Operating Partners Forum: Cutting costs not an easy fix

Even though cutting costs can improve portfolio company performance, doing so without consideration of product quality can damage a business’s reputation.

One of the simplest ways private equity firms can improve portfolio company performance is by trimming costs. But be warned, cutting costs can come at a price, said Christopher Kipley of Z Capital Partners at Private Equity International’s Operating Partners Forum this week.

“Everything we get involved in is underperforming from day one,” he said, while participating in an underperforming portfolio company panel. “But it’s important not to cut cost for the sake of cutting costs.”

Case in point: Z Capital invested in a restaurant company that attempted to reduce costs by shrinking its serving staff, Kipley said. Prior to the cuts, the restaurant’s waiters typically handled approximately four tables per shift. After staff was reduced, that ratio inflated to approximately eight tables per server.

The increased workload put a greater strain on the restaurant’s waiters and waitresses, which in turn led to poor customer service. As the customer service quality fell, the restaurant began to suffer.

To remedy the situation, Z Capital decided to increase staff. The move led to greater costs, but ultimately improved the overall quality of their portfolio company.

Kipley’s point was echoed by Paul de Janosi of Celerant Consulting.

“It’s not a pure cost-out play,” he said. “You also want to revive it … you don’t want [the company] to get too out of balance.”

In addition to exploring cost cutting strategies, the panel also discussed the importance of working alongside portfolio companies’ management teams – although that can lead to difficulties as well.

After investing in a company that had not committed to a long-term business plan, Z Capital tasked the company’s management team with designing a business plan for the next three to five years.

“The CEO was emphatic that we needed to get the equity program in place in order to keep everyone. And we said that’s fine, but we need you to bring us a three-to-five year business plan,” Kipley said. “A month and a half goes by … and he says, ‘We ‘ll give you a business plan, but we’ll just change it until you like it’.”

“So our business plan; first line was ‘severance’ and ‘recruiting new CEO’,” Kipley said.

Human capital has become a much more important concept in the private equity industry as firms shifted their focus toward operating improvements and away from financial engineering. As more firms work to build value in their portfolio companies through operations, the necessity of having strong managers running those companies is more important than ever. 

However, investment professionals have not traditionally been adept at dealing with human capital issues, according to speakers on a separate panel. For example, evaluating CEOs — either existing leaders or candidates for the top role — is an essential part of ensuring operational improvements. 

“It's just not something that deal folks think about, it's not in their foray. It's not really been a function other than to do the employee handbooks and [organising] blood drives at some of the firms they've grown up in,” said Joelle Marquis, partner at Arsenal Capital Partners. “It's not what they've known, it's not been part of the culture.”

The fact is, during the early days of an investment, say the first 100 days, human capital professionals can help “assess how the new team will work together or what kind of sweet spots are absent in the CEO's skill set”, said Michael Feiner, senior managing director and head of human capital at Irving Place Capital.

Christopher Witkowsky contributed to this report.