Financier Worldwide (FW) discusses rethinking private equity value creation in 2023 with Corey Smith, Merrill Strobel Bohren, Kevin Cowherd, Dave Owen, and Ankur Sheth at Ankura Consulting Group, LLC.
FW: How would you define value creation, and what it means for the current market?
Bohren: Value creation is the realization of the perceived intrinsic value of a deal with the actual execution of growth opportunities. This requires a determination of how to leverage and scale the capabilities of a company across products, services, talent, and technology to drive value. When investors commit and add a company to their portfolio, the clock starts for all parties to deliver that value in the determined time horizon. A roadmap, associated detailed plan, and governance are critical components to ensure stakeholders stay aligned on how to accomplish desired outcomes throughout the timeline. Resiliency planning is also imperative to identify potential threats and establish strategies to adapt quickly and mitigate impact to the business.
Smith: Value creation is the continual process of understanding the market position and key trends that will impact a portfolio company, having a thesis of the capabilities that will be sought out by potential investors, and executing on the most accretive investments. It also involves having the right expertise at the table to identify and prioritize value-creation opportunities. In today’s market, investors and management teams must consider a broad set of drivers, including environmental, social, and governance (ESG) and other societal matters, define actions, and measure the impact of delivering these drivers.
Owen: Value creation is the measurable expansion or contraction of a business or organization’s ability to generate economic value. This is measured by several dimensions. One is the capability of the organization to translate products or services into commercial value, most often measured as earnings before interest, taxes, depreciation, and amortization (EBITDA). Another is the company’s ability to translate commercial transactions into cash, most often measured as operating cash flow. And a third is the company’s capability to consistently generate commercial value and cash, evolve with industry dynamics, actively manage through uncertainty, and better the competition, most often measured as multiple expansion or shareholder value. These elements can and should be viewed under a lens of time and risk, which determine time-to-value and risk profile.
“The value creation process will be more directly connected to pre-close due diligence activities which, rightfully so, are being expanded.” — Ankur Sheth
FW: How important is it for private equity (PE) firms to have a value creation plan in place to ensure investments reach their full potential?
Sheth: To bolster the likelihood of an investment reaching its potential, there must be a value creation plan in place that maximizes opportunities across the business and considers and addresses risks. Risk will always be present, and exposure will only increase as the business engages in additional strategic growth initiatives. As an example, for many businesses, digitalization is a key driver for their customers as well as business partners wanting to easily access products and information. While this inherently brings additional risk, understanding what that risk is and how it can be managed during value creation planning can mitigate it while driving value.
Bohren: As is true with most goals, it is essential to articulate the vision and define the details on how goals will be realized. However, having a documented plan is not enough to ensure success. The plan must be aligned across stakeholders and measured and monitored to provide accountability and transparency. It is also critical that the plan includes the detailed financial investment required for any initiatives, return expected, and agreed-upon key performance indicators (KPIs). It is also critical that there is a collective mindset that allows for flexibility to adapt the plan when a pivot is required.
Cowherd: A value creation plan is important as it is a roadmap to achieve the growth and profitability expectations for a business. The financial, market, and capability analysis that goes into the plan lays out the high-level direction that a business will take to achieve top-line growth while also improving operations to achieve it profitably. A key value proposition of the plan is the alignment of the management team with the private equity (PE) fund’s deal and operating partners on what can be achieved and how. Without this alignment of expectations and goals with an actionable plan, achievement of the investment thesis is significantly at risk.
“A unifying value creation roadmap sets many of the best PE firms apart from the rest.” — Dave OwenFW: What methods and approaches to value creation are proving popular among PE firms? Conversely, are any strategies generally avoided?
Smith: There are multiple successful approaches, and the preferred path depends on factors such as region, industry, and market position of a portfolio company. Levers for growth may include building on the core and expanding into new markets and customers, growing through M&A, and launching new products and services. Capabilities that support growth may include improving talent acquisition and employee development, engaging an ESG strategy, improving scalability and margins through operations, digital and data enhancements, and de-risking across the business, including cyber security, supply chain, and financial controls. While each of these are options that may drive value, firms that seamlessly connect the due diligence process to the value creation process and relentlessly prioritize building the right capabilities are best positioned for success.
