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.