Rapid post buyout change is fundamental to the turnaround strategies employed in the portfolio companies of private equity houses. The pressure to revitalise and then sell on lean, profitable and growing investments within 3-5 years has pushed the leading private equity firms to focus increasingly on actively cultivating profitable top line growth.
Reducing operating cost and rationalising business processes have long been the mainstay of initial post buyout activities. This focus has allowed bottom line targets to be met and healthy EBITDA performance. But it is only half the story. Consistent revenue growth has to be demonstrated over the medium term as well.
Few private equity firms have, however, concentrated their process optimisation drives on the revenue side and specifically on pricing process optimisation. Recently, and perhaps reflecting the increased recognition in board rooms of pricing as the fundamental revenue and profit driver, the rapid financial benefits of price and pricing process optimisation have moved to centre stage.
The Four Advantages of Pricing (Process) Optimisation
Pricing process optimisation has four clear advantages over cost reduction as a method of increasing company performance. Firstly, cost reduction potential can quickly be exhausted leaving little room for consistent future medium term gains. Secondaries – investing in companies previously owned by another private equity firm – can find that much of the cost reduction potential has already been exploited. In contrast, improved pricing models and price differentiation can provide consistent revenue growth even from within the existing customer base. The recent sale of the mattress maker Sealy by a consortium lead by Bain Capital to KKR is a good example of this. While the Sealy profits have progressed steadily, this performance has not been equally matched by their top line growth. After a good seven years of process improvement under Bain Capital, it seems likely that the main growth areas left for KKR to make an immediate impact are on the product portfolio and pricing side.
As KKR are undoubtedly aware, price optimisation brings an investment advantage as it is a lot cheaper and has no immediate negative cash flow. Costly severance packages or plant closures are not necessary to optimise pricing.
In this way, pricing changes can be used to provide a quick boost to top line figures immediately after acquisition. Thirdly, pricing process improvements have an immediate positive impact on revenue and profit. While price changes can often be implemented over night, the real effects of cost cutting usually do not emerge for several quarters. Lastly, basic economic theory shows that pricing is a far stronger lever on profits than cost reduction (price is a multiplier in the profit formula while cost is merely subtracted [Price x Units Sold – Costs = Profit]). Consequently, improvements to pricing processes often have a substantially higher impact on return on sales (ROS) than cost cutting. An improvement of the ROS by up to 2 percentage points is realistic.
Price Optimisation: Value to Customer and Value Extraction
The corner stones in building an optimal pricing strategy are understanding the market’s needs, the perceived value of the product or service and the consequent willingness to pay that can be exploited. The most common mistake made in pricing is erring too heavily on the “safe” or lower price side so as not to risk market share. But often this leads to panic competitive reaction and ruinous price wars. Herein lies one of the main areas of opportunity for realising rapid profitable revenue growth in a matter of months. In reality, the “safe” low price option can lose a company millions in revenue through untapped willingness to pay.
Understanding in detail the perceived value of a product or service and accurately quantifying the price elasticity (the change in sales volume associated with price changes) are the fundamental ingredients in an optimal pricing strategy. In most cases, they are enough to identify quick win areas for price changes within the existing customer and product range. Once the value perception and price elasticity are understood, more sophisticated pricing strategies can be employed unlocking a powerful revenue driver. Often, revenue growth can and does come with minimal investment from existing customers when the price strategy is changed.
Naturally, the value to customer and price elasticity differs between different market segments. Thus, segmenting the market and the associated differentiation of products and pricing holds the biggest growth potential. Identifying groups of customers with homogenous needs and ensuring the right products are available to them increases the willingness to pay for these products. It stands the test of reason: the closer the product is to what you are looking for the higher the willingness to pay. The task of extracting the value back from each of the different segments via accordingly differentiated prices then becomes easier. “Fences” are erected to ensure that certain offers are accessible only within certain segments. Thus, the market can support many prices and the willingness to pay can be better extracted. For example, T-Mobile restrict their high value corporate minute bundles and phone offers to business users only to prevent certain high usage non-corporate customers taking advantage of them.
What to do?
Conducting a probing price audit using internal data, internal interviews and benchmarking provides a clear and detailed overview of the current situation. It is surprising how often this basic overview summarised in one clear document is missing. Basic key analyses, for example, looking into profitability by customer and identifying pricing inconsistencies lead directly to quick-wins. By simply removing pricing inconsistencies and concentrating corrective, profit increasing sales activities on certain less profitable accounts, positive profit impacts are possible. The medium term result of a thorough pricing audit is to identify areas of price increase potential, be they product portfolio changes or gaps that need to be closed. This prioritised action list can serve as a “road map” towards improving the current pricing landscape.
One of the key advantages of price process optimisation is the speed with which results can impact the P&L sheet. Constantly under pressure to unveil improving quarterly figures, pricing “quick wins” can prove a welcome financial shot in the arm for investors. In the medium term, pricing process optimisation is key to driving profitable top line growth and significantly increasing shareholder value. As the financial results imply, top line growth driven by pricing process optimisation can be the difference between a good investment and a great investment.
Stephan A. Butscher is a partner and Balraj Kalsi is a consultant at the London office of Simon-Kucher & Partners, a leading pricing strategy firm. They can be reached at firstname.lastname@example.org and email@example.com