Cowherd: While there are many methods and approaches to creating value, some may be more effective than others given current market and economic trends. Growth through acquisitions remains popular, but more companies are exploring vertical integration to reap the benefits of compounding margin across the value chain. Many companies are also gaining value by introducing the discipline of product management to increase investment in profitable products and eliminate underperforming ones. Another approach that we see often today is building stronger sales capabilities to gain new customers, especially as the market turns down and competitors falter.
Owen: Each sponsor has its own unique value creation tactic, such as technology platform building and geography roll-ups, among others, but four value levers – talent, pricing, data-driven decision making, and corporate governance to get consistent results – are at the top of most PE agendas for 2023. Competition for people is at an all-time high and it is essential to get the mix right with the great recession, quiet quitting, and the robust labor market. Inflation has impacted nearly all sectors, resulting in supply chain cost pressures, pricing sensitivities, and a different dynamic around employee investment. Data and insights, along with the processes to make sound decisions, will enable boardrooms and management to react intelligently amid a volatile and unpredictable environment. Effective management and governance will be key to helping companies navigate turbulent waters, whereas weak governance can lead to whipsaw decision-making.
“Growth through acquisitions remains popular, but more companies are exploring vertical integration to reap the benefits of compounding margin across the value chain.” — Kevin CowherdFW: To what extent is today’s challenging, competitive deal landscape influencing the levers that drive value creation for PE transactions?
Owen: Competitive pressures have increased on three particular aspects of PE transactions. First is transaction competition. In today’s world of strong buyer competition, PEs firms must present a case that is greater than the price tag. Their firm reputation carries significant weight. Sellers want to be aligned in vision and execution principles and know that the PE firm is good to work with and willing to provide support resources to grow the business. The PE and management team should align early on strategies and levers, if not pre-transaction. Second is talent competition. The challenge to find the right talent in the right location for the right role has created significant stresses, particularly for middle market companies. It is critical for boards to retain strong talent in critical leadership roles to de-risk and improve time-to-value. Engaging interim resources for key roles can also help to deal with the unexpected. Third is platform building competition. Third parties are increasingly creating solutions focused on the unique PE environment. It is essential to pull levers around acquisition integration, technology architecture, organization design, and process improvement. In addition, PE operations teams should build a shortlist of qualified and vetted providers to reduce the risk of potential costly, failed initiatives.
Bohren: The competition for deals has influenced every aspect of the deal process. Like a hot housing market where buyers will waive home inspections or pay over market price, competition can sometimes drive investors to abbreviate due diligence or pay higher multiples. This can result in a significant amount of investment required to shore up risks and position a company for growth. For example, a key driver for value creation may focus on accelerating the number of acquisitions. If the company does not have a solid acquisition and integration engine in place, investments in people, processes, and technology will be required. The decision on when and where to prioritize spending can impact the pace of growth and the overall timeline of an exit. Careful review of the options and the competitive landscape is essential to translating assets into a real return.
Sheth: Through every transaction, there are several diligence items that will help the buyer understand potential additional investments and risks. One of those risks is cybersecurity. In today’s environment, from the moment a deal is announced, there is an over three times likelihood that a bad actor will attempt to breach the target company, knowing it will soon integrate with other companies and have access to PE backing. Technology and cyber security diligence is becoming more complex as it can have a large impact on the buyer if an event does occur – not just financial impact, but legal and reputational impact to both the buyer and the target. How the ever-changing and expanding IT landscape is evaluated and reviewed is a challenge and can greatly affect the value of a deal.
FW: How significant is information in allowing PE firms to boost value within their portfolio companies?
Sheth: Having the right information to make strategic and informed business decisions is critical for any business and even more so for a growing business – as a misstep could prove to be much more disastrous. The right information and data are not only needed at the company level but also against comparative businesses. Not all companies are created equal and making informed decisions based on your industry, size, services, and outlook are paramount to being successful.
Cowherd: Access to information is critical for increasing value. First, access to information is needed to establish the value creation plan and to determine what the company is capable of doing with the resources available given the market conditions. Once the plan is in place, information becomes critical to understand how the company is performing against the plan and to make necessary adjustments to achieve profitable growth.
