Q&A: Creating value through transformation in portfolio companies
September 2019 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
September 2019 Issue
FW moderates a discussion on creating value through transformation in portfolio companies between Jean-Philippe Grosmaitre, Jan Rattay, Dave Sharman, Mark Steele and Andreas Warner at Deloitte LLP.
FW: Could you provide an insight into how private equity (PE) firms have historically created value in their portfolio companies? To what extent is a ‘new’ approach required to build value?
Sharman: Private equity (PE) firms drive value by improving the earnings before interest, tax, depreciation and amortisation (EBITDA) and cash position of their portfolio companies. Traditionally, many PE houses have taken a hands-off approach to managing the operations of portfolio companies, enabling management to drive operations and only being involved in contributing to their strategic direction. More recently, some PE firms have hired operating partners and, in some cases, built operational improvement teams to capture the value that can be derived from operational improvements at an accelerated pace. These operational specialists normally work collaboratively and closely with management teams by providing additional bandwidth and support to drive incremental initiatives. This approach is being adopted across an increasing number of PE firms.
Rattay: Historically, PE firms have focused on operating cost savings. Over the last five years, however, there has been a much bigger focus on capital efficiency improvements, pricing improvements and operating model re-platforming. More recently, we have seen the advent of the use of digital technology and insights to drive all of these, but with a better level of granular insights. A new approach is required to include a digital or analytical toolkit for every chapter of the PE value creation playbook.
Warner: In the past, PE investors relied heavily on classic financial engineering. With increasing multiples paid for portfolio companies, this is no longer enough to ensure a successful investment. Hence, there is an increasing demand for operational performance improvement services which address both top line and cost aspects to improve cash flow and EBITDA.
Grosmaitre: Historically, PE funds based their success on three key levers: the improvement of company performance or the increase of EBITDA, an increase in value multiple, such as buying at enterprise value of seven times EBITDA and selling at nine times EBITDA, and reducing the debt lever, for example using operational cash flows of the portfolio company to reimburse the acquisition debt of the holding and increasing equity value. The industry went through various cycles where it tested the limits of having a too-high valuation and too-high debt ratio versus low performance. Nowadays, given the strong increase of funds to be invested, value multiples have reached a high level and the debt ratio is more closely monitored and limited by banks. To generate best-in-class returns, PE funds realised that company performance improvement has no real limits, although it might require a more hands-on approach of portfolio management. As value capture is more limited, value creation becomes critical to deliver above-standard performance.
“A good value creation plan clearly relates operational performance, such as transformation or improvements, to financial performance – the business plan.”
FW: How important is it for PE firms to formulate a value creation plan that identifies the full potential of a portfolio company and creates a clear programme to capture it?
Sharman: It is important for firms to formulate a value creation plan, but it is perhaps even more important to create a plan collaboratively with management such that there is buy-in toward an achievable, common goal. Another key success factor is prioritisation and focus. We often see that in the initial ownership period, there are multiple projects being launched which will improve the business but which can put a significant strain on management’s time and detract focus from progressing key value-driving initiatives. Prioritisation and timing is therefore key as it allows focus on two or three initiatives that are likely to have the highest impact. We also find that having a dedicated team responsible for driving the initiatives accelerates progress and allows management to continue to focus on day-to-day operations.
Rattay: In order to deliver the super-returns that PE strives for, more needs to be done than delivery of the management plan that was presented when the PE fund invested. Having a clearly articulated financial goal with key milestones that can be tracked by the PE fund is pivotal to assessing and agreeing the financial benefits from any operational transformation, as well as the timeline for implementation. It also enables the PE fund to keep on top of management and make sure that there is no slippage in the implementation of the value creation plan. The process of formulating the value creation plan will also create the necessary buy-in from management to believe in the additional benefits and savings for the business, as well as dedicate sufficient C-suite sponsorship of the value creation programme.
Steele: In digital and technology terms, it is essential that the timelines and investment commitment, both in monetary terms and in changing business practices, are significant enough and are only exasperated in the presence of ambiguity. The value creation plan gives clarity on the overall business direction and foundations for the digital investment activities, be that its impact on customer experience or the effectiveness of digital integration.
Warner: A sound value creation plan is essential to ensuring that the subsequent project is efficient and focuses on the key value drivers. If possible, this plan should be created during the buy-side due diligence and after closing at the latest.
