With the focus of LPs squarely on a GP’s proven ability to create value – almost three-quarters of respondents to the PEI’s LP Perspectives survey report they conduct due diligence on performance track record – the ability to deliver operational improvement at the portfolio company level is ever more important. Graphite Capital senior partner Markus Golser and portfolio management partner James Markham explain why.
How important is operational effectiveness to overall value creation?
Markus Golser: It’s fundamental. In a more challenging environment the focus on organic growth has risen. It’s also a reflection of what businesses expect private equity owners to contribute. Quite often with the size of businesses we buy, which tends to be between £50 million and £150 million in value, the company is evolving fast and its operations need to evolve too to support the growth plan. We want to create a scalable platform that will continue growing beyond our period of ownership.
At what stage in the investment process does Graphite start to think about the potential for operational improvement?
MG: If we can get access during the sale process and there’s time, we’ll undertake operational investigations. Post-deal, we put a lot of effort into understanding the operational capability of the business. Alongside management, we’ll start to hone in on areas of weakness that need to be tackled.
James Markham: One of the things we assess early on is organisational design. If the business is currently generating a few million pounds of EBITDA but we want to take it to £20 million, for example, does it have the right business functions to deliver that? Sometimes we help management establish functions from scratch, or the existing functions might need considerable enhancement and professionalisation.
Markus Golser tracks how Graphite helped Micheldever overcome major inventory management issues
Micheldever Tyre Services was a large and growing distributor of car tyres in the UK, which also operated a chain of retail outlets. We invested in 2006 and about halfway through our ownership period, due to a change in demand for tyres in the UK, the business encountered difficulties related to its IT infrastructure and stock ordering and forecasting. These resulted in too much stock arriving in their warehouses from suppliers mainly in the Far East on long lead times. Pricing controls proved insufficient to manage that stock effectively. That led to a fall in margins and the business underperforming.Talk us through an operational challenge and how you overcame it.
We stepped in very quickly and created what was effectively a project team to stabilise that situation. We implemented a completely new stock forecasting and planning system, reinforced pricing controls and hired someone to focus exclusively on pricing. We also changed the way the business purchased tyres from its Far Eastern suppliers.
This challenging phase was at the heart of making the business more robust. Margins recovered strongly and the business began to report record profits, which grew from £9 million to £24 million under our ownership. We sold it in early 2017 for £215 million to a large Japanese tyre manufacturer, making 3.7x our money on the deal.
What are your key areas of focus?
JM: We will tackle any area if it is key to unlocking value. We always start with a diagnostic phase during which we assess the quality of management information, the robustness of internal processes and the extent to which the management team really understands where the business is making its profit. Upgrades to the quality of management information, in turn, will often lead to improvements in IT infrastructure, in systems and processes and, of course, in the finance function as a whole. We look very closely at the cost base of the business to understand where there are either areas for potential savings or areas for investment required to support the growth plan.
There are also commercial considerations. Businesses may not have evolved their planning or sales and marketing functions in line with the intended direction of revenue growth. Very often we work with businesses to put in place, for example, key account management, as well as examine the effectiveness of the sales force, the efficacy of their digital marketing strategy and if they need to invest in any new products or channels. And, although we invest in UK businesses, we have helped many of them expand internationally.
Practically, how do you help businesses implement operational change?
MG: Our involvement could be limited to a specific issue such as strategy, funding, profit improvement initiatives, IT systems, business development, or span across many of them. For example, Alexander Mann Solutions (see box) was a very comprehensive exercise.
JM: As a firm, we’ve been focusing actively on operational improvement for some time. We have had a dedicated portfolio management team since 2005 and, in addition, now have a colleague in the US, which is our key focus territory for international growth.
Opportunities and challenges come at any time. We constantly assess the ability of the company to deliver and the extent to which we are involved will depend on how ambitious the growth plan is, whether there are any market headwinds, and the bandwidth and experience of the management team.
What challenges can arise implementing the plan?
MG: It is important to communicate and agree common objectives with the management team. With businesses that are preoccupied with running their day-to-day operations and are relatively small, there are constraints around how much resource people can allocate to change projects. We can supplement that from our internal resources. Having invested in the mid-market for almost 30 years now and in around 100 companies in that time, our team has developed a broad range of skills. We can also tap the advisory network that we’ve built up over many years.
JM: We have worked with many of the advisers in our network for a decade or more. They know how we work, the types of businesses we invest in and what’s needed. For example, we might make an assessment that a business’ sales force is not as effective as it should be. We may then bring in external parties to work alongside the company to undertake a full diagnostic and put together a plan for improvement. Where appropriate, those advisers will also help implement it.
James Markham highlights the importance of operational transformation to multiple enhancement
Can you share an example of operational transformation and its impact on the value of the business?
In 2007, when we bought the global leader in recruitment process outsourcing, Alexander Mann Solutions, it had been very successful, but then was affected by the financial crisis. We undertook our own diagnostic and a number of issues came to light.
One key area was the inefficient utilisation of internal resources on contracts. The business serviced large contracts, sometimes with 80 dedicated personnel, but the profile of the staff assigned was not optimal. Working with external consultants on an 18-month project, we adjusted how staff managed their time and ensured central control over the allocation of staff on contracts. We attended weekly project steering committee meetings throughout.
The business wasn’t sufficiently aware of where it made profit. We also spent a lot of time analysing and improving management information and amending key terms within contracts. We hired a new finance director with the right level of focus on cost control and margins, who is still in the business working alongside the founder.
It was very much a partnership, the management team and ourselves working together to transform the operational efficiency of the whole company. The direct result of our work was a profit improvement north of £4 million and a doubling of the operating margin – which was very influential in improving the multiple. The business grew its EBITDA from £5 million to over £20 million and was eventually sold in 2013 for £260 million, generating a 3.6x money multiple for our fund.
This article is sponsored by Graphite Capital and appeared in the Perspectives 2018 supplement in the December 2017/January 2018 edition of Private Equity International