The downturn is driving private equity firms away from an emphasis on deal making and toward a new focus on operational improvements—a shift with important implications for public companies. By Andy Tinlin, Markus Rimner and Rajesh Sennik Outlook Journal, June 2009 Download this article [PDF, 269KB]
PDF Help It was deal making on an unprecedented scale: Between the start of the latest buyout boom in 2002 and the onset of the credit crunch five years later, private equity firms acquired and co-invested in $3 trillion worth of assets globally. Inevitably, with so much money flowing in, competition for assets intensified during this period. And as more players acquired the financial engineering skills pioneered by private equity firms, assumptions about gains from balance sheet restructuring started to be built into bids. Indeed, by the time the credit markets ground to a halt in July 2007, it was not unusual to see a host of private equity firms bidding for the same asset. As a result, the sellers of the asset were in many cases getting more of the financial upside than the buyers. So where does the private equity industry go from here? Even before the credit crunch, some firms were shifting their focus from clinching new deals to the challenge of boosting returns from those already done. And during the past 18 months, prompted by the dearth of deal-making opportunities, others have joined them. Leading firms, in fact, now work with a new value-creation toolbox, with a focus on effecting the operational improvements in their portfolio companies that can boost cash flow and fuel higher operating profits. To achieve this, they have strengthened their teams by recruiting seasoned executives and advisors who can support portfolio company management teams in identifying and driving those operational improvements. Since portfolio companies are in a wide range of industries, the most effective approach for most private equity firms is to develop a toolbox that can be similarly effective across industries. Private equity firms, therefore, have been zeroing in on a few key operational areas. This has broad implications for public companies. Significant operational improvements among companies owned by private equity firms could make them much more daunting competitors. At the same time, however, public companies can learn from the approach private equity players are taking. Improving cash flow
Accenture research suggests that improvements in supply chain efficiency and the introduction of pricing disciplines can each improve underlying cash flow by 25 percent to 30 percent—and that the basic tools for making these changes can be applied across most industries. Accenture's experience also indicates that the rationalization of back-office functions, including finance and accounting, IT and human resources, can improve cash flow by a further 5 percent to 10 percent.   In 2007, for example, the New York-based private equity firm Vestar Capital Partners implemented a supply chain improvement program at Solo Cup Co., which provides paper coffee cups to foodservice operators and distributors to leading chains like McDonald's and Starbucks Corp. The program, which included boosting inventory turns to lower working capital requirements and the closure of peripheral manufacturing plants, increased cash flow by some 33 percent.
Meanwhile, when a leading family entertainment group that had recently come under private equity ownership raised prices at its attractions, it had no effect on attendance. To the contrary: Although prices were raised twice in 2008, by a total of 10 percent, visitor numbers rose by nearly 30 percent in the same period—a clear indication that the private equity owners had judged price elasticity correctly. Similarly, because the owners could offer visitors holding an annual pass for one of the group's most popular attractions access to other attractions as well, they were able to raise the price of the pass by 50 percent in the two years following the deal. Value gap
Given the urgent need to plug what is by now a large value "gap"— $2 trillion must be created globally by 2011 if investors' expectations are to be satisfied—more and more private equity firms will seek to create value by driving such improvements. What's more, Accenture analysis suggests their efforts could bear significant fruit. A recent sample of private equity transactions shows that if the operational improvements outlined in their management plans were fully achieved across the entire sector, they could close almost half the current value gap.  In the meantime, private equity's new focus on operational improvements has much broader implications. Sustainable value creation in any asset derives from its future cash flows. Accenture research shows that up to 70 percent of the value of any company—even a large, mature company— can be based on an expectation of future cash flow growth. That suggests that any management, whether of a privately held or publicly traded company, struggling to create value in the downturn and beyond could benefit by viewing the challenge through a private equity lens.
To be sure, when it comes to value creation via operational improvements, private equity firms have a built-in advantage. Thanks to their Wall Street origins, their mindset is overwhelmingly financial. Because they have an exceptionally clear view of the financial impact of change initiatives, they know exactly which ones will have the most positive impact on value. Private equity owners select only a very limited number of change initiatives—those most likely to result in the kind of financially viable company they can sell for a profit a few years down the line. Moreover, leading firms pursue these projects with the exceptional rigor that characterizes just about every aspect of their approach—including the way they handle the commercial due diligence that identifies portfolio companies with potential in the first place (see sidebar, below). When it comes to execution, private equity's commercial instincts can be especially effective. Having defined a value-creation target for the company and having identified those operational improvements most likely to lead to its realization, leading firms align the interests of all stakeholders around both immediate priorities and the end goal. They hire managers—including outsiders with operational backgrounds—and motivate them through equity ownership to act like owners. They also track their progress relentlessly and take immediate corrective action when things go awry. (For an example of how private equity firms are becoming much more active on the boards of acquired companies, see sidebar) The spread of performance-based pay for chief executives of public companies might be expected to limit the upside from incentive alignment when a company is taken private. But private equity owners still do much better than their public counterparts in this respect, in part due to taking a longer-term ownership approach to incentives. Operational improvement initiatives can be disruptive for any company—private or public—especially when they involve outsiders. But as long as they are judged correctly in the first place and their implementation engages the portfolio company's management without disempowering them, they can also reap substantial rewards. That has certainly been the experience of many leading private equity firms. Public companies seeking to drive higher operating profits and bolster competitive advantage could do worse than seek to emulate their example. About the authors Andy Tinlin, a senior executive in Accenture Strategy, leads the company's global Mergers & Acquisitions group. With nearly 20 years' experience, Mr. Tinlin currently works with the boards of leading clients to help address their strategic and operational issues in areas such as growth strategy, M&A and business transformation. Before joining Accenture, Mr. Tinlin held a number of management positions in commercial organizations. He is based in London. Markus Rimner leads Accenture's Mergers & Acquisitions group in the United Kingdom. Mr. Rimner, who is based in London, advises private equity firms and companies through the entire M&A cycle, focusing on commercial and operational due diligence as well as integration planning. Rajesh Sennik leads Accenture Strategy in India. Prior to this role, Mr. Sennik led the company's private equity service line in Europe. He has advised numerous private equity funds and companies on their commercial and operational due diligence activities during mergers and acquisitions—including Europe's largest leveraged buyout. He is based in Delhi. Sidebar 1