Grosmaitre: Formulating a value creation plan is important for two reasons. First, you broaden the scope of what could be improved by literally turning every stone, exploring blind spots and building a systemic view of performance and options of value creation, such as industrial footprint, transport blueprint and so on. Second, value creation takes time, which is vitally important in any investment. It is key to speed up the value creation process with a programme enabling parties to identify prioritised actions, resources to dedicate either internally or externally, time to delivery, expected returns and to monitor it closely.
“A sound value creation plan is essential to ensuring that the subsequent project is efficient and focuses on the key value drivers.”
FW: What measures can PE firms take to manage the challenges and pitfalls they are likely to encounter during the different phases of the PE investment lifecycle? How effective is a holistic approach to value creation in this regard?
Sharman: Regular communication with management is key. Having a clear governance structure and consistent ‘drumbeat’ to review progress against plans helps maintain momentum. Initial plans will always deviate and change through implementation, requiring regular review and adjustment. Being in touch with management and working closely with them, in a collaborative way, delivers alignment and generates value.
Rattay: Value creation is at the heart of PE investment and as such it is a prominent feature across the investment lifecycle. Leading value creating PE firms assess the full potential of investment targets at the investment screening stage, followed by the development of a value creation case during the due diligence phase, which then forms the basis of the 100-day plan to be developed after closing. Some of the pitfalls are that not all of the potential benefits are included at the investment stage, and also ensuring that management are fully on board with delivering that value creation plan, which is often well above what was developed and presented during the sales process. Also, if the value creation case and the associated initiatives are not tracked comprehensively during the implementation phase, there is often a disconnect between the exit story and the financial results being presented to potential new owners of the portfolio business.
Steele: It is becoming common practice for PE firms to develop value creation programmes as they recognise the impact of data analytics and the benefits of a digital presence, as well as protecting against the downside risks of cyber security. The recent fines have demonstrated the issues of past ownership immediately become the challenge of the new incumbent.
Warner: PE firms need to include experienced value creation professionals in the process to ensure that management of the portfolio company has a senior sparring partner next to them. This, combined with a professional project management office, covering all key performance indicators, ensures that ‘eyes stay on the road’ so that the project team can quickly react and change course, if needed.
Grosmaitre: A good value creation plan clearly relates operational performance, such as transformation or improvements, to financial performance – the business plan. It does not solely support the investment case and its bank financing. Rather, it is a tool to best interact with management along the investment lifecycle. Since there is a clear map of objectives and resources to deploy, it provides agility to make decisions in case of challenges, pitfalls or opportunities. The management team and the board share a common view of the link between operational decisions and financial impacts and therefore can review options more quickly and select priorities.
“All too often, the lack of programme engagement through the ‘go live’ period results in issues as the business adoption fails to fully materialise.”
FW: To what extent is digital transformation impacting the process? What benefits do analytics, self-learning algorithms and other insightful technology tools bring to unlocking value in portfolio companies?
Sharman: Digital transformation is a key enabler. The first step toward driving performance improvement is having clear visibility and understanding of data, which creates ‘one version of the truth’ and allows the business to drive accountability through the organisation in a consistent way. Analytics can help to quickly create a pragmatic view of performance, such as customer profitability, product profitability, cash conversion and so on, which allows the business to ‘get started’ in the right direction, while embedding long-term solutions that drive automation and efficiency.
Rattay: Digital transformation has been accelerating in response to customer behaviours and demands in the business to consumer (B2C) space and this is now also affecting many business to business (B2B) businesses, which are able to benefit from the streamlining of their operations through digitally-focused initiatives. Through the use of robotic process automation (RPA), businesses are able to automate back office processes with relatively low cost investments, and with the use of improved digital analytical tools, management teams are able to better understand their business and react to changing trends or customer behaviours quicker.
Steele: Organisations are continuing to explore the limits of analytics and automation. Clear benefits are being found in the scale and quality of the data now being analysed. But the habits of the past around the approach to and treatment of data mean that groundwork is needed to clean up historic data sets. Digital technology and operational management teams are now working much closer together to help drive insights and algorithmic solutions. As a result, benefits are being seen in manpower planning, procurement, working capital and customer analytics.
