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Maximizing Operating Value to Generate Superior Returns


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Maximizing Operating Value to Generate Superior Returns

  1. 1. Gotham Consulting Partners Value Through Operations Maximizing Operating Value to Generate Superior Returns by Deepak Agrawal Published in 2004 Service Provider Directory
  2. 2. Directory of Venture Capital and Private Equity Service Providers Maximizing Operating Value To Generate Superior Returns by Deepak Agrawal T he private equity industry has gone tiating factor among bids—bids with the highest through a massive change in recent years, operating value improvement assumptions tend to one that has brought portfolio company be the winner. operating performance to the forefront of success- In this deal environment, it is not surprising that ful investments (see Exhibit A). Historically, pri- financial engineering levers (multiples and financial vate equity firms created value by finding great leverage) are no longer sufficient to generate historic deals through their proprietary deal flow and uti- ROI. A recent General Partners survey confirms the lizing creative financial engineering techniques to growing importance of operating value in achieving extract value from portfolio companies. With targeted ROIs (see Exhibit B). today’s higher competition for deals, auctions have supplanted proprietary deal flow. As a result, fuller PRIVATE EQUITY FIRMS MUST BE ABLE TO prices are being paid, with financial engineering ACCESS OPERATIONS EXPERTISE capabilities no longer a differentiating factor. In the current, more mature private equity world, With operating value taking center stage in assumptions about potential opportunities to ROI generation, private equity firms have to revis- improve operating value are often the key differen- it their capabilities and ensure they have or can Exhibit A 22
  3. 3. Directory of Venture Capital and Private Equity Service Providers Exhibit B access the requisite expertise to foresee realistic KNOW THE KEY LEVERS FOR INCREASING operating value improvements (during the buy OPERATING VALUE process), to plan for and capture improvements (during the ownership period), and to have opti- In the private equity world, operating value is a mized EBITDA and demonstrated further function of EBITDA and working capital manage- prospects for operating value improvements as they ment. With the sale price tied to a multiple of EBIT- prepare to exit the investment. DA, even a small increase in EBITDA—from mar- In short, the historic reliance on portfolio com- gin improvement and/or top-line growth—can pany management teams to identify and capture bump up the value of investment. Tighter working operating improvements is no longer sufficient. capital management frees up cash that can be used to These teams are often new to the LBO environ- pay down debt, re-invest in the company, or recover ment where effectiveness requires focus on some of the original cash investment in the deal. new dimensions not found in normal corporate Thus, there are three key levers available to set-up—namely, cash generation (beyond the con- increase the operating value of portfolio companies: ventional focus on earnings and growth). As a result, they may struggle to come up with a com- 1. Margin improvement—Margins can be prehensive and credible value creation strategy on increased by improving price realization and/or their own. reducing costs. Considering the competitiveness of Today’s most successful private equity firms are today’s market, opportunities to improve margin actively engaged in the operations of their portfolio through pricing are relatively limited. This leaves companies. This involvement goes well beyond cost savings as the primary means of improving mar- board membership, and is made meaningful by gins. Untapped savings opportunities often run the strong operational expertise that supplements the full gamut of the cost structure (material, labor, over- private equity firm’s traditional transactional expert- head, and SG&A expenses), with operational cost ise and avoids over-reliance on the portfolio compa- excesses often as high as 20-50 percent of the total ny management team. cost of goods sold. 23
  4. 4. Directory of Venture Capital and Private Equity Service Providers Exhibit C 2. Working capital management—While typically a TAKE FULL ADVANTAGE OF WHAT CAN BE company’s Accounts Payable and Account ACCOMPLISHED OPERATIONALLY Receivables situation can be improved to reduce THROUGHOUT THE INVESTMENT LIFECYCLE working capital, significant reductions can only be achieved by dramatic cuts in inventory levels. Those players who understand and have the Manufacturing and distribution businesses have expertise to capitalize on the relationship between changed drastically in recent years because of more operations and ROI are ahead of the game through- complicated supply chains with multiple facilities and out the life cycle of the deal (see Exhibit C). global sourcing, as they seek to meet increasingly demanding customer requirements. Absent stream- BUY BETTER lined, efficient management and proper configura- tion of these complex supply chains, inventory