Maximising the value of private equity portfolio companies
June 2013 | TALKINGPOINT | PRIVATE EQUITY
FW moderates a discussion on maximising the value of private equity portfolio companies between William Sherer, a managing director at Houlihan Lokey, Uwe Väth, a partner at PwC, and Matt Sondag, a senior director at West Monroe Partners.
FW: Could you outline some of the key risks that affect the strategic management of portfolio companies throughout the investment cycle?
Väth: In our experience, the key risks are a narrow market focus and a ‘hands-off’ management approach, especially in the areas of operations and sales. Additional risks include high cash extraction and underinvestment. A narrow market focus leaves PE firms vulnerable to market volatility, and it can harm the exit story and reputation of the portfolio company. Hands-off management can cause value to be unnecessarily destroyed if ‘taking control’ of the entity, ‘day one’ planning, and the ‘first 100 days’ of transition are left unmonitored; this is especially true in volatile market conditions. High cash extraction can restrict future investment potential which can lead to underinvestment, and therefore, underachievement of value creation in the stabilisation and growth phases of the investment cycle.
Sondag: I’d highlight four key risks. First, there’s the big risk that is out of everyone’s control – that being the economy and how a slowdown might impact them. All companies should have a game plan to combat a slowing economy. Second, many companies have the wrong strategy in place. Even the best execution of the wrong strategy will result in poor performance in the long run. Third, many companies rely heavily upon innovation to stay ahead. And let’s face it, continuing to successfully innovate is a very tough thing to do – just think of Apple. Finally, depending on the type of business, the asset of human capital can be a key risk. When the majority of the company’s assets goes down the elevator at the end of each day, this is a big risk that requires constant attention.
FW: What role does due diligence play at the pre-purchase stage? What risk factors could potentially damage value pre-close?
Sherer: Deep, insightful pre-purchase buyer due diligence is critical to understanding the business being acquired, the risks assumed and, ultimately, the price paid. Further, it can serve as the basis or framework for a high impact 100-day – or similar – post closing action plan. Key value drivers should be identified and possible action steps identified for management implementation. Interestingly, we find that even before the buyer diligence begins, the seller’s due diligence process preparing for a sale can drive value. Consequences of this work include populating a data room with thoughtful responses to concerns a buyer is likely to have and documenting thoroughly adjustments to reported financial results. While common in Europe, seller retention of third-party advisors to supplement and improve this effort has only started to take hold in North America.
Sondag: Let’s start with operational diligence. The key role of operational diligence is to assess the maturity of the operations in order to estimate if additional value can be gained through improvement. Specifically, operational diligence identifies how much opportunity exists to improve operations and, thereby, reduce costs – which directly enhances EBITDA. Not all PE firms perform operational diligence and it’s a key reason why valuations between PE buyers will differ. Those that successfully perform operational diligence have more insight into what operational value they can add, thus warranting a higher multiple. As for IT diligence, its role is becoming more critical due to the ever increasing role of technology. The role of IT diligence is to identify if the IT systems can scale to meet the PE firm’s investment thesis, coupled with providing insight regarding the opportunities to better leverage technology to streamline processes, reduce costs, or increase customer loyalty.
Väth: Historically, due diligence was completed primarily to provide an independent financial view of the potential portfolio company for financing or re-financing of bank dept. Today, additional factors such as evaluating the market, revenue projections, identifying and confirming value Creation, or cost reduction are becoming increasingly important to PE firms. Unidentified commercial risk factors, such as unsupported revenue sales margin growth and unidentified operational risk factors, such as underinvestment in capital expenditures, failure in the ramping up of new products, and underestimated carve-out complexity, can easily cause business plan underachievement, which damages pre-close value. Operational and commercial due diligence provide a higher level of transparency of the targeted business. Even more important: by identifying untapped improvement potentials like the optimisation of the purchasing efficiency or the streamlining the product portfolio, due diligence can help PE firms create a value-add investment case.
FW: What strategies are PE firms employing in the immediate post-acquisition phase to maximise long-term value?
