Finding value in late stage investments

Alvarez & Marsal managing director Adam Bradley makes the case for funds refreshing their focus on the performance of longer-held assets.

2015 was a record year for private equity fund exits, with firms disposing of a large wave of assets, surpassing expectations. The record rate of funds realising their investments has led some to suggest we could be reaching the peak in the cycle.

Yet this does not mean all firms are in a rush to sell assets.

Indeed, many major funds are holding an increasing number of investments in the late stage – generally understood as four years or more past the initial investment date. A recent sample survey conducted by Alvarez & Marsal showed that mid and large cap funds held an average of nine European investments per fund in this late stage. 

The question is what should they do with these assets?

These investments present a significant opportunity for additional value. But they can sometimes be overlooked as sponsors focus on value enhancement for their most recently acquired assets particularly if older investments are in a vintage where overall performance and potential for carry is lower.

In a crowded market, with stiff competition for acquisitions, funds need to work harder to deliver returns. More than ever it is important to maximise the value of each individual asset, including late stage investments. Demonstrating successful improvements is also vital in realising a strong return from current funds and in supporting investor relations activity for future funds.

Typically the sponsor will have been working with a company and had board-level visibility of the investment over a long period of time. To ensure that each asset reaches its full potential, there must be a renewed focus on improving performance. This includes reviewing potential actions that may not have been considered in the initial investment case.

Firms need to ensure that they spend enough time working on these improvements before looking to sell an asset – typically 12 to 24 months before the intended disposal. This will provide sufficient time to demonstrate an impact from improvements, as well as a credible future plan, which will be accepted by buyers following rigorous financial and operational diligence.

There are a number of areas that advisors, the deal team and management should look at. Firstly, a review of the structure and shape of the business, in particular on divisions or groups that may be non-core, often enables quicker decision making and a leaner enterprise.

Secondly, refining and standardising processes is key to increasing operational efficiency and margins. This will also involve tackling complexity and waste, as well as addressing the performance of lagging business areas.

Finally reducing any duplication in the delivery of services and functions, as part of delivering a robust plan ahead of an exit, is vital.

For instance

To take one example, a private equity fund was looking to improve value in a late stage portfolio company – a business facing significant regulatory pressures and escalating operating costs. They set out to drive significant annualised improvements to operating costs. This was achieved by improving work scheduling and labour deployment, outsourcing back-office services and reducing the variation in use of raw materials. They were able to deliver the first wave of improvements within one year, with a 20 percent increase in EBITDA.

Similarly, another private equity fund recently held an investment in a communications business. The company’s key customer contracts were due to expire and market factors were putting pressure on pricing. The group was approaching a refinancing and wanted to demonstrate EBITDA and operating cash flow resilience to assist with this process.

In the face of these challenges, a project was initiated to reduce the cost base while preserving service and customer satisfaction. A one month review identified achievable reductions equivalent to 20 percent of operating costs. Improvements were realised by consolidating operational teams undertaking similar tasks, reducing the scope of external support contracts and redesigning processes to reduce key input costs such as power.

Crucially, the majority of these improvements were delivered within the first nine months of launching the performance improvement work, allowing enough time to showcase them to potential investors before the disposal process.

As the overall trend of high exit volumes is expected to continue in the early part of this year, funds should continue to focus on getting the most value from their assets before disposing of them. By recognising the chance to improve performance or remove key risks in businesses they hold, private equity funds can ensure they create the most value from the assets they own.

The potential to enhance the value of late stage investments before a sale is an opportunity not to be missed. It takes time, planning, and selective operational intervention, but well executed this incremental investment will provide a compelling return.

Adam Bradley is a managing director in the Private Equity Services practice at Alvarez & Marsal based in London.