After two decades of falling interest rates and rising asset prices, the private equity industry is being asked to show its value-creation mettle. Rather than basking in a market buoyed by climbing multiples, firms are having to fight hard to maintain returns.
The asset class has long extolled its hands-on, operational expertise, of course, but now it is being asked to prove it. Contrary to the marketing spiel, multiple expansion has been the greatest contributor to buyout returns over the past decade, outstripping revenue growth and margin improvement as drivers of value creation.
Over the past five years, multiple expansion accounted for 56 percent of value creation in the average deal, according to data from CEPRES Market Intelligence. Meanwhile, revenue growth and margin expansion accounted for 38 percent and 6 percent, respectively.
“Effective value-creation strategies are crucial to helping businesses survive – and even thrive – through an economic downturn”
Sponsors will need to dig deep to overcome a hostile combination of high inflation, tightening monetary policy, supply-chain disruption, painful labour shortages and a retreat from globalisation if they are to maintain historical performance.
“Effective value-creation strategies are crucial to helping businesses survive – and even thrive – through an economic downturn,” says Oakley Capital partner Rebecca Gibson. “This is even more true in the current environment, where entrepreneurs face an unusually severe combination of macro headwinds that they may never have faced before.”
Indeed, the current macro maelstrom is requiring radical and decisive action from private equity owners. “In today’s environment,” says Michael Gahleitner, co-head of the industrial tech team at Triton, “many businesses are dealing with operational disruptions and liquidity issues that are caused by volatile demand, material and labour shortages, and often amplified by shortcomings in operational excellence.
“In light of that, companies have to reassess – and likely adjust – their operational setup and supply-chain strategy to ensure competitiveness and resilience longer term. In stable market conditions, these aspects are frequently deprioritised by companies that are otherwise growing, which can lead to significant problems that become more complex to address during times of macroeconomic turmoil.”
According to Emanuela Cisini, principal in the operational improvement team at Investindustrial, the number one priority for private equity firms is to move quickly, rather than waiting for problems to present themselves before they react.
“That is one lesson we can take from the pandemic,” she says. “The businesses that emerged strongest from that period were those that were responsive and adaptable in the face of change.”
Following the experiences of the covid era, Investindustrial has set up a control tower to assess portfolio risk exposure. In particular, the operational improvement team has been working to diagnose exposure to macro risks and devising strategies to react swiftly. For example, the team analysed the impact of potential interest rate rises on the entire portfolio, enabling hedges to be put in place well ahead of central banks’ actions.
“At the same time,” Cisini adds, “we are seeing a lot of volatility in the currency markets and so we have carried out analysis on unhedged positions across the portfolio.”
“Ensuring that you are creating real underlying value, rather than relying on leverage and multiple expansion to generate returns, is going to
Cisini also believes it is important to be proactive when it comes to tackling inflation. “The time to start is well before it begins affecting performance. You cannot wait for suppliers to send you price increases. You must plan ahead, preserve cash and act with broader stakeholders in mind.”
As a result, Investindustrial is stepping up its efforts to embrace the buying power of its portfolio in order to extract economies of scale. Supply-chain disruption means freight costs have increased almost six-fold since the onset of covid, and the firm has responded by creating a network of procurement and logistics experts across its various investee businesses. “Portfolio companies are essentially contracting directly with the same forwarders for shipments, especially out of Asia, enabling them to secure better rates,” Cisini says.
Elsewhere, Permira has also looked at opportunities to consolidate spend, although operating partner Riccardo Basile says the firm has identified only a small number of supply-chain components where combining purchasing power can have a meaningful impact.
“We have therefore decided to focus on enterprise software and have built preferred relationships where portfolio companies can access better terms in that area,” he says. “But we have deliberately decided to leverage our purchasing power in just a few, specific verticals. Our funds’ portfolio companies don’t operate in industries with large, bulk energy, chemical or metals purchases, where inflation is really taking hold.”
For the many private equity firms that have limited exposure to heavy-lifting industries, the biggest challenge right now is not the availability or cost of raw materials, but a punishingly tight labour market.
“Most of our funds’ portfolio companies do not have complex supply chains, but access to talent, whether that’s tech engineers or white-collar professionals, such as accountants and lawyers, is incredibly tough today,” Basile says. “That is our biggest area of focus.”
Permira is addressing the issue by widening the talent pool available to its portfolio companies. “In the US, for example, most of our tech companies are now recruiting remote engineers,” Basile explains. “These people don’t have to be located in Silicon Valley, Florida, Utah or Texas where the companies’ operations are based, but can be located anywhere in the country.”