Sondag: One of the first and most critical strategies is to ensure the right leadership team is in place.Without this, the achievement of the investment thesis could be at risk.For some acquisitions, leadership changes might not be required.Others will require new leadership to take the company to the next level and this may take up to six to nine months.A second immediate strategy is to socialise the diligence reports and results with the management team.Doing this ensures everyone is on the same page regarding not only the strengths and weaknesses, but also the action plan to achieve the investment thesis. A final immediate strategy for many PE firms is to begin the task of contacting acquisition targets.During the diligence phase, synergistic acquisition targets are identified.Many PE firms will perform add-on acquisitions during their hold period and, therefore, beginning this process early is important.
Väth: We have seen a trend in recent years in which leading PE firms are taking a more ‘hands-on management’ strategy to manage and drive value within their portfolio companies. PE firms are now more active in taking control and 100-day planning activities to ensure the day-to-day operations of their new assets. Their focus also seems to be shifting toward monitoring operational aspects more closely. For example, in the area of planning, they are executing 100 day plans to realise the full benefits of the upside potentials identified in the due diligence process. PE firms are also increasingly adding external industry and operational management experts to their teams early in the post-acquisition phase, or as early as in the second due diligence phase. Post-acquisition, these experts are tasked with creating the value identified as upside potentials within the due diligence process.
FW: Have market conditions influenced the amount of time that PE firms tend to hold on to their portfolio companies? Do you expect this to change significantly in the next 12-18 months?
Väth: Since exit timing is critical and dependent on industry specific market conditions, some PE firms are being forced to hold on to their portfolio companies longer than expected, particularly in those industries impacted by the 2008-2009 financial crisis. This is mainly due to two factors: company value and buyer interest. Company value has suffered in markets such as the automotive industry which was due to the down-turn in 2012 and weak to moderate projections for 2013. This has led to PE selling value expectations not being met. Buyer interest in weak market companies has also waned, thus, compounding the issue.
Sondag: Yes, PE firms have been influenced – the 2009 recession caused many PE firms to extend beyond their planned hold period. Given that the traditional hold period is five to seven years, all of the data is not out just yet, regarding the specific impact of the 2009 recession. It’s similar to buying a stock. If it falls in value – you’re likely to hold the stock longer in order for the value to rise again. However, corporate balance sheets have been flush with cash in the last three years, which has driven many acquisitions of PE owned companies by strategic buyers. This has helped reduce the hold period for many PE firms. As for the next 12-18 months, I don’t see this changing significantly, at least for the US. The debt markets are strong and although the economy isn’t very strong, it’s been stable.
Sherer: Currently the timing of LBO exits is driven by a number of factors but two are predominant. The first is cyclical – the availability of financing. When financing is scarce, exits are delayed; witness the decline in deals in 2008 and 2009. The current low interest rate environment has helped create an expansion of values across a variety of asset classes, and private equity is among them. The proliferation of credit from banks, BDCs, and CLOs, as well as a favourable equity market has accelerated plans by GPs to realise returns on their portfolio. The second factor influencing timing for PE exits is secular – LP capital is scarce, these funds are frequently at maximum allocation to the sector and returning capital is a necessary catalyst to raising a new fund. Together these trends are shortening hold periods and I expect that to continue.
FW: To what extent does technology play a role in maximising a portfolio company’s value? In what ways can modernising or integrating a portfolio company’s IT infrastructure add value?
Sondag: Not only can technology play a role in driving value, but technology can sometimes be the value of the company. Take, for example, data-driven companies that collect, cleanse and mine data in order to predict outcomes. Regardless of the company type, successful organisations are using technology to generate data that helps drive more informative decision making. This visibility certainly drives value, especially when it’s real time, automated and expandable. Investing in business intelligence or reporting solutions is typically a high ROI investment. Also, outsourcing certain IT commodities – such as infrastructure, back office applications – can enhance value by decreasing costs and, more importantly, allowing IT to focus on more strategic initiatives. Finally, for the key business applications, ensuring they are updated and scalable will increase value, since the new buyer will require less capital to remediate risks. Very similar to buying a home – if the roof needs replacement, the value will decrease.
