I had a chance to re-read the great study from INSEAD on the emerging new models of value creation ( VC 2.0). The research contrasts traditional value creation models to a new and more comprehensive framework.
Traditional value creation elements tend to be:
- EBITDA impact – focusing on operational value creation, process improvements, technology improvements which ultimately translate to growth of free cash flow. This cannot separate impact of general industry growth from PE impact on the specific company
- Multiple impact – focuses on basically changes between entry and exit price levels. Mostly ignores economic cycles and industry shifts.
- Net debt impact – shows the overall improvement in cash position and ability to generate free cash flow. Most relevant in LBOs and not growth equity
The report argues that in recent years academic research shows no clear differentiation from industry peers vs PE backed companies in the above value creation strategies.
To measure the real impact of PE outperformance over industry in the businesses they transform, the report proposes a set of new frameworks. The analysis narrows down value attribution to value creation strategies vs general industry movements, i.e. the company-specific alpha.
The report attempts to deconstruct value creation into more drivers than the 3 traditional ones, seperating industry infleunces. Using a sample of 28 investments they found the following conclusions:
– Revenue growth was 68% of the total value creation, confirming the most impactful and most elusive area of repeatable value creation theses
– Margin improvements accounted for 16% of the total value creation. This is notable because most PE operating teams tend to focus on this much more than top line process strategies
– The rest (22%) was multiple expansion due to market conditions and industry cost of capital
The report has a series of case studies and a lot of other insights. Well worth the read.
Last week we had our 22nd global PE operating partner dinner. This event roams around the globe and so far had our dinners in New York, London, Beijing, Hong Kong, Singapore, Seoul, Tokyo, Sao Paulo. The primary purpose of the dinners is to bring together operating partners and experts focusing on value creation in the fast paced world of private equity and exchange ideas on what works best to accomplish that goal. Reflecting on the last few years a couple of themes are emerging recently in these discussions:
1) Procurement is getting more sophisticated
While several firms established operations / resources teams to improve elements of working capital and maximize free cash flow, only few firms have a repeatable and scalable engagement model for their portfolio. The strategies are limited to spend visibility and negotiated discounts and terms but contract compliance to these leveraged procurement arrangements still elude many. More sophisticated strategies involving cross-portfolio auctions and dynamic pricing are out of scope for most firms. Leveraged procurement is still very labor intensive in PE with GPOs and procurement consultants and limited use of modern marketplace and auction tools.
2) Web and mobile commerce tools are more common
Some PE firms explicitly focus on improving sales effectiveness with a broader implementation of multi-channel commerce strategies that can improve marketing and sales effectiveness but also open entirely new markets for their companies especially in low-tech industries. Surprisingly after a two decades of e-commerce, many portfolio companies have neither a comprehensive multi-channel platform nor a mobile marketing / sales approach in place to address an entire generation of customers.
3) Value creation levers are being commoditized
The strategies that are effective (like spend visibility and leveraged procurement) are highly commoditized and can neither give competitive edge to the portfolio companies nor differentiate the GP’s value creation approach in the eyes of the LPs. More importantly as procurement tools in the market mature, the procurement value creation opportunities in new targets will be less significant as the companies will have had access to GPOs and e-procurement tools as effectively as the GPs.
4) Great value creation innovation in emerging markets
Many mature market GPs look to their peers in the same markets for insight and best practices. As we worked with many firms, I noticed that some of the most creative value creation ideas will come from markets where management talent and workforce quality is less predictable. In places like China, GPs implement technologies like mobile commerce at a much faster rate to leapfrog the ineffective processes and work around the cost and churn of hyper-competitive talent markets.
I just returned from a trip to Japan talking to a dozen private equity firms about market and economic outlook.
Bain’s recently published report on the next decade’s massive capital abundance talks about a baseline of low return expectations. One way many firms countered this in the past was increased allocations to emerging markets.
