Operational Excellence — The key lever for Private Equity value creation
In this article, we attempt to explain the PE model in simplified terms and explain the high-level value creation levers for a PE firm to deliver returns to their investors. Market forces and comparables determine the entry multiple, exit multiple and amount of debt a type of business can support. Given the run up in the market and the high number of competing PE firms’ businesses are being bought and sold at high EBITDA multiples. Given the 5–7 year holding periods there is a high probability that businesses being transacted currently will face a downturn. In such an environment, businesses will need to focus on operational excellence as lever to drive/extract business value. In this article we identify the impact of a potential downturn on the value creation levers and make a few recommendations to prepare for a potential downturn for PE held firms
Private Equity — industry at a glance
We are facing one of the longest bull runs in the history of capital markets. Underlying the bull run, there has been a fundamental change in the capital markets with the rise of Private Equity and Venture capital investments. In 1996, there were as many as 8090 companies listed in the traditional US capital markets, that number has now shrunk to 4018 firms in 2018.
In capital markets, an organization is expected to live in perpetuity while a typical PE holding cycle is 3–7 years with most exits to a strategic or a secondary PE firm. The 3–7 year cycle is necessary due to 10-year life of funds and the need to unlock capital and return it back to the investors.
The typical investors for PE and VC funds are the pension and endowment funds. Endowments such as Yale and Harvard invest as much as 60% in alternative investments such as PE and VC. Traditional pension funds have also increased their exposure to alternatives in the 20–30% range. There are now more than 3000 PE firms and over 1000 VC firms in the US.
The PE model itself started as an innovation to take distressed assets, restructure them and return the assets to the capital markets in terms of IPO exit. In 2018 less than 16% PE held companies exited through IPO. A PE holding allows firms to restructure their business model, away from the glaring eyes of quarterly reporting. The IRR for such investments is in the 30% range.
Following chart shows PE investments have swelled around 200% since last financial crisis. Increasing competition among PE firms for assets has created a trend of falling IRR though. The IRR returns from PE firms have been falling from 25%-30% range to 11–18% range in the last 10 years.
Market has become competitive putting pressure on Valuation multiples soaring up to 10.5x from low of 7.4x in 2009.
In a PE/VC model, firms need liquidity events every 3–7 years in form a IPO, Strategic sale, Secondary sale to another PE/VC or a Strategic recapitalization to unlock firm value and return capital to the endowments and pension funds (limited partners).
Anatomy of a PE deal
A typical PE deal involves acquiring an organization as multiple of revenue or EBITDA. PE firms usually finance such deals with 4x-7x EBITDA as debt and the balance is equity investment by the PE firm.
The key levers in value creation for a PE deal are
Note — We use value creation as getting a return on invested capital from a PE firm perspective.
Following is an example of a simplified LBO Model for a PE investment with entry multiple (EV/EBIT) at 10 and debt multiple (Debt/EBIT) at 6. Assuming revenue grows at 4% and PE firm believes they can improve the margins from current level of 20% to 30% within next 2 years. For simplicity sake, CapEx and NWC have been kept out of the equation. Assuming interest rate is 8% throughout the investment horizon of 7 years, after which they expect to sell it at the same EV/EBIT multiple of 10. IRR of the investment comes out to be ~ 24%.
Known unknown — Economic Downturn
We are facing the longest bull run in the history of US capital markets and various metrics are indicating towards an imminent recession. Yield curve inversion, business sentiments and lagging growth in Europe, China are few of the leading indicators of a potential economic slowdown.
Impact of downturn on key value creation levers
IRR sensitivities for individual levers
For the example deal mentioned earlier, following tables explain sensitivity of IRR to the individual levers. As seen below the revenue growth and margin expansion I.e., Operational effectiveness have a huge impact on value creation. Over 7 years typically 1x-2x of debt might be paid down.
Growth:
Margin:
Exit Multiples:
Recommendations for an operating company to prepare for a potential downturn
Evaluation of Market Correlation
Understand the correlation of market sector to a downturn. Best way to know this is to know the Industry sector beta for your organization. A beta of 1 means your business industry group is correlated in line with the capital market and a fall or rise in the capital market will have same effect on the industry group. A negative beta means your business industry group is counter-cyclical to the capital market. A fall or rise in the capital market will have an inverse effect on the industry group. A positive beta means your business industry group is cyclical with the capital market. A fall or rise in the capital market will be amplified for the industry group
Zero-based budgeting
Understand each line item on the Income statement, Balance sheet and Statement of cash flows. Understand the drivers of the line items. Start with Income statement then build out the balance sheet and cash flows. Build out Income statement and balance sheet concurrently. I.e., build out one year of Income statement, build out corresponding balance sheet for the year before going forward. We have seen Income statements and Balance sheets built out separately and can potentially provide erroneous results.
Outside in vs Inside out view
Most budgeting and internal plan development processes start with revenue and EBITDA growth requirements in next year and budgets are pushed down to various functions in the organization. Create an outside in view starting with revenue. Understand the market (market growth rate), competition (are you taking market share, why, how) and customers (NPS scores, win rates, customer lifetime value etc.)
Understand the Sustainable Competitive Advantage
It is imperative that each firm clearly understand its sustainable competitive advantage. It might be in form of customer intimacy, product/technical strength or operational effectiveness. Understand the best practices across each function Sales, Product Management, Product Development, Services, Support and understand the functional impact to the sustainable competitive advantage. It is important to deploy the appropriate tools with the best practice driven business rules and metrics to drive continuous improvement. Rarely have we seen the business process are written down with the context of best practices and impact on customer and value creation. Being data driven is a practiced discipline and a cultivated culture.
Strategy as an Innovation practice across functions
Embrace the mindset of option plays across all functions
Examples
○ Sales — Pricing pilots, NPS scores, reference development to maintain customer intimacy
○ Product Management — Voice of customers, prototyping, A/B testing, Conjoint analysis, customer valuation to drive roadmap development
○ Product Development — DevOps, Agile sprints aligned to customer value, design thinking to drive fast Innovation cycles
○ Support — Self-service, chat bots, knowledge base focus. Automation of tasks using AI etc. to continuously drive down support costs
Summary
A PE firm has five high level levers 1) Entry multiple, 2) Exit multiple, 3) Invested Equity/Debt level, 4) Revenue Growth, 5) Margin Expansion in driving in value creation to generate expected IRR’s. As seen from the models above the revenue growth and margin expansion are maximum impact to IRR levers. In the event of a slowdown, a greater burden of value creation will fall on these operational effectiveness levers. Focus on growth acceleration and expansion of EBITDA will require a disciplined data-driven, innovation and best-practices culture. Building the disciplines and culture will take time but the firms that will prepare for operational excellence and sustainable competitive advantage will better weather the downturn. Businesses with PE firm partners that will collectively plan and prepare for the downturn will be provided opportunities to drive roll-up plays, change competitive dynamics and return greater value to the investors.
About the authors:
Gautam Gole: A business leader with growth acceleration and business model transformation experience through leadership roles in Strategy, Product Management and Business Unit Management. Wharton MBA. https://www.linkedin.com/in/gautam-gole-7b608b2/
Shekhar Gupta: CFA Charter holder with extensive experience in Financial Services and Technology Strategy. Change agent managing transformational initiatives. Wharton MBA. https://www.linkedin.com/in/shekharggupta/