levels Astute private equity players validate and refine can build up quickly—with cash tied up in the 30 to their investment thesis by gaining important insights 50 percent of inventory that is excess or avoidable. into the operations of the target company. They con- duct robust operational due diligence to uncover 3. Top-line growth—Certainly the age-old ways to both problems that may be masked by standard achieve top-line growth, such as aggressive sales and financial reporting and hidden operational potential marketing approaches and acquisitions, are still that may justify a winning bid. Beyond ensuring the options. However, for most companies, the greater, potential buyer is not blindsided by egregious opera- more enduring growth opportunity comes from cre- tional flaws, rigorous operational due diligence sig- ating a lasting competitive differentiator that enables nals when to persist in the purchase of a target and pricing power gains, promotes customer retention, lays the groundwork for quick capture of operating and attracts new customers. Capturing the bigger value after the purchase goes through. opportunity requires a broad understanding of the To quickly uncover both showstopping opera- external business environment, creative thinking, tional issues (i.e., we shouldn’t buy it because the and new operational capabilities. “wheels might fall off”) and operational opportunities 24
  5. 5. Directory of Venture Capital and Private Equity Service Providers that can over-deliver on return targets (i.e., maybe we opportunities as falling into one of three categories, should place a higher bid because we don’t want this each with a different capture timeframe: one to get away), a “freestanding” model is required. In order to be “freestanding”, the model must be • “Quick-hit” opportunities to streamline opera- focused on key operational metrics, incorporate as tions (immediate to 1 year capture timeframe): much objective actual data as possible, and correctly Such opportunities are applicable when there are fun- weigh and interpret the impact of assumptions leading damental issues with and excess costs in basic opera- to various scenarios of operational outcomes. Finally, tions or individual functions at the portfolio company the model must translate these operational outcomes and the private equity firm does not plan on holding into financial measures and implications. the company for long. The operational value these While routinely bringing in specialists to address opportunities deliver comes from such “quick-hits” as legal, accounting, environmental, and other aspects of purchasing savings (via vendor consolidation, non- due diligence, private equity firms have tended to rely strategic spend consolidation, accessing low-cost on finance people (transaction staff and accounting materials); inventory, waste, and overhead reductions; firms) and the existing management team for opera- productivity improvements; and product portfolio tional assessment. Such assessments are “top-down” in optimization. Capturing these “quick-hits” begins nature, failing to “get under the hood,” thus missing with a rapid, but rigorous diagnostic to identify and out on critical front-line data and first-hand observa- prioritize improvement opportunities based on level of tions. Further, they may be biased. Successful firms rec- effort required vs. likely return, followed by speedy ognize the high risk of not doing rigorous operational execution of “low pain/high gain” initiatives. due diligence and build such expertise as one of their core capabilities, either through additions to their staff • Opportunities to gain cost/capability advantages and/or alliances with outside operations experts. (one to two year capture timeframe): These types of opportunities are pursued when portfolio company RUN BETTER operations are functioning smoothly but tougher opportunities have yet to be tackled and/or existing The private equity firm that has conducted robust cost/capability advantages have yet to be leveraged, and operational due diligence as part of the buy process the private equity firm is not targeting an immediate has a jump start on effecting operational improve- turnaround. Capturing these opportunities entails ments as soon as the deal is closed. This advantage is benchmarking today’s cost performance and capabili- important because, while the targeted ownership ties relative to best-in-class performance and ensuring period varies, time is always of the essence in the pri- full leveraging of advantages in the marketplace, while vate equity world. The trick is to create and execute a strengthening capabilities as necessary via quick-pay- value-creation strategy that aligns with both the port- back (<two years) capital investments and other harder folio company’s operational performance situation initiatives. What can be expected from these opportu- and the private equity firm’s target exit date. nities is maximized marketplace performance as a To fully realize the value of operational improve- result of strengthened capabilities and honed cost ments typically requires three to five years—this time- advantages (from, for example, facility closures/net- frame may exceed that targeted for the investment