Somehow the global economic outlook is troubling. Europe is in perpetual bailout mode, Japan is still in negative growth, the US has that nice fiscal cliffhanger. On the emerging side, India is in a political and regulatory chaos, China just closed its IPO markets. Brazil seems to have an upswing in activity as some western firms like KKR expand operations.
Hopefully all this global gloom will mean increasing value creation focus in the firms to regain ground on the IRR.
After all the capital is there in abundance and needs to be put to work. And public equities, bonds and commodities don’t seem to save the day for LPs. This may just be the beginning of the golden age of operational value creation.
Ever since I got involved with Private Equity operators and their many times straightforward, simple and obvious finds for value creation, I wondered why management couldn’t find the same paths to success prior to change of ownership. Taking financial engineering aside, which is arguably a major value creator, what is most astonishing is how many companies’ core operation performance improves under PE. While there is no definite answer, the seed of the truth lies somewhere in the following areas:
The oldest and biggest value creation argument has been – “while we back management we are quick to bring in the best talent”. Recruiting great performers does not sound like rocket science to me. Why can’t a company upgrade their managers and functional specialist before PE shows up?
Performance and Rewards
The outsize rewards of meeting and exceeding EBITDA targets are a major lever. This may be one of the most important. Many companies I met had a hard time with their incentive models both on the upside and the downside. Without PE owners managers would rather keep a narrow band of rewards between top players and bottom performers than create a competitive workplace. Over time the underperformers stick around and the top athletes leave for a workplace that better rewards them for delivering twice as much. If you think you have meritocracy try this test: if your top sales guys deliver 2x the expected do they get 2x of the bonus? How about your CFO or CPO? How about delivering half? Is that half or none of the bonus pool? I rest my case.
Knowing What Works
Having been involved in performance benchmarking for a decade now, I’m convinced that the average company is woefully unaware of where they stand against their peers in most but a few functional areas. Benchmarking becomes a tool to justify a pet project to the board vs. a way to discover and fix weaknesses and exploit strength. PE brings this discipline to bear.
This is huge. I spent the early years of my career in projects like ‘improvement portfolio optimization’, which was a way for a company to rationalize and prioritize hundreds and sometimes thousands of initiatives. Most projects remained on the books and I believe the average large corporation still has hundreds of competing and parallel programs, most with massive negative impact on the business in distraction, wasted resources or simply sunk cost. PE has an unparalleled ability to cut down the chaos and focus the business on very projects with quantifiable results. And executive compensation tied to the results.
Initiative du jour is so true it is a cliche in most companies. Beyond the question of focus above, the cash flow pressure of debt paybacks many times create a culture of thrift, attention to real business cases and results. My former boss at a public company had this approach even without PE: whatever the project needs in terms of resources – give them half. Mostly the projects will still come in on time, delivering the results and not wasting too much time and resources in navel gazing.
The key point here is this: almost all operational tools PE deploys are available to management teams. If they had the focus, discipline and right talent they would be able to reap similar returns to PE firms without surrendering most of the rewards.
In the last few months China’s Private Equity revolution got a lot of attention due to the Focus Media LBO, touted as largest to date. Apart from size alone, I do think the shift from minority non-control investments to LBOs is very interesting. While I leave the regulatory and financial engineering aspects of these changes to other specialists, I do think control will inadvertently bring a need for more active investors, operating partners and more effective operational methods. Maybe Brazil and India will follow…
In fact, as we work with several large indigenous Chinese PE firms we noticed a unique value creation approach. Instead of just tweaking operations, some PE houses use western best business practices to help grow businesses. In addition, some firms use IT to solidify and enforce business rules and optimal processes. As one operating partner described it to me, it is a lot harder to secure the necessary talent to upgrade management (job competition in major Chinese cities is enormous). Instead of just “hiring and backing good managers” as the traditional GP approach goes, more firms train managers in world class processes. As this experiment unfolds, China may invent a new approach to value creation in emerging markets that other GPs in India and Brazil will be hard pressed to replicate.
