Driving value creation in the PE space

March 2024  |  COVER STORY | PRIVATE EQUITY

Financier Worldwide Magazine

March 2024 Issue

Private equity (PE) firms must utilise every tool at their disposal to drive value creation within their portfolio companies. Over recent years, general partners (GPs) have amassed an historically high number of portfolio companies. To create value within them, the old playbook of financial engineering cannot be relied upon; PE firms are instead largely focused on active portfolio management – driving operational efficiencies to reduce costs and propel growth.

The ability to deploy capital and generate returns is more difficult to accomplish in the current economic landscape. In recent months, deal valuations have risen, interest rates have increased, inflation has hit record highs, and economic and geopolitical uncertainty persists.

There is hope in the PE space that the industry bottomed out in 2023 and is set for a new growth cycle. According to BluWave, 2024 could see economic fundamentals improve, with dealmakers under increasing pressure to put dry powder to work.

An evolving playbook

As Goldman Sachs notes in its ‘Private equity’s new math’ series: “Private equity managers have adapted their value creation playbook depending on market conditions. Leverage and financial structuring have become less important in recent decades, while multiple expansion and operational factors have gained prominence.”

Indeed, Goldman Sachs believes that the next 10 years for PE are unlikely to resemble the previous decade. “In our view, the radically altered investment backdrop means that for private equity, the path to operational value creation will need to look different than may have been the case in the past. Leverage and multiple expansion are unlikely to add as much to value creation as they have in the past. GPs, and many LPs, are coming to the realization that operational value creation levers will become even greater determinants of success or failure for individual deals and funds.”

The tech imperative

Perhaps the most potent tools in today’s playbook is technology. It is seen as a central pillar in the value creation process across the PE space. Utilising technology as a value creation lever can provide a powerful competitive edge.

In its ‘Three tech pillars driving value creation for PE portfolio companies’ analysis, EY argues that: “The pivotal role of technology in shaping the value of PE firms’ portfolio companies has become undeniably paramount. It has evolved from a mere cog in the wheel that drives operational efficiencies to a powerful engine that propels revenue growth. Yet, the stage upon which this transformation unfolds has itself drastically shifted. We now operate in a macroeconomic landscape fraught with perils, geopolitical conflicts, economic risks and lingering effects of the pandemic, all casting long, uncertain shadows. In this tumultuous scenario, harnessing technology and innovation is not just a choice for PE firms, but an urgent imperative.”

In the view of EY, there are three vital technology driven pillars: fuelling top-line growth, optimising costs and maximising capital efficiencies. “Each pillar individually and collectively fortifies the foundation, amplifying exit multiples and paving the way for heightened returns.”

Historically, the PE space was shaped by GPs relying on local knowledge, personal relationships and the intuition to spot opportunities, predict future trends and extract value. But the coronavirus (COVID-19) pandemic had a significant impact on technological adoption. Following the outbreak, GPs and their portfolio companies had to quickly adapt to the widespread disruption – and technology often presented the answer.

PE firms increasingly embrace the power of technology to automate workflow processes, extract data from internet of things (IoT) sensors, improve accounting and reporting, streamline due diligence, and track investment targets, for example. All of this requires significant investment in data storage and analysis. On the upside, use of open-source software is growing, and cloud storage cost per gigabyte has fallen exponentially in recent years.

According to Accenture: “Tapping technology during M&A journeys activates additional value levers for PE investors, leading to cost reduction, enhanced flexibility and top-line growth.” But, it says, portfolio companies often fail to maximise the benefits technology offers.

As Goldman Sachs points out: “GPs will need to question everything – from raw material procurement to marketing budgets, to structure and focus of sales organizations – in order to understand the most efficient ways to drive growth, customer acquisition costs and unit economics. This effort will likely need more systems, processes, and technology to accurately understand costs, quantify their impact, and identify prudent ways of reducing expenses without hurting topline growth.”

Data insights

Data can assist a portfolio company on its path to achieving the strategic goals laid out by senior management, and should be tied closely to those goals. By creating an inventory of their data, portfolio companies can assess any data gaps within the context of their strategic goals. This process will also illuminate any issues with data quality, including completeness, consistency and accuracy.

Embracing developments such as artificial intelligence (AI) and machine learning can dramatically improve business performance. For this, data must be protected and prioritised. Collecting, organising and analysing data from inside and outside the company can reveal actionable insights. These can improve business outcomes and generate value over the long term.

The chief data officer (CDO) is a key part of this process. Today’s CDOs define data strategy for the present and take steps to futureproof it. Using technology, CDOs can build and maintain data infrastructure and drive value in the process.

According to BluWave, 2024 will see data scientists become the most in-demand hires across PE firms and their portfolio companies. As data sets expand and evolve, companies are seeking to add professionals with expertise in statistics, Python and SQL, for example.

Indeed, data science transformation is one of the most sustainable and impactful ways for portfolio companies to generate value. It facilitates smarter, quicker decisions – more often and at scale. It can allow companies to outperform their market, to grow quickly and sustainably, enhancing return on investment.

Data science is a versatile discipline that can influence various parts of a company’s functions, including sales, marketing and operational excellence. Improvements may be made to demand forecasting, stock optimisation, store location, logistics and delivery, marketing initiatives, pricing and promotions, omnichannel sales, cross-selling opportunities, customer engagement and client churn, for example.

Data science can also have a transformative impact on PE firms at the fund level. While most GPs are smaller and more agile than their portfolio companies, they too can benefit from applying data science, such as for deal sourcing. Data science and analytics can help fund managers to assess key business characteristics to identify potential future targets. It can also boost decision making, making it better, quicker and more reliable – vital in the competitive, fast-paced PE industry.

