This article is sponsored by Simon-Kucher & Partners
Achieving top-line growth during a downturn can be a significant challenge, and private equity firms will need to pull all the levers at their disposal to build more resilience in portfolio companies. Although many managers already have expertise in areas such as supply chain optimisation and cost cutting, few have placed serious emphasis on pricing to date. We caught up with Mark Billige, CEO of Simon-Kucher & Partners, and Adam Echter, partner at the consulting firm, to discuss how pricing can tie into value creation strategies and how portfolio companies will need to navigate revenue generation in the year ahead.
What are the recent trends in private equity operational improvement?
Adam Echter: Most private equity professionals we work with describe four eras of value creation: leverage, balance sheets, cost cutting and now growth. Each period has captured attention for approximately a decade and they are cumulative, meaning the current private equity professional needs to be proficient in all four topics. Growth really emerged as a focus following the 2008 crisis. Although nearly all aspects of the first three phases are well understood, there are still some elements of top-line growth that are not receiving the attention they should. Pricing is one of these.
Mark Billige: We see the ongoing build out of value creation teams separately to investment teams, with significant access to portfolio companies, greater influence, and a bigger mandate. But more and more I am also being introduced to value creation professionals who wear a dedicated pricing hat. This is still the exception, and whilst revenue topics are starting to get more traction, there is still some way to go.
Why does pricing not always get the attention it deserves?
AE: It’s really a conundrum. There is recognition in private equity that pricing can have a huge impact and it scores highly on return on investment, but there is simultaneously an acknowledgement that too little resources are devoted to it. Based on what we see, around 10-15 percent of firms actively look at pricing as part of their investment thesis, most still see it as a ‘nice-to-have’ as opposed to a systematic, planned process.
MB: As pricing is a relatively new area of focus and value creation lever for many, there are not that many people with the necessary expertise. The skill set is harder to find than, for example, cost optimisation. This means firms are finding it difficult to grow teams with experience in pricing at the speed and quality they would want.
AE: The other key factors are financing and risk aversion. If you go to a bank and present an investment hypothesis that relies on taking cost out, the bank is more likely to underwrite the deal than if pricing is a key theme. We are working with banks to help address that and seeing traction there. The next issue is risk aversion – it often seems riskier to increase prices and push hard on customers rather than pushing suppliers to take out costs. As firms get more cycles with pricing, they realise how to de-risk pricing moves, so that concern is changing as well.
How does pricing fit within private equity’s value creation playbook?
AE: Pricing is a well-kept secret in private equity. It feeds into the three main components of value creation. Optimising pricing can push EBITDA growth, particularly in a more benign market. It can also generate multiple expansion through, for instance, the creation of recurring revenue streams. If we take the example of a well-trodden path – software businesses – it is clear that you can create a more valuable business by evolving pricing models. For example, if you buy a $100 million revenue transactional software business at, say, an 8x multiple, then convert it to a recurring revenue model, you might have the same revenue four years later but you can achieve a double-digit multiple because the subscription model creates more resilient revenue streams.
MB: Pricing also comes into play in buy-and-build strategies. While traditionally the focus has been on reducing operating costs and increasing operating synergies post-acquisition, more private equity firms are now looking at revenue synergies as a source of value creation. If you put together company A and company B, they may have the same customer base, but one business may offer cheaper products and services. This can lead to pressure to reduce the higher prices, but it is possible to avoid that by proactively restructuring the product portfolio to avoid price cannibalisation.
What trends are you seeing in pricing?
MB: The biggest single trend is revenue model transformation as businesses try to build recurrence and resilience into pricing. The move that Adam mentioned in software is an obvious example, but we are also seeing this kind of shift in other areas. We are working with far more traditional services and products businesses and helping them to move towards a subscription or recurring contracts model. This is increasingly becoming part of the private equity investment thesis as firms look at ways of generating a return beyond simply optimising operational areas.
AE: If ever there was a time to shift revenue models, 2021 will be it because businesses cannot afford to track the ups and downs of renewed lockdowns – they need stable revenue models.
How is the pandemic playing into private equity’s interest in pricing?
MB: When covid-19 first hit and the lockdowns came into force, we saw private equity firms focus on cash preservation, they created war rooms and worked hard to stabilise portfolio companies, but that phase is now over. And while firms were already showing curiosity in pricing well before the start of this year, over the coming period we expect more focus on pricing and revenue management as they seek to create more agile portfolio companies. Unlike previous downturns, which have been more linear in nature, the current economic picture is more unpredictable as we may well have ups and downs with lockdowns and businesses needing to adapt to social distancing measures. Commercial agility will be key in this kind of environment. You can’t just cost cut your way out of a downturn; you need to generate income wherever you are in the cycle.
What kind of heavy lifting do you expect to see in this area?
MB: The topics are the same as they would be in any environment, but the uncertainty will create opportunities for private equity and there will be action across all levers, with pricing moving up the agenda. Some will view this as an opportunity to pick up acquisitions, including stressed businesses that may have engaged in heavy discounting – here we would expect to see product and service restructuring come into play.
AE: There is a bias for action in private equity and the current crisis has accentuated this. Private equity-backed companies are most likely to go on the offensive to capitalise on an unprecedented event to clear out bad pricing practices and unprofitable customers.
How will private equity’s approach to pricing evolve?
AE: Currently management is asked during due diligence about products and supply chains, for example, but going forward it will become standard practice to ask about pricing. Private equity will become as comfortable interrogating pricing and the price/value model as it currently is with manufacturing and supply chain issues. That shift will lead to stronger companies.
MB: We will see a move beyond simple pricing ‘quick wins’ into much more sophisticated revenue management capability as firms focus on getting the apparatus and skills in place to ensure their work in this area reaches the same standard as on cost management. Part of the answer to this in portfolio companies will be technology – most projects we work on involve swapping out Excel for pricing software and controlling tools.
AE: We don’t know what the next era of private equity will be, but we are confident that in 20 years the pricing playbooks will be developed to the level financial engineering is today and the next generation of private equity professionals will struggle to imagine a time when pricing wasn’t on the agenda.
How will work on pricing develop through 2021?
AE: There will be increased consolidation as we work through the downturn, including acquisitions of companies that are in a weak position because of erratic pricing. While many managers will accept issues in their market may be driven by lower demand, some will recognise that discounting does not help. Others will continue to discount, and these will be the businesses that get bought. This will require the acquiring firms to quickly unwind bad pricing policies of their targets.
MB: The days of being able to tolerate anarchic discounting have now gone. Every penny and every percentage point will count because the cost of doing business has increased in the wake of covid-19. You will see repatriation of supply chains and a focus on quality, which will affect the cost of goods sold. Cost-inflation is coming, and companies will have the option of absorbing that cost through lower margins or working out how to structure pricing to pass the increase on to customers at a time when demand is soft. That is a brand new skill for most businesses.