Given all the negative publicity and attention to PE these days it’s too bad more firms haven’t embraced and publicized green initiatives across their portfolio. If you have to lean operations to create value why not save the environment at the same time. Especially since looking at KKR’s Green Portfolio Initiative the returns can be significant. According to KKR in 2011 with 13 participating portfolio companies they were able to avoid $365 million in costs, 810,000 metric tons of GHG emissions, 2.2 million tons of waste, and 300 million liters of water.
Why haven’t more PE firms taken green initiatives seriously, or at least publicized their results? Apparently Carlyle has “adopted environmental, social and corporate-governance (ESG) principles due to influence from investors” however they are not sure it leads to more cash flow. In this case I think the difference between KKR and Carlyle is that KKR incorporated their Green Portfolio Program into their Capstone improvement plans where Carlyle only adopted principles to satisfy investors and didn’t believe in their impact. This is not to say Carlyle isn’t a hugely successful firm, they are, but they fall on the other side of the spectrum when it comes to creating value through operational improvement.
But what about other operationally focused PE firms like TPG, Blackstone, or even Bain Capital that have operating teams and could easily incorporate green initiatives into their improvement plans. Sure TPG and Blackstone mention sustainability on their website but I would guess they are whimpers to appease LPs. They surely don’t state they are generating value from sustainability. So why not focus on green initiatives and sustainability, the returns are there and the industry could use a bright spot.
I’m at an operating partner dinner in Calgary and this provided a great background for a conversation on the wide variety of operating partner models. Interestingly our firm holds these dinners around the world from New York to Beijing, London, Toronto, Singapore and other PE centers. We have seen the operating models work great in full control situations in LBOs, in minority investments and even in models where the sponsors clearly have limited say on the board or in operations.
What we learned is that industry/operating expertise translates directly EBITDA improvements and increased EV and both GPs and management are eager to explore those avenues.
Not that the operating models have standardized much. There are a couple of common themes emerging that are of interest:
– Operating Expertise provide differentiation in deal origination
This is obvious for industry specialist firms but general process expertise (procurement, sales, distribution) do play a key role in gaining support from management or promoters to back a certain sponsor for a deal. Interestingly, this is an emerging theme in markets like Brazil, India and China where capital is perceived to be abundant (ignoring the obvious regulatory hurdles in all these markets). The owners desire to retain control over the business may be somewhat mitigated by the investor’s ability to expand management expertise. Especially in markets like China and Brazil where backing good management is an insufficient investment theses given the competition for top leadership talent. The investor’s ability to provide best practices and a steady hand is critical in the growth of the enterprise.
– It is critical to get early wins and then getting beyond leveraged procurement
Most firms we work with realized that the most reliable way to add value to the portfolio is through procurement programs (ignoring turnaround situations that obviously demand a series of working capital and cash flow management actions).
The great thing about leveraged procurement is that there always seems to be a way to get a better deal, more reliable supplier and expending that across even a modest portfolio provides immediate cash savings.
The issue becomes that of diminishing returns. Once the program is established, the suppliers aligned, the analytics and KPIs are in place – where does the operating partner add value next?
It seems to be fairly inconsistent both in approach and results. Sales is one obvious target and both due diligence and post-close activities focus on sales effectiveness, territory alignment and other programs. Improving sales seems to be a very industry specific expertise once operators get beyond the basic questions of coverage, account profitability, cost of sales and segmentation. Depending on the market, especially outside NA and mature EMEA – true expertise is harder to come by.
– Repeatability of success is dependent on operating partner coverage
Private Equity loves repeating success. If something worked in one company let’s do it again in our next acquisitions. From an operating partner perspective, again, leverage procurement is perfect for this as many purchasing categories (office supplies, telecommunication, IT hardware, employee benefits) work easily cross-industry. Coverage emerges as a key problem from two angles 1) how many portfolio companies can a partner cover to assess, develop and support these programs 2) how can they get beyond procurement without having to bring in a wide variety of specialty consultants for different processes and industries. The more players are involved the less likely that a repeatable lwo-risk thesis can emerge.
