Managing directors can modernize their approach to value creation for their portfolio companies with these six practices.
Persistent inflation. Expensive debt. High valuations – following a record-breaking 20211 – that now increase risk and pressure to perform. As private equity groups (PEGs) face these challenges, value creation strategies for newly acquired portfolio companies take on greater urgency.
Operational improvements remain among the most fundamental and effective ways to create value and boost earnings before interest, taxes, depreciation, and amortization (EBITDA) margins. But some PEGs might be following an outdated playbook – and failing to achieve the full potential of their investments. Only a thoughtful, data-driven approach can identify all the available efficiencies and maximize their impacts.
PEG managing directors can follow these six best practices to drive deeper operational improvements.
1. Begin the process earlier
Day one of ownership is too late. Well before a deal closes, deal teams and operating partners should begin assessing operational improvements in parallel with due diligence activities. Involving external advisers and consultants earlier also can help achieve results sooner.
Proactive analysis at the start of a hold period also can help PEGs identify and mitigate operational challenges that otherwise might not become apparent until year three or four, when margins have already degraded and issues are more difficult to address.
Crowe observation: While underperforming portfolio companies often draw significant time and attention from deal teams, sponsors should not overlook the opportunities that often exist within their companies that are growing rapidly and tracking toward goals. Current success doesn’t mean that there aren’t major operational improvement opportunities to find and execute, leading to even greater EBITDA margins.
2. Emphasize cooperation and trust
Managing directors often don’t have the capacity for day-to-day involvement in operational improvement planning. As leaders, their role is often to promote trust-building and open communication among PEG teams, portfolio company management, and external consultants.
Again, timing is key. The due diligence phase presents an opportunity for PEG teams and external consultants to begin a “listen, diagnose, and execute” process in collaboration with company management. Stakeholders can discuss challenges, develop a shared understanding of the business’s maturity, and align on value creation priorities.
Example: A multimillion dollar commercial heating, ventilation, and air-conditioning (HVAC) company worked with an external consultant to identify inefficiencies holding back its next phase of growth. Honest communication and close collaboration identified wasteful inventory management, a frustrating lack of standardized processes, and high turnover among key HVAC technicians. A 20-week execution plan addressed these issues and increased EBITDA by more than $5 million per year.
3. Assemble a team with deep industry expertise
Trusted relationships can flourish when PEG teams and consulting partners speak the same language as their portfolio company counterparts. Most PEGs are skilled at building deal and operating teams with experience in their portfolio company industries (such as manufacturing or healthcare). This shared experience improves their ability to analyze day-to-day operations more effectively and recommend the best operational improvements.
Example: A private equity-backed manufacturer engaged a third-party consultant with deep experience in heavy industry logistics and operations. After a five-week analysis, the consultant recommended improvements to freight logistics, sourcing practices, and vertical integration to the tune of millions of dollars in savings and a significant return on investment.
4. Push PEG teams to interrogate the data
A quick scan of a portfolio company’s profit and loss statements often can reveal obvious areas for cost savings and operational improvements. But many opportunities remain hidden without deeper analysis. Managing directors should promote a firmwide culture of hands-on, data-driven analysis that pushes team members and consultants to ask probing questions, analyze data sets more closely, interview portfolio company staff, and uncover the “whys” behind the data.
Getting closer to the people who are doing the day-to-day work can reveal more insight about the issues than sound bites from executives on monthly operating reviews.
Example: A multimillion dollar food supplier experienced declining sales and single-digit EBITDA. Its average return rate (for the products stocked on grocery store shelves) had grown to above 10%, leading to tens of millions of dollars in lost revenue. Analysis by an external consultant revealed the story behind this statistic: overstocked shelves due to poor inventory management and prediction of variable demand. Operational improvements netted millions of dollars in EBITDA savings.
5. Look beyond traditional value creation levers
Tried-and-true operational improvements such as pricing optimization; selling, general, and administrative overhead reduction; and salesforce effectiveness will always have their place. But digital transformation initiatives hold tremendous promise as well. As companies grow rapidly, their existing technology-driven systems and processes often don’t scale to meet their changing needs. PEG teams and consultants can recommend improvements such as robotic process automation (RPA), cloud computing, or cybersecurity upgrades.
Example: Consider the hypothetical case of a newly acquired manufacturing company with labor-intensive, error-prone processes for purchase order creation, inventory reports, and transportation logistics. RPA could address each of these repetitive tasks and dramatically reduce labor costs.
Crowe observation: Many PEGs do not invest significant time to understand the value creation solutions of their consulting partners – especially the solutions that emphasize repeatability and situational strength.
The takeaway: PEGs should spend time with consulting partners to iterate delivery of replicable solutions across the portfolio. Focusing on repeatability can significantly increase the likelihood of success.
6. Document improvements for the next buyer
Executing successful improvements isn’t enough anymore. PEG teams must document their value creation strategies and key performance indicators to chart the trajectory of operational improvements during the hold period and beyond. An effective process to map out improvement initiatives and measure progress often increases the likelihood that the next buyer will accept EBITDA adjustments related to achieving “run rate” on the in-flight initiatives.
"Managing directors should promote a firmwide culture of hands-on, data-driven analysis that pushes team members and consultants to ask probing questions, analyze data sets more closely, interview portfolio company staff, and uncover the 'whys' behind the data."
Value creation remains central
With so much economic uncertainty ahead, PEG leaders should tap every opportunity to create value and increase returns. The modern playbook goes well beyond cost-cutting and financial engineering. Through careful analyses and collaboration with portfolio company leaders, PEG teams can unlock the full potential of their investments.
1 “Private Equity Reached New Heights in 2021 as Average Deal Size Pushed Past the $1 Billion Mark for the First Time Ever,” Bain & Company, March 7, 2022, https://www.bain.com/about/media-center/press-releases/2022/global-pe-report-2022/