LDC: A Culture of Ownership For many in the private equity industry, deriving value from operational improvements in the companies they own is a relatively new strategy (see story). For Lloyds TSB Development Capital (LDC), however, it's pretty much business as usual. LDC, which is a wholly owned subsidiary of Lloyds Banking Group, one of the United Kingdom's biggest banks, was founded in 1981 when the modern private equity industry was just taking off. At that time, pioneering firms could generate returns for investors up to two and a half times those available in the stock market, as well as handsome profits for themselves, just by buying low and selling high. Those days, of course, are long gone—and LDC was swifter than some to anticipate their passing. The UK mid-market player shifted its focus in 2001. The bursting of the dot.com bubble prompted the firm to review its approach to new investments as well as its existing portfolio and concentrate on helping management teams grow shareholder value. LDC currently holds a portfolio of some 60 companies, across a range of sectors in the United Kingdom, with an aggregate value of around £2 billion. Each year, it invests in 10 to 20 new companies and sells roughly the same number of businesses. The key to success: a hands-on approach to ownership that involves investing a lot of time and energy in relationship building with existing management—even before a deal is done. LDC's Value Enhancement Group, a team of strategists, industry and operational improvement specialists, is involved, alongside the transaction team, in the three- to six-month due diligence process leading up to deal completion. The aim, explains LDC deputy CEO Patrick Sellers, is for the group to formulate, with the management team, a 100-day plan aimed at identifying areas for improvement and focusing on "quick wins" that will boost profits and cash flows. Once the plan is completed, LDC continues to work alongside management teams on longer-term value-enhancing projects. Because LDC prefers to work in partnership with existing management, the group pays particular attention to assessing the quality of management teams and understanding their strategy and ambitions. LDC may, where appropriate, bring in outside expertise to help in certain specific areas, but the firm would rather walk away from a deal than have to recruit a whole new team to run the business. In fact, although LDC will act as a facilitator, it relies on existing management to implement its value-creation strategy for every company in its portfolio, so once an investment has been made, the firm maintains a continual dialogue with them. Differences are openly discussed at the board level, and rather than trying to unilaterally impose its point of view, LDC uses the power of persuasion to resolve disputes. An outside, independent non-executive chairman is an especially important appointment in this regard. Sellers recalls the pivotal role played by one such director in convincing a management team to change its procurement policy. The company had historically sourced in the United Kingdom, a practice that was depressing its margins. But the board feared that sourcing abroad would diminish product quality. The non-executive chairman, who had many years' experience sourcing overseas in similar industries, was able to address these concerns and help the team successfully plan and execute the transition. Procurement, indeed, is viewed as so important to value creation that LDC employs a specialist to help management teams identify and capture opportunities in sourcing, tendering and pricing strategies. As its model has evolved, LDC has continued to develop a longer-term view of operational improvement projects in general—a reflection of its deep conviction that only sustainable improvement will boost cash flow and profitability and thus contribute to an uplift in value when the business is sold. All ultimately depends, of course, on the management team's conviction as well. And this is where LDC's hard work upfront really pays off. As Sellers observes, "One of the beauties of private equity is that the interests of shareholders and the management team can be so very closely aligned." By obtaining management's buy-in from the very beginning, LDC ensures that they are. Sidebar 2
The Right Target If private equity firms are going to meet investors' expectations, they need to optimize cash flow (see story). And that means they can't afford to pack their portfolios with companies that will underperform. Picking the right target is essential. It is the job of commercial—also known as strategic—due diligence to provide a view on the potential operating cash flow of a target company. Yet most commercial due diligence concentrates either on the market dynamics only or on validating the information that underpins existing—not future—cash flows. What's more, it tends to do so rather simplistically, leaving many acquirers with only a sketchy understanding of the assumptions underlying management plans. Good commercial due diligence, by contrast, identifies the key performance drivers at the outset—and thoroughly tests them to provide a rigorously objective reality check on management forecasts. The devil, typically, is in the details. A prospective private equity buyer recently pulled back from a deal with a major European media and entertainment company after doing some detailed analysis of the current management's forecast. The forecast was based on the assumption that 70 percent of revenue growth would be driven by annual advertising price increases. After analyzing the planned increases in light of historic pricing, market price elasticity and the ability of then current operational processes to support them, the prospective buyer decided the forecasts were too optimistic. It was clear, in fact, that future cash flows would be significantly lower than projected. In this instance, future growth would have required substantial operational improvements—rewarding the sales force for increases in margin, not revenue, for example, to discourage rate discounting, as well as improved tracking and management reporting. All of which underscores the importance not only of commercial due diligence that addresses many of the post-deal improvement issues typically tackled in the first 100 days after an acquisition, but also the often complementary role of operational due diligence on those parts of the business most critical to meeting growth projections and capital expenditure plans. To Top Back to Contents |