Private equity sometimes earns a poor reputation because of a historic perception of cutting costs (including laying off workers and staff) to improve profits. This is an extremely limited view, and modern private equity is more focused on growth: hiring new talent, developing new products and services, expanding production facilities and the workforce, and growing the company’s footprint and the business as a whole. It’s no longer just about cutting costs to boost profits — it’s about boosting the long-term viability of the asset via a more fundamental strategic change in direction.
Private equity investment strategies that have a defined approach to making a value creation plan are important. Making operational improvements to portfolio companies and then selling them at a higher intrinsic value for investment returns is a more durable and robust strategy than the alternative: relying on clever deal structuring, financial engineering (leverage), and/or multiple arbitrage (buy low, sell high). Under certain market or business conditions, these latter techniques may generate attractive returns, but if pre-investment assumptions do not go according to plan, then the likelihood of achieving the target return diminishes. Here are two high impact private equity value creation techniques that will create more value in your portfolio:
1. Understand the true capacity of your portfolio company
The level of capacity directly relates to the amount of output in the form of goods and services that manufacturers can produce to satisfy customer demand. Capacity planning strategies can guide manufacturers on how much raw materials, equipment, labor, and investment in facilities need to be acquired over a period of time to meet future demand for products. When there is a lack of capacity planning, customers’ needs are not served promptly, and these customers may be lost to competition.
A good capacity planning strategy helps adequately plan manufacturing resources. Excess capacity means the manufacturer’s money is being spent inefficiently, and this could have been invested elsewhere for a profit instead. On the other hand, low capacity implies the inability of the manufacturer to produce as per what the customer wants at a particular period of time costing companies top-line revenue growth.
Your portfolio companies’ questions that should be addressed at a board meeting or during a quarterly review might be, “Can you share with us what the capacity percentage is of your bottleneck operation?” or “What steps are you taking to increase capacity at your bottleneck to promote growth?” If the local senior leadership team does not know the answer to these questions, it could mean that the business processes are so unpredictable that the company’s performance could drop quickly as demand increases/decreases.
2. Challenge KPI’s/current operating standards to drive performance
Only one-third of CEOs say PE owners provide a clear structure for key performance indicators (KPIs), and the number drops to 10 percent for those in underperforming companies. The level of clarity seems to correlate with the size of the fund, with mid-market funds being the worst offenders.
It all starts with defining your vision and strategy; not at a high level, but at a more tangible one which allows each level of the organization to make the right choices daily. A clear, prioritized strategy enables an organization to push decisions to the lowest possible level because people at that level understand the ultimate priorities. Once you have a clear strategy, how do you translate it into meaningful KPIs for every level of the organization? How will the shop floor worker know that, at the end of his shift, he has contributed to the business goals?
Visual display and visual management of meaningful and real-time KPIs for each department enables regular performance dialogues. The ultimate question should be: How can you get the rhythm of the whole organization ‘in sync’ to achieve these business results? How is the shift change-over discussion escalated to a daily cross-functional review between operations, maintenance, and engineering? And which topics need to be escalated to the weekly or monthly longer-term management processes?
Strong performance metrics/ KPI’s allow problem-solving at different levels. Highly effective problem-solving uses the problem-solving capabilities of the entire organization, by moving the majority of actions to the lowest level possible (first tier). That may require a change in company culture toward a more independent or interdependent organization, so operators, mechanics, lab technicians, and customer service representatives not only feel permitted, but positively encouraged, to solve the majority of problems themselves, right away.
The operational culture improvements described above ultimately materialize in the form of top-line revenue growth and higher operating margins that translate into stronger operating profit, typically measured in EBITDA. Value creation as an analysis is commonly expressed in terms of company enterprise value, or the overall value of the company and the key drivers of enterprise value in a value creation context are revenue growth, (EBITDA) margin expansion and multiple expansion.
If you are interested in learning more about private equity value creation levers, POWERS is here for you. We are an implementation-focused consulting firm that works with your portfolio companies’ leadership team to increase cash flow, EBITDA, and growth. Learn more about how we can improve your private equity value creation strategies.