– Learn to influence when you are not in control
We work a lot with minority investors, some in the States but mostly in Asia. The control issue becomes both a major impediment and also a differentiator to successful operating models. One of the largest Asian firms has a captive in-house consulting arm that is used as a differentiator in deal cycles (as stated above) but also has the necessary specialist expertise in both the industries and the thesis of the GP. When the consulting team is offered by the sponsor to management, they have a clear edge over an outside consultant. In effect, the minority investor becomes both the trusted advisor but also the integral element in the value creation plan without compromising the proper governance of oversight but not overstep.
Just a quick call out to an article that was in the New York Times on July 11th called “Private Equity Giants Use Size to Lean on Suppliers”. It focuses on the Blackstone Group and discusses shared procurement/group purchasing, one of the main value levers I mentioned in my post on June 13th. It also positions an interesting counter argument that group purchasing could strain relationships with critical suppliers while getting minimal benefits. I think it’s pretty clear where you draw the line on this one: commodity goods like computers, shipping, office supplies vs unique goods from strategic partners used for competitive differentiation.
Also interesting in the article…
If you aggregate their portfolio company revenues, Blackstone would be the 17th largest company and KKR would be the 5th.
Last Friday Private Equity International (PEI) launched their first awards category for Operational Excellence in private equity. First I want to say, it is about time! Secondly, my biggest hope when I saw this was that these awards would help to show how successful firms are creating value through operational improvement rather than just select a winner based on the success of one portfolio company while the firm may not have a true focus on operational improvement. However after looking through the submission form and the metrics they are asking for it looks like we will get the latter. From my experience the top firms across the industry are all facing the same challenges with operational improvement. They are all grappling with the same questions; how many operating partners to have internally, what is the ideal profile, how should they work with the portfolio companies, how should they be incentivized, when to outsource operational improvement to specialized consultants, etc…. Many firms and portfolio companies could benefit from learning how other firms are approaching these questions, where they have failed, and what actually works. While I appreciate PEI’s new award category and think it is long overdue for firms to get the recognition they deserve for the value they create I feel the criteria for the awards miss the target on the most beneficial insight.
The submission form for the awards includes the following questions:
Private Equity firm name:
Portfolio company name:
Location of portfolio company headquarters:
Initial investment date (deal agreed):
Investment fully realised date:
Top-line revenue growth:
Employee numbers at entry & exit:
Market share growth:
Product number growth:
Exit multiple & IRR:
Average time per month spent with portfolio company (days):
The last question and the narrative portion just start to get at the heart of it. All the metrics are great for showing a business has improved over the period of PE ownership but not HOW or if the PE firm actually made a difference. It is also unclear if the winners of the awards will be judged on the success of one portfolio company or multiple portfolio companies (which would require multiple submissions). The biggest challenge with operational improvement is making it scale effectively with limited resources while adding value across a portfolio of companies. By adding questions that focus on how PE operating teams are structured and how they operate along with the performance data from the companies they work with we could begin to see which strategies and methods really work.
So, here are some suggested additional questions for next year’s submission form. These would begin to get at the heart of how PE creates value with operational improvement. Do you have any to add?
How many operating partners are fully employed by the PE firm
Are the operating partners aligned by industry or functional expertise
What percentage of the portfolio are the operating partners involved in
Typically who, beyond company management, is primarily responsible for the operational improvement plan at the portfolio company (company board, deal partners, operating partner)
How many operating partners typically get involved with a portfolio company, average time per month
Do the operating partner/partners have a specific expertise (lean, industry depth, IT, etc…)
Who do the operating partners report to (portfolio company board, deal team, the PE firm)
When do the operating partner become engaged with the portfolio company (due diligence, part of 100 day planning, drive execution during holding, prepare for exit)
Do the operating partners typically also sit on the board of the portfolio company
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.