“The recruitment market is challenging, with significant wage inflation,” agrees Duncan Ramsay, a partner at ECI Partners. Ramsay says a laser focus on retention is therefore critical: “Our view is that the more highly engaged the workforce, the better the investment outcome, because people are the key to success in our portfolio companies. That translates into everything from ensuring we offer attractive career progression to considerations around health and wellbeing.”
A digital response
While people are undoubtedly central to any private equity investment thesis, leveraging automation has only become more important as those people have become increasingly thin on the ground.
In particular, the importance of data analytics in value creation has come to the fore in the last decade, says Cisini. “In many cases, covid sped up companies’ focus on operational efficiency and automation. However, in the future, the most competitive businesses will have invested heavily in their people learning digital skills, such as data analysis, computer science and information technology.”
Indeed, digital transformation is increasingly recognised as the value-creation jackpot. “Digital transformation is the grand prize in any value-creation strategy, and even more so in a downturn,” says Gibson. “Shifting business models to sticky, recurring and subscription-based revenues makes companies more resilient. It also makes them more valuable.”
Getting the basics right in a portfolio company is equally important, however. “Helping a business to professionalise its accounting process, reporting and KPIs may not sound very exciting,” Gibson says, “but it is an excellent value-creation tool at the best of times, and becomes critical in a downturn.”
Ensuring management teams have regular reporting processes in place means they – and their private equity owners – have the best, most up to date data at their fingertips in order to inform tactical and strategic decision-making, including where to rationalise costs and target investment. As with digitalisation, slick processes ultimately remove pressure from human resource. “It speeds up decision-making and conserves the most precious commodity of all: the time and bandwidth of the entrepreneurs we back,” says Oakley Capital’s Gibson.
Meanwhile, other mainstays of private equity’s value-creation playbook have not been put on the backburner. ECI Partners has a team of five working with management teams to deliver their inorganic growth ambitions, for example, resulting in 16 bolt-on acquisitions over the past 12 months, according to Ramsay.
International expansion is also a hot topic for the UK-based firm, with 40 percent of portfolio revenues now originating outside the home market, three quarters of which stem from the US. “Our New York office is currently supporting a number of portfolio companies with their North American growth, both helping those with existing US operations to grow faster as well as looking at organic routes and acquisitions for those who plan to enter the market.”
Gibson, meanwhile, adds that ESG should not be overlooked as a value-creation tool, even as macroeconomic noise threatens to drown out the siren call of sustainability. “By rolling out KPIs across the portfolio we can measure how they score on key indicators such as emissions and governance,” she says. “And by strengthening supply chains, reducing carbon, and enhancing training and employee retention, we can embed long-term, sustainable growth and make our companies more valuable to future investors.”
The ultimate outcome
Value creation is only crystallised, of course, when a business is sold to a new owner and there is no doubt that securing exits is going to be more challenging in the months, and perhaps years, to come.
“The impact of the current macroeconomic and geopolitical situation on valuations at exit cannot be ignored,” says Investindustrial’s Cisini. “While we have not witnessed any significant disruption yet and have been able to dispose of three assets since the beginning of the year, ensuring that you are creating real underlying value, rather than relying on leverage and multiple expansion to generate returns, is going to be crucial going forward.”
Holding periods may also be extended, but Permira’s Basile says that, for value-creation specialists, the investment horizon is irrelevant. “We continue to enhance EBITDA and drive value creation all the way until the last moment, whether a sale is likely to happen in the next month or several years down the line.”
Private equity firms are ramping up their value-creation resource in preparation for the task ahead. “We are definitely hiring more people internally,” says Cisini. “We have hired people with research backgrounds; we have also hired someone focused on margin enhancement through cost efficiencies, and a data analyst focused on extracting value from portfolio company data.”
Permira has also invested heavily in data science, with a team of five within the broader value-creation team currently working on client churn, among other projects. “We use data analytics to help portfolio companies identify early signals of churn risk and take action to minimise the likelihood of that churn taking place,” Basile explains. “Similarly, we use analytics for pricing and packaging and, finally, for go-to-market. In this pressurised environment, in particular, data analytics is an incredibly powerful tool for identifying pockets of value creation that might otherwise be missed.”
While the economic outlook may be daunting, this is an asset class that has a track record of stepping up to the task.
“Private equity has many advantages in this environment,” says Gibson. “Most important, it has effective value-creation levers, along with the strategic patience and control equity to implement them for the benefit of businesses and investors alike.”