Enormous increases in computing power, cloud computing architecture and inexpensive storage, mean the sheer quantity of data available to companies today is growing exponentially.
The increased sophistication of artificial and machine learning technologies means data can be analysed to produce ever greater insights. Private equity firms are investing heavily in the operational resources required to exploit this trend.
“Today’s best performing companies are utilising data and supporting technologies to drive operational excellence, sales and marketing efficiencies, and improved customer experience, generating significant returns for their investors,” says James Prebble, director at digital consultancy Palladium Digital.
As private equity firms face soaring asset prices and heavy competition for deals, analytics can be used in due diligence to help understand the target and uncover its true value. It can provide clarity on key business drivers including where the company is growing, customer segments and how they are changing. Once the deal is completed, analytics can be used to identify value creation opportunities, uncovering areas of potential improvement.
Many firms are already using scraping tools to extract and analyse data from the web to evaluate customer sentiment or obtain competitive data on product pricing or selection, for example. Analytics can also be used to optimise digital marketing, evaluate traffic patterns, and crucially, predict how disruptive new technologies or business models may change the markets in which they are operating.
Furthermore, analytics can provide immediate feedback on the drivers of key performance variations across sales, margin, cost management and cashflow, to support real-time decision-making.
The use of analytics in private equity remains nascent, with the majority of firms still tapping into external expertise. However, some larger firms, such as Oak Hill Capital and Blackstone, have hired dedicated data analytics teams, and managers everywhere see analytics as a key to value creation.
ECI Partners recently built a lead-scoring model to assist a portfolio company in allocating its sales resources to the leads with the highest chance of conversion and the highest potential lifetime value, explains the firm’s investment director, Duncan Ramsay. “In other recent projects, the team has built churn propensity models,” he says. These allow the portfolio company to assess segments of the customer base most susceptible to churn and to intervene to reduce the likelihood of this.
“We believe the opportunity to create value through data is greater than ever before. The volume of data generated globally continues to double every two or three years, with the capacity to store this data rocketing and the associated costs plummeting – despite fears over the future of Moore’s Law. What’s more, rapid advances in data science and artificial intelligence mean the insights that can be generated from this data are becoming ever more valuable. Whether you think that it is the new oil or not, the rise of data cannot be ignored.”
Buy and build
High entry multiples mean buy-and-build strategies have soared in popularity, supporting business transformation with access to new geographies, in addition to cost savings through synergies and the rationalisation of support functions.
The increased size of the company can also allow for enhanced leverage opportunities and better position the business for a trade sale or IPO, as well as commanding a higher multiple on exit.
Indeed, the success of the private equity buy-and-build model has been exemplified by the consolidation of the veterinary and dental industries in recent years. One of the biggest veterinary players, AniCura, backed by Nordic Capital, was acquired by Mars Petcare in November 2018.
“Buy and build is a key method of potential value creation through gaining scale in a market, accelerating new market entry or moving into adjacent products or services,” says Gareth Whiley, managing partner at Silverfleet Capital. “We can be of particular help to our portfolio companies by sourcing, structuring and executing add-ons, especially internationally, if they don’t have the in-house expertise.”
For a buy-and-build strategy to work, however, firms need to be
investing in highly fragmented markets. They also need to identify
a stable platform company to act as a building block for growth. A strong pipeline of targets and stable environment in which to pursue them is also important, as is consistent free cashflow to finance deals and repeatable financial and operational models.
“In a fragmented market the best way to create value is often through buy and build, particularly for a services business where the alternative of opening new points of sales is typically slower,” says Carl Nauckhoff, senior principal and head of investor relations at Investindustrial. “It is important that the original platform has the right quality and systems and a management team with experience of integrating acquisitions, although in some cases management may need to be reinforced.”
Cashflow is the single most important financial factor determining a company’s success or failure.
Great products and revenue streams are useless without processes designed and managed efficiently to spin off cash.
Failure to adequately manage cash brings many businesses to the door of turnaround specialist Endless, says the firm’s managing partner Garry Wilson. “Many profitable companies need my help at short notice because they haven’t managed their cash properly, which is crazy. [It is] such basic stuff and one of the things that private equity firms have learnt how to do very well. Every cent generated from better management of working capital during our ownership goes straight to value. Everyone talks about EBITDA and wants to see the P&L, but for me it is cash generation and funds flow every time.”
