Creating value in the mid-market

GPs are doubling down on value-creation strategies as the cost of debt rises.

Private equity firms are having to think carefully about value-creation strategies in the current inflationary environment, as portfolio companies come under pressure from rising costs and continued supply chain woes.

Meanwhile, the emphasis on value creation is being further compounded as it becomes more difficult to generate returns through financial engineering. Leverage multiples increased in the US mid-market last year, according to Capstone Partners’ September 2021 Middle Market Leveraged Finance report, with total debt to EBITDA multiples reaching 5.7x in Q2 2021 – the highest since 2005. The increase in leverage multiples was driven by elevated purchase multiples and excess dry powder, the report noted.

However, rising interest rates and an increasingly uncertain environment could see the use of debt decline. “In the last five or six years, private equity [firms] would put a third of the amount of capital of a deal in equity,” says Matthew Frankel, a managing partner at Levine Leichtman Capital Partners. “Today, we see they are putting in two-thirds or three-quarters.

“When markets are more jittery, private equity starts talking more about value creation”

Christian Zabbal
Spring Lane Capital

“When you put that much equity into a deal, value creation is so important. Plus, private equity has gotten so much more competitive over the last 20-plus years. It’s very difficult to make money on the buy. There aren’t that many proprietary deals in the market.”

Yet for those firms slower to wake up to the importance of value creation, enacting such strategies may be easier said than done. “When markets are more jittery, private equity starts talking more about value creation,” says Christian Zabbal, a managing partner at Spring Lane Capital. “The challenge is it cannot be done in a few months. It takes years to build an operating group that works well. And if you don’t have that culture of adding value, it’s very difficult to shift gears.

“Setting up an operating group is getting more in vogue now… and more firms have been forced to create a strategy where they add value. While that’s easy to say, the reality has been fraught with a fair [few] problems.”

One of the main challenges is getting the dynamic between the deal team and the operating team right, says Zabbal. There can be tension between the two teams over decisions for portfolio companies, as well as how incentives might be split, he says. “Unless the dynamic is very carefully architected and the culture of the firm encourages conversation, it can be challenging.”

Spring Lane Capital’s investment strategy helped to address this potential problem before it arose. The firm invests in projects, rather than just businesses, with a focus on making those projects more effective. This means the deal and operating partners are working in the same environment, with the same goal.

Levers for value creation

There are several levers mid-market firms can use to drive value creation within portfolio companies.

For LLCP’s Frankel, these are organic revenue growth, including geographical and sales force expansion; operations; supply chain; and add-on acquisitions.

More recently, Frankel says LLCP has been responding to the current inflationary environment by helping portfolio companies to mitigate any cost increases they have encountered on the supply chain side. This has included working through staffing models to enhance efficiency and increasing some prices where they can.

“If you take a very good business that has cyclical ties… you need to be able to accelerate that growth and have a plan for value creation when you buy the company,” he says. “Our process is that we can’t get a deal approved at our investment committee until the deal team can present our value-creation plan and what levers we see to accelerate that growth, so we can double, triple or quintuple EBITDA. We sold a business recently where EBITDA grew eightfold under our ownership. Over the past 20 months, we sold 14 companies, and the average EBITDA growth was 3.1x during our hold period.”

Peggy Roberts, managing partner for the Riverside Company’s Riverside Capital Appreciation Fund, which invests across tech-enabled business services, speciality manufacturing and consumer products and services, notes that the rising cost of raw materials and wages can impact businesses across a number of different sectors. Roberts is focusing on investing in businesses where the brand is strong enough to have pricing power and where they can diversify supply chains.

Companies can also use technology and automation to build a more defensible position, become less reliant on talent, extend supply chains and manage them more productively, which can create more value in the current environment, adds Roberts.

Jeff Brown, chief executive at Azimut Alternative Capital Partners, which acquires stakes in private markets firms, says more PE firms are taking a data-driven approach to adding value to their portfolio companies. He has seen GPs make significant investments in software, and points to the example of one firm that has built a system it uses to win deals by developing case studies on potential targets and showing founders the different levers that can be used to create value.

While tech is playing a growing role in value-creation strategies, talent remains as important as ever. For Roberts, her operating team – as well as the dedicated human capital leaders, and sales and marketing resources that have been added in recent years – have been key.

Roberts says there are approximately 40 people working on her team and half of those are operators. “We are working across our portfolio on pricing opportunities. That can be anything from how we raise prices, what tactics to use, and when to raise prices.

“The second part is on talent – we have a dedicated human capital leader inside my group who can go into portfolio companies and work with their heads of HR on how they are attracting talent and how they are retaining [talent].”

The firm has also added a dedicated resource in sales and marketing – someone who can work on pricing strategy, commercial growth and help implement new systems such as CRM or digital marketing.

Typically, about 35-40 percent of value creation within Riverside Capital Appreciation’s portfolio has come from growth, Roberts says. The second biggest contributor to value creation is add-on acquisitions, with very little coming from financing.

“The value from those add-on acquisitions will probably grow as part of our formula,” Roberts says. “The deal market in the US is still very open in the smaller space and we’re doing a lot of add-on acquisitions.”