Väth: Technology is playing an increasingly important role in maximising value for portfolio companies, especially in high cost countries. PEs are quickly realising the most efficient method to create value is to focus on reducing material and direct and indirect labour costs. Material and direct labour cost reductions can be achieved, in part, by investing in new technologies that increase productivity. Simply put, to ‘do more with less’. The modernisation and integration of IT infrastructures can act as an early warning system for markets and as an enabler to reduce material and indirect labour costs. This is especially true for PEs who pursue a ‘buy and build’ strategy through, for instance, the centralisation of indirect functions and realisation of increased cross-portfolio company purchasing power in order to reduce material prices.
FW: Do you believe PE firms pay enough attention to working closely with the management teams of their portfolio companies? What affect can this have on the firm’s operational performance and value?
Sherer: The best collaborations between private equity owners and managers are true partnerships that leverage the strengths of each party. Most PE firms invest in companies, and their leadership teams, precisely because they have key operating strengths and capabilities. But the best PE firms usually press management teams beyond their comfort zone. This can mean onboarding additional skill sets through recruiting, pursuing new distribution channels or customers, or streamlining processes, and so on. This is often the main driver of value for a company’s stakeholders, and its importance cannot be overemphasised.
Väth: How closely PE firms work with the management teams of their portfolio companies depends on the setup of the PE firm. PE firms are, however, extremely active with portfolio company management and the operation of the business in order to ensure the value that they are seeking is being generated. In addition, the management of the portfolio company can learn from the PE firm’s financial know-how. In our opinion, this is a positive trend which should lead to PE firms maximising their future portfolio value, thus maximising returns. Even more crucial than actively managing portfolio companies is for PE houses to find and maintain the right management team capable and motivated to driving value on their own.
Sondag: This is actually a calculated decision by PE firms. Some firms intentionally don’t get very involved with their portfolio companies and stress this approach during the sales process to differentiate themselves. Other PE firms get very involved in their portfolio company’s operations and work closely with management on a weekly basis. That said, I feel like we entered PE 3.0 coming out of the 2009 recession, where PE firms realised the days of financial reengineering – PE 2.0 – are limited. This is evident by many PE firms hiring operating executives, who dedicate their time to working with the portfolio companies – versus working on deals. As for how this impacts performance, most of the operating executives are hired for their specific industry expertise and immediately add value. In addition, they play an important liaison role between the PE firm and the portfolio company, helping manage expectations and establish the desired working style.
FW: In your experience, what steps should PE firms take to prepare portfolio companies for exit? What are the most important considerations in determining the final valuation?
Väth: In my experience, exit strategies are established prior to the pre-purchase stage of the deal cycle. Most PE firms have a ‘short-list’ of potential buyers prior to building their portfolio. When preparing an exit, PE firms should have a clear understanding of whether the exit strategy for their portfolio is for instance a growth or a synergy case. The type of case and the buyer pool will play a crucial role in determining the final valuation. Corporate buyers will most likely pursue a synergy case, or they are following a ‘technology access’ or ‘competitor removal’ strategy. PE firms, on the other hand, will most likely be interested in growth cases, in some cases also realised by a ‘buy and build’ strategy. Beside those strategic considerations PE firms should also focus on preparing a robust, ‘due diligence proof’, and even attractive, business case together with an underlying documentation of underlying assumptions and historical achievements – reports, KPI analysis, track record, and so on – early. This should also include the investigation of additional growth opportunities and a ‘360 review’ of still unaddressed cost opportunities.
Sherer: In a nutshell, the best step a PE fund can take to create value is anticipating and developing attributes in a business that make it a necessary ingredient for a strategic's business plan. Establishing those capabilities bodes well if the strategics are buying – which is difficult to predict – and will cornerstone the enthusiasm of another PE buyer that is excited to continue that development and catch the strategic next time around. Regarding ‘final valuation’, fundamental performance is where you have to start. A portfolio company that's hitting its targets engenders confidence and enthusiasm during a process. The icing on the cake will be the credit markets. Illustrated by a HY index running below 5 percent, easy money and easy terms expands valuations. By our gauge, mid-market deals have exit multiples that are up one to 1.5 times EBITDA during this period of monetary largess.