Owen: Getting it right can be really challenging. There is the ‘reference point’ argument when two parties bring two sets of data to a meeting and focus on whose data is right rather than on a solution or decision. There is the ‘who owns the data’ argument, when IT, finance, operations, or other functions have turf battles on systems or data. There is the ‘great systems, poor data’ challenge, which often points to poor master data management or transactional data governance and control issues. There are many other challenges: who gets access to what data, which systems are source data, what external data should get captured, and how to manage too much data; the list goes on. The best companies are rallying around an enterprise data strategy to address the potential issues above and reframe data as a corporate asset, helping companies think through how to use data to boost value creation.
“Careful review of the options and the competitive landscape is essential to translating assets into a real return.” — Merrill Strobel Bohren
FW: What essential advice would you offer to PE firms on identifying value-creation opportunities at all stages of the investment cycle, to maximize returns on exit?
Owen: A unifying value creation roadmap sets many of the best PE firms apart from the rest. Key elements we find most impactful for a strong value creation plan include the following. Clear targets and consistent reporting will unify expectations, create accountability and enable teams in making informed decisions. Combining this with an effective long-range model, cash forecast and integrated annual budget will give management a runway to guide operations. Outside of a crisis, very few teams operate well under micro-management. Well-structured board and management business review meetings facilitate constructive and collaborative decision making and provide clear lines of authority to let each team do what they do best. A strong audit committee, technology oversight, cyber incident response planning, and insurance, legal and compliance functions are needed for all organizations. Building a risk mitigation plan into a value creation roadmap allows companies to respond quickly and reduce the impact of the unexpected. Lastly, articulating the business strategy and history can be incredibly impactful in selling the value creation story. Investment in the financial planning and analysis function and business intelligence tools supports the translation of data into proof points about the strength of the platform, quality and consistency of the business, and readiness to grow or shift in the market – all factors in driving multiple expansion.
Smith: To maximize returns, we advise firms to connect diligence to the value creation process to ensure there are no growth opportunities or risks identified in diligence that are not addressed in the value creation plan. In the early stages of an investment cycle, firms should spend time to align the management team on what a next potential investor will find most attractive and how that aligns to exiting priorities. Firms should also continuously pressure test the capacity and capability of the management team to execute, to minimize the risk of delays and poor execution.
Bohren: We advise management teams and PE firms to start with the end in mind and work from there to develop a plan. Alignment of all the responsible parties cannot be overemphasized. What are the goals at exit? Involving key individuals accountable for execution in the value creation plan development process builds shared ownership in the results. Developing a detailed, actionable plan with critical milestones and realistic timelines drives accountability. Do not try to ‘boil the ocean’ in the first year. Invest in and prioritize highest impact initiatives to execute first and continuously measure and monitor the results. And then repeat. Understand that alignment has a half-life and change is inevitable. The regular review of the competitive landscape, the plan, the progress, and realigning with the team on the path forward is paramount in maximizing returns. “In the early stages of an investment cycle, firms should spend time to align the management team on what a next potential investor will find most attractive and how that aligns to exiting priorities.” — Corey Smith
FW: How do you expect the value creation process to evolve going forward? What additional tools and methodologies are likely to emerge?
Smith: I would expect two key components to evolve in ways that will impact value creation processes going forward. One is the expansion of stakeholders at the table that can help identify and execute value creation opportunities. Key trends such as the scarcity of talent, ESG matters and opportunities, and emerging technical and data tools require input from additional stakeholders at the early stages of the investment cycle. The other component is data-driven approaches and processes to accompany the identification of value creation opportunities. We continue to see an emerging trend of companies layering advanced analytics tools that combine the data from core systems such as customer relationship management and enterprise resource planning with external data sources such as competitive intelligence tools. We expect this trend to complement how value creation opportunities are identified and prioritized.
Cowherd: Given the increasing number of analytical tools, I expect that value creation planning will continue to evolve and incorporate larger data sets to validate growth opportunities and model outcomes. And, as PE firms gain experience from investments where they conducted value creation planning, they will refine the planning process to leverage insights from businesses that have a demonstrated track record of producing growth.
Sheth: The value creation process will be more directly connected to pre-close due diligence activities which, rightfully so, are being expanded. As an example, cybersecurity and data privacy is now being broken out as an individual item to be reviewed. Companies without a sound program can lose business to competitors and potentially not be able to work with certain partners and suppliers. However, these opportunities can be identified, and risks mitigated with proper diligence.
Initially published by Financier Worldwide.