work rebalancing; leveraging of low-cost global manu- holding period. If the goal is to exit the investment facturing opportunities; automation/technology within two years, the value-creation strategy should not upgrades; distribution strategy overhaul; organization- focus on “long payback” operational initiatives. If, on al restructuring; and SKU, product design, vendor, and the other hand, the plan is to hold the investment for customer rationalization/-complexity reduction). three years or beyond, the private equity firm wants to avoid a singular focus on “incremental” opportunities • Opportunities to achieve break-away growth from at the expense of “bigger impact” opportunities. new operational capabilities (three to five year cap- In helping the portfolio company craft an appro- ture timeframe): When a private equity firm is look- priate value-creation strategy, it is useful to think of ing for dramatic growth in the value of its holding and 25
  6. 6. Directory of Venture Capital and Private Equity Service Providers is willing to make the necessary investment in time oritized and phased and relevant to both the portfo- and money, this last category of operational opportu- lio company’s situation and the investment horizon nities is relevant. That is, assuming the portfolio com- pany in question has already milked the value from its • Putting in place rigorous performance tracking/ existing capabilities and has the management strength meaningful Key Performance Indicators (KPIs) that to commit to aggressive growth targets. Success here measure internal and external performance means that the portfolio company is well on a path to break-away financial performance from new, industry- • Being actively engaged in setting direction for and leadership capabilities (e.g., value-added services, mar- monitoring portfolio company operations ket-making capabilities, pioneering in new geogra- phies, innovation capabilities, specialized/customized • Bringing in outside expertise as necessary to sup- manufacturing and distribution capabilities) that are plement and challenge the portfolio company man- developed organically and/or the result of targeted agement team strategic acquisitions. Pursuing these type of opportu- nities requires in-depth market intelligence (market • Securing buy-in from/ownership by all stakehold- and industry trends, new channel and customer ers at the portfolio company (from CEO down to opportunities, competitive landscape) coupled with a the shop floor) and “external” stakeholders as appro- visionary mindset in order to identify new opportuni- priate (e.g., vendors, third parties that complete the ties for growth, the sweet spot for long term competi- supply chain, key customers), thus solidifying the tive advantage, and the operational capabilities likelihood of rapid, successful execution. required to capture these opportunities. While the above may seem challenging, it is SELL BETTER both doable and necessary in today’s world. And many private equity firms are beginning to recog- The most successful exits share the following nize the need for a stronger focus on operations. characteristics: the maximum possible value has been When asked to rate itself on its performance vis-à- created in the portfolio company given any con- vis maximizing operating value at its portfolio straints imposed by the investment timeframe; and a companies, one of the largest private equity firm next-generation value creation strategy is laid out to gave itself a “three” out of a possible “ten”. This help interested buyers with their own operational firm went on to say if it could achieve a “seven” on due diligence effort and allow them to clearly see the that scale, its IRR would probably reach 30 percent value they can get from acquiring the company. Any from its current 20 percent. Said another way, buyer is willing to pay the full (and maybe a premi- those who can maximize operating value hold the um) price for a company that is well-run and has key to the difference between superior and indus- clear plans for where to go next. try average returns. KEY SUCCESS FACTORS FOR MAXIMUM, RAPID CAPTURE OF OPERATING VALUE Deepak Agrawal is a co-founder and the managing director of Gotham Consulting Partners LLC Those private equity firms who properly pull the (, a specialist in helping private equity operations lever to maximize EBITDA and optimize firms create exceptional value through operations in working capital do so by: manufacturing, distribution, and service companies. He has extensive experience in achieving superior and last- • Ensuring a strong, fact-based understanding of the ing financial performance and operational capabilities financial implications and potential of the portfolio improvements for clients ranging from multi-national company operations before the deal is closed Fortune 500 companies to middle-market buyout port- folio companies. He can be reached at 212-497-9201 • Creating an actionable operating plan that is pri- or 26
  7. 7. For access to a complete list of articles and white papers by Gotham, please visit Gotham Consulting Partners LLC 630 Fifth Avenue, Suite 1776 New York, NY 10111 Tel: 212.497.9200 Fax: 212.497.9210 © 2004 Gotham Consulting Partners llc