In addition to simple survival, cash is required for capital expenditure programmes, ranging from new manufacturing facilities to office space or developments in new technology. Cash is also critical for transformational acquisitions. Without cash, growth-related investments suffer and a company can fall behind the competition.
“For many portfolio companies, there is scope for us to assist in creating value by optimising cash dynamics, and our experience can be helpful,” says Andrew Backen, partner at Equistone Partners Europe. “This can include adding specialist finance and treasury expertise from our network, investing in systems and processes, and ensuring the company’s banking facilities are a good fit. Our investment in Small World, an international money transfer provider, is an example, as the company seeks to manage its flows of cash around the world ever more effectively as it realises strong growth.”
Digital transformation is now a fundamental driver of operational performance enhancement in private equity-backed businesses.
This can include a combination of new technologies such as big data analytics, high performance computing, artificial intelligence, machine learning and the Internet of Things, to name a few.
The pace of innovation is astonishing. PE firms and their portfolio companies have taken note. “This next wave of change including increased and more intelligent automation will fundamentally change the workforce. We have to prepare for that,” says Georgette Kiser, operating executive at the Carlyle Group. Advances in AI and predictive analytics are extremely important for companies to embrace and harness. Sean Epstein, senior vice-president and head of private equity at SAP, says: “This, plus the coupling of operational and experience data to make smarter decisions, improve business models and delight customers is a game changer.”
Alex Mathers, assistant director in the digital team at Inflexion Private Equity, says: “Digital transformation is changing the way we do business across B2C, as well as B2B businesses and even in so-called traditional sectors such as industrials.
“This includes the front office – how and where we identify and win new customers and make them more loyal. And also the back office, even down to fundamental business models and ways of working.”
The transformation process begins early in due diligence, adds James Prebble, director at Palladium Digital, a digital consultancy for private equity. “Understanding the digital maturity of a company, relative threats to position from competitors and potential market disrupters is the first step in delivering successful digital transformation,” he says. “Post-deal insight from digital diligence can be used in post-transaction planning to enable investors to accelerate value creation. Due to the scalability and immediacy of these changes, digitisation should be seen as a strategic imperative.”
The process involves setting up systems to merge the best of the digital and physical worlds, such as tracking the customer experience to personalise marketing campaigns. In a manufacturing business, data analytics could manage assembly line flow to minimise waste or predict maintenance.
“Digitisation is impacting all the businesses we work with – whether it is helping to pivot to direct digital marketing and communication, using data within a business for greater insight and efficiency, or using or developing software to improve performance or to sell,” says Gareth Whiley, managing partner at Silverfleet Capital.
“As technology pervades every industry and absorbs them into the digital economy, digital transformation has become a tool driving value creation,” adds Paul Guély, managing partner at Arma Partners. “GPs can buy a business in an ‘analogue’ industry and invest capital and expertise to build out a proprietary tech platform, organically or through acquisitions, that delivers and differentiates its core service. This positions it to achieve a higher valuation multiple at exit, irrespective of earnings growth during the hold period.”
EBITDA is one of the most critical metrics for private equity investors because it directly reflects value creation.
Furthermore, EBITDA is a fundamental cornerstone of private equity valuations, both on entry and exit, and therefore can be closely linked to returns. EBITDA is also an important metric in private equity because it is used to indicate a private company’s debt load. If EBITDA is too low, a company cannot service
For each of these reasons, private equity firms meticulously pursue operational changes that will support EBITDA margin enhancement throughout the life of their investments.
There are two principle routes to EBITDA optimisation. Most firms will pursue them simultaneously. The first is increasing sales income. This can be done through pricing strategies or by boosting demand through marketing or the creation of new goods or services. The eradication of discounts, meanwhile, often represents the lowest hanging fruit.
The second route to EBITDA optimisation involves decreasing the cost of goods sold through a tactical analysis of every expense and ways in which these can be cut.
“We never lose sight of the fundamental tenet that EBITDA is a proxy for cash. In a leveraged environment, with debt to service, and the opportunity to enhance returns through cash generation, it’s key to understand the quality of EBITDA in terms of conversion to cash,” says Edward Taylor, associate director of portfolio management at Inflexion Private Equity. “We take a very close look at any cashflows post EBITDA. For example, challenging working capital dynamics, ongoing exceptionals or products that require significant research and development spend that is being capitalised.”