According to Goldman Sachs: “Data science, AI, robotics, and automation continue to mature and accelerate. They are increasingly in a position to drive revenue growth and enhance efficiency in ways not possible before. As such, they are providing opportunities to effect large-scale business transformation while forcing a re-imagining of the characteristics of successful businesses.”

Risks of technology adoption

There are many considerations when it comes to rolling out new technology solutions. Arguably, the priority should be to maximise the value of what portfolio companies already own. Can investment in legacy technology or existing operating models deliver results? Can current processes be streamlined by improving existing technology? With no shortage of solutions available, GPs need to identify and prioritise those that will have the anticipated impact on their portfolio businesses.

According to EY, organisations can achieve significant margin improvement through application rationalisation and infrastructure optimisation, IT organisation redesign and tech-enabled operational improvement. Such initiatives require a strategic approach, however, and a willingness to embrace technological innovation.

But the process of adopting technology is complex. It is not enough for portfolio companies to simply add new solutions; instead, there must be top-down oversight of a clear, well-defined strategy. Technology needs to be integrated in a way that allows the portfolio company to better serve customer, employee and shareholder needs. To do this effectively, the company must set explicit goals.

Culture is also important. Companies must ensure that change caused by technology is embraced rather than feared. “Cautionary tales abound of companies that spent heavily on technology without reaping the full benefits due to organizational frictions”, warns Goldman Sachs.

According to EY, PE firms using technology to boost value creation should aim to avoid five critical risks and pitfalls, outlined below.

First, inadequate due diligence. Failing to conduct sufficient technology due diligence can result in unforeseen challenges during the integration phase, including system incompatibilities, legacy technology issues and cyber security vulnerabilities.

Second, resistance and shock. If employees and stakeholders are resistant, this can hinder the successful implementation of new technology initiatives. In addition, the demand from GPs for quick results can create a culture shock for workers, especially at the mid-to-junior level.

Third, unrealistic expectations. When the benefits of technology investments are overestimated, or the time and resources needed for implementation are underestimated, this can derail efforts to create value.

Fourth, insufficient governance and monitoring. Technology initiatives need proper oversight, without which the portfolio company may suffer from misaligned priorities, inefficient use of resources, inability to track progress, and lapses in regulatory and industry compliance.

Lastly, neglecting cyber security. Lack of investment in cyber security solutions may expose the portfolio company to risks such as a data breach, financial loss and reputational damage.

As Goldman Sachs notes: “The adoption of new technologies will be fundamental to long-term success, but in order to reap the full benefits of new technology tools, companies need to create first-mover advantage, build a defensible moat, and form a realistic view on the ability of technology to expand or create new markets.”

Chasing an ESG value boost

Another, more recent area of value growth for portfolio companies is environmental, social and governance (ESG). Environmental and sustainability issues have become core issues for many customers, employees, regulators and limited partners. There is a heightened demand for PE firms and their portfolio companies to adopt more sustainable, socially conscious strategies.

Those that can deliver on ESG are reaping the rewards. According to Accenture, companies with deeply ingrained sustainable management practices outperform their counterparts on earnings before interest, taxes, depreciation and amortisation (EBITDA) margin by up to 21 percent.

However, there is a long way to go before sustainability is considered mainstream within the PE space. Many GPs recognise sustainability as a strong value driver but struggle to operationalise it. Integrating ESG into PE remains a challenge, with many GPs still finding their way to develop suitable practices and policies.

Yet an increasing number of PE firms are shifting their approach. Indeed, a majority believe that ESG management can help create value. In a recent PwC survey, 70 percent of respondents placed value creation among the top three drivers for their organisation’s ESG activities. The survey findings also indicated that it is standard practice for PE firms to consider ESG factors when sourcing opportunities, carrying out due diligence, forming post-acquisition plans and deciding on deal terms.

Further, many firms believe ESG management is consistent with their overall efforts to generate returns for clients. More than 80 percent of respondents said that considering ESG performance is ‘in line with the pursuit of returns’, compared with just 1 percent who said it is ‘in conflict with the pursuit of returns’.

Moreover, a third of PE respondents said that ESG was a primary driver of value creation in more than half of their organisation’s recent deals. Moving forward, GPs are likely to target companies that proactively address and manage ESG risks and opportunities. Maturing ESG strategies are set to play a greater role in target selection.

Integrating ESG strategy throughout the investment lifecycle is becoming more important. According to Deloitte, GPs should define ESG investment objectives in the context of their core mission, values and current investment approach. This requires a mechanism for evaluating portfolio company performance on ESG priority topics.

Steps should also be taken to implement policies and training on ESG across the PE portfolio. Employee incentive schemes centred on ESG can help build a culture. According to Harvard Business Review, employees of purpose-driven organisations are 25-40 percent more productive. Strategic workforce management can help mobilise the right ESG measures for HR, performance management and incentive plans.

GPs should identify ESG performance metrics and develop processes to collect, analyse and report on this information. Doing so will allow the GP to communicate performance at the fund and portfolio company level to investors and regulators.

ESG performance could also have a bearing on exits: those companies that are ESG-minded and technologically advanced may command a higher valuation.

Tailored plans

Value creation is an ongoing process, not a one-off exercise. GPs and their portfolio companies will continue to explore new ways of driving value. In a competitive, uncertain business landscape, PE firms will need to use all the tools at their disposal to generate maximum value for investors. Technology, data and ESG performance will be a key part of this process in the coming years. Integrating successful strategies in these areas will provide advantages.

Value creation plans should be tailored to the needs and circumstances of individual portfolio companies. Ultimately, their prosperity is a key source of future investor returns. GPs need to take steps to make their portfolio companies more resilient and likely to thrive in an uncertain, volatile marketplace.

© Financier Worldwide

BY

Richard Summerfield