Sondag: From a technology perspective, I’d focus on four things, two of which are strategic and two tactical. First, ensure your reporting environment is mature. This may require investment, but the ROI is high. The ability to report on various operational and financial metrics – profit by customer, by product, and by velocity – is critical. Also, all interested buyers will immediately request many reports to begin the process, so this is a good way to establish a favorable first impression. Second, consider outsourcing commodity IT services. There’s likely some savings to be realised and this allows IT to focus on more strategic projects. Third, ensure you are fully compliant with respect to all software licensing. All buyers will require compliance prior to signing, so get this done early to mitigate exposure. Finally, all buyers will want to see detailed IT spend. You’d be surprised how many companies can’t produce this information.
FW: Are more PE firms undertaking vendor due diligence at the pre-sale stage? What impact can this process have in terms of identifying, quantifying and addressing any problems and exposures prior to the company, being examination by potential buyers?
Sondag: Although we don’t see sell-side diligence often, we have certainly seen it increase in the last few years. I think the value is two-fold. One, it gives the portfolio company some insight into what the diligence process will look like, kind of like a ‘dry-run’. This, in turn, gives the portfolio company some lead time to address issues. Now, the smart PE firms will do this 12–18 months prior to sale, which will give their portfolio company ample time to address the risks – rather than just putting lipstick on a pig. Performing sell side diligence three months prior to sale reduces the value in half because it only highlights the issues and doesn’t give much time to react. The second area of value is what I call ‘no surprises’. By doing the sell side diligence, there should be no surprises when the interested buyers execute their diligence process.
Sherer: While common and expected in Europe, vendor due diligence remains a rare beast in the US. When we have seen it adopted, however, sponsors find a lot of value. These deals tend to be smaller ones where scrubbing the numbers and vetting the add-backs helps minimise downstream headaches. The gating issue remains trust among counter parties; buyers of companies – PE owned or otherwise – expect to do their own homework and retain the appropriate advisors. So, while a vendor due diligence package helps gets that work started it remains a prologue to the task at hand.
Väth: As deal complexity increases, sell side due diligence becomes an important step in the pre-sale stage and we have found that more PE firms are undertaking sell-side due diligence – at least in Europe. Due diligence offers an independent view of the portfolio company to the PE firm and potential buyers. This independent view can be used to identify and quantify potential deal risks prior to starting the transaction process, which provides the PE firm with an opportunity to mitigate the risks at an early stage to increase deal value. More importantly, it can be used to identify and quantify untapped upside potential which can be used as leverage to increase the selling price.
William Sherer is a managing director in Houlihan Lokey’s Financial Sponsors Coverage Group. He is based in the firm’s New York office, where he helps coordinate the firm’s interaction with a variety of private equity and hedge funds. Before joining Houlihan Lokey, Mr Sherer completed financings and M&A transactions working with corporate and financial investors across a spectrum of industries. He has nearly three decades of experience as an investment banker and principal. Mr Sherer received a B.S. in Economics from the University of California at Riverside and an MBA from the University of California at Berkeley. He can be contacted on +1 (212) 497 4278 or by email: email@example.com.
Uwe Väth is a partner at PwC in the Management Consulting practice, based in Frankfurt am Main. Mr Väth joined PwC’s Transaction Services team in 2004 and played an integral role in establishing the Operational Due Diligence practice. Prior to joining PwC, Mr Väth worked primarily in the Plastics and Consumer Goods industries. Having primarily worked on due diligences, operational restructuring and improvements and carve-outs during his time at PwC, he transferred to the Management Consulting practice in 2012 where he has further focused upon serving the private equity market and delivering deal value to his clients. He can be contacted on +49 (0)69 9585 3150 or by email: firstname.lastname@example.org.
Matt Sondag is a senior director in West Monroe Partners’ Chicago office. He is responsible for expanding and deepening the firm’s unique offerings to the private equity market, including its merger and acquisition services. Mr Sondag works with private equity and strategic buyers involved in or preparing for investments and acquisitions. He assists buyers with pre-deal IT and Operational due diligence, as well as post-close projects (integration and carve-out activities). In addition, he works with portfolio companies to drive operational value through IT initiatives. Mr Sondag can be contacted on +1 (312) 980 9446 or by email: email@example.com.
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