discussed that based on their analysis of their own internal portfolio the Partners Group determined that approximately 75% of value creation came from direct operational improvement. I’ve been searching for other papers and publications that quantify the “alpha” attributed to operational improvement in PE investments and have found a limited number of them. There are plenty that argue the value of an operating team and a focus on operational improvement but very few that quantify the impact or discuss HOW operating teams are driving value. The 75% of value creation the Partners Group attributes to direct operational improvement is considerable and regardless of whether you believe the results or feel the impact is much lower it is still very relevant and important to better understand how operating teams are driving value and what models work best in PE.
There is a recent Booz & Company paper “Value Creation Tutorial What Private Equity has to Teach Public Companies” that lays out a nice framework for the discussion on where PE firms are focusing their operational value creation efforts in the portfolio.
Any business creates value by increasing profits or improving capital efficiency. The PE investment thesis and operational improvement plan will obviously differ based on numerous factors. However we’ve seen that procurement and sourcing is almost always the first priority in a new acquisition, it is the low hanging value for the firms I work with. Most of the time this is the first operating partner a PE firm will hire fulltime. He or she will focus on spend analysis, maverick spend across the portfolio, and reducing spend with suppliers across the portfolio. Many times a shared service entity for procurement is established to drive down costs on commodities by leveraging volume across the portfolio. This is a tried and true lucrative and effective strategy for PE firms. So what are the second and third critical levers for PE firms, where do they focus beyond procurement?
A huge portion will depend on the business , however it’s also going to depend on the PE firm and the expertise of the PE firm’s operating team. So how does a firm choose and build its operating team around particular value creation strategies and expertise? Should a firm leverage its operating team more for growth related strategies or cost cutting?
One of my favorite reports is the country attractiveness index published by IESE, the business school in Barcelona. Its primary audience is Limited Partners seeking validation for country and geographic risk within their allocation for alternative assets. I also think it is a great barometer of global geopolitics and economics.
Countries are ranked along several qualitative dimensions that are hard to gain from GDP tables:
– Overall economic activity
– Liquidity of capital markets
– Tax regime
– Corporate transparency
– Investor protection
– Social enviroment
– Entrepreneurial culture
Each country and region is then given a composite rating of these factors.
While North America (index at 100), UK (95), the Nordics (85-90), Australia (92) and Japan (93) are consistently high rated, many European economies have been downgraded over the years, predictable Greece (47 with their economy at 23), Portugal (66) and increasingly Spain (75), Italy (69) and even France (84) and the Benelux (85-87).
The trend analysis alone is making it worth to browse the report and gain insight into the shifting sentiment of where the smart money is going… Hong Kong (92), China (79), India (66) or Russia (59) or somewhere else?
As a value creation professional, how much should we and can we learn about the differences of the expanding target economies when it comes to finance and regulatory regimes, supply chain, transportation, compensation and labor laws, sourcing environment and the like? Where would you get these insights?
I recently came across an interesting study done by the Partners Group. The Partners Group is a “global private markets investment management firm” with over EUR 25 billion in investments under management and EUR 18 billion dedicated to private equity.
The study “Understanding private equity’s outperformance in difficult times” is a look at the commonly held idea that private equity outperforms public equity (even in a downturn) and the predominant factor is a focus on operational improvement and a hands-on governance model with portfolio companies. However, what I find most intriguing about this study is that it is the first I’ve seen to quantify the expected amount of value creation across the four main levers: revenue growth, margin improvement, multiple expansion, and cash flow generation.
To begin, the paper states:
- Since 2000, private equity investments have outperformed the respective public equity indices by 5% in North America and 9% in Europe per annum.
- During the financial crisis from Q3 2007 to Q1 2009, private equity investments beat public market indices by 19% in both North America and Europe on an annualized basis.
It is interesting to note that based on the analysis a downturn in the economy can make the tactics and benefits of the private equity model more apparent. By having controlling stakes and board representation, incentivized alignment between owners and management, and regular performance reviews of management and the business private equity owned businesses can be quicker to respond to a downturn and are laser focused on the value creation areas in the investment thesis.
More interesting though is the breakdown of expected value creation across the four main value creation levers; revenue growth, margin improvement, multiple expansion, and cash flow generation and that the Partners Group see an astonishing 75% of expected value creation coming from direct operational improvements, i.e. revenue growth (37.4%) and margin improvement (36.9%). In relation to EBITDA improvement, revenue growth accounts for approximately 60% and margin improvement 40%.
Revenue growth includes strategies like global expansion, product and category expansion, as well as M&A activity like add-on acquisitions. Margin improvement can result from “more efficient organizational structures”, process efficiencies, and shared services. The breakdown of expected value creation is based on the Partners Group analysis of their own direct investments in the past 24 months and begs the questions What would a similar analysis of your portfolio look like? What is the biggest bucket of value creation for your firm? Can your firm drive more value from operational improvement?
Of the many surveys that come out of the PE industry I find the McGladrey Private Equity Survey the most insightful.
For starters, it focuses on value creation strategies, on building and expanding businesses vs. financial engineering. In that sense it is more universally applicable to business outside private capital. I also find it refreshing that most firms they interviewed admits that operational performance improvement is the most important way to value growth. There is no study I could find before 2009 that reached a similar conclusion.
Some of my favorite insights were the following. The notes below the headings are my observations unless quoted from the report.
1) One third of the firms assume value creation responsibilities at the fund level
This is definitely a new trend. Of the 100+ firms we worked with at my firm, until recently most wanted management to develop the plan. Now increasingly the firms get involved with developing and some even in owning part of the plan through their in-house and contract advisors. The report noted that 31% of the LPs interviewed directly requested GPs for operational involvement in their portfolio companies.
2) 28% of the firms plan on moving offshore production back to the US
Offshoring manufacturing has been an effective way of improving both operating expenses and working capital during the holding period. Increasingly the report noted the move away from especially China based offshoring to other Asian countries or back to the US.
3) 89% of acquired businesses maintain or grow their workforce
As the adage goes, you can’t shrink yourself to greatness. It is very true in private equity. The primary objective of most firms is increased enterprise value, which translates to rapid cash flow growth. The only reliable way to get there is by growing top line sales, revenues and as a result, headcount.
4) The top tools of intervention remain profitability, operational reporting and working capital growth
While most firms I work with start by optimizing the management team and reducing spend levels, all firms tend to gravitate to the above levers to sustain and grow the business. The importance of business insights is obviously crucial as way too many businesses still run somewhat in the dark. The report states that over 60% of the firms believe their portfolio companies have inadequate business analytics and management reporting capabilities.
There are many more great insights in the report that you can find on McGladrey’s website here.