Warner: Modern analytics tools completely change the way some projects are done. Thorough data analysis ensures that the following value creation measures are 100 percent on target and that nothing essential has been missed during the analysis phase. Also, applying the latest technology can successfully transform a business, for example by applying neuroscience in retail environments.
Grosmaitre: Digital transformation creates new opportunities for the portfolio company on several levels – from back-office to front-office operations. It also provides new opportunities to unlock value in a value creation plan: analytics enable firms to process heterogeneous data and identify new opportunities for value creation, self-learning algorithms enlarge automation opportunities and create new spaces for radical cost structure change and service level. All these new technologies enable more radical changes with a lower transition cost. This is providing new spaces for value creation, and we are only at the beginning of the process. It is essential for firms to stay realistic about the ways that changes will be implemented in order to ensure that portfolio companies can finally create the expected value.
FW: How important is it to have a dedicated value-creation team in place that can track the operational and financial performance of a portfolio company?
Sharman: Different PE firms have a different approach to the operational performance of their portfolio. Some deploy large teams to support management with a ‘hands-on’ approach, while others adopt a more passive role and use consultants when management require further bandwidth or support. Having a dedicated team, regardless of size, which has the capacity to interact with the management of the portfolio companies, to varying degrees, depending on need, tends to accelerate incremental value and fosters a more collaborative relationship that ultimately benefits management as well as the owner.
Rattay: Different funds deploy different operating models to identify and support portfolio companies in the delivery of their value creation plans, with many funds now having dedicated operating partners in place, and some having a full operations team with more than 10 dedicated executives. This ensures that the operational transformation mindset is at the head of each investment and investment committee and is part of the DNA of the fund. Having a dedicated team with an operational transformation background is also key to developing the right kind of relationships with the management teams and supporting them on the execution of the value creation plans, while the deal-focused executives concentrate on the next deal to deploy their fund’s capital.
Steele: For digital programmes, it is essential to sustain the close alignment, prioritisation and structure of the technology to help ensure the efficient delivery of the programme and ensure organisational readiness for the change is delivered. All too often, the lack of programme engagement through the ‘go live’ period results in issues as the business adoption fails to fully materialise.
Warner: Personally, I do not think that it is necessary to have a dedicated value-creation team in place, but if the portfolio reaches a certain size it might make sense to build a core team. However, I believe that the core job of this team should be to select and guide the value creation activities in the portfolio company through a project management office (PMO) setup.
“Many PE firms have been more professional around exit planning, and ensuring that the value of the operational transformation is clearly demonstrated to new investors in the disposal process.”
FW: What essential advice would you offer to general partners on replacing passive stewardship with a hands-on approach to building value across a portfolio?
Sharman: A more hands-on approach is only relevant in certain cases, such as where management needs additional support. In those instances, passive stewardship can lead to diverging objectives and ultimately may not result in delivering the expected value. It is important to consider the level of involvement in the context of the PE firm’s objectives and the type of assets they invest in. In some cases, where portfolio companies are more stressed or going through a turnaround, PE firms should be prepared to take a more active role in managing performance.
Rattay: A more active approach to value creation across an investment portfolio will no doubt create better returns for the PE firm and its investors. In fact, many investors now require PE funds to have operating partners and teams in order to deploy capital into the PE asset class, so this is simply no longer an option in the PE landscape. With even more dry powder across PE funds and a limited number of attractive investment targets, a holistic value creation approach will also enable the PE firm to see more value than other bidders at the investment stage, thus helping them to create a higher return and allowing them to bid more to win the auction. A more active value creation approach will also demonstrate the ‘value add’ of the PE firm during ownership, and facilitate a smoother exit process.
Warner: The clear recommendation is to onboard experienced, hands-on advice from the outside which combines financial and operational competence and clear implementation skills. This is key to getting PE managements’ acceptance and also ensures results that hit profit and loss (P&L) and balance sheets.
“Looking forward, I would envisage even closer collaboration between PE firms and their portfolio companies as a general trend.”
FW: Going forward, how do you envisage value creation initiatives evolving as PE firms seek to maximise return on exit? What new strategies are likely to emerge in the years ahead?
Sharman: Looking forward, I would envisage even closer collaboration between PE firms and their portfolio companies as a general trend. There is ever-growing pressure for PE firms to deliver significant returns in a short space of time. Applying an accelerated lens to performance improvement is key to this and requires focus and resource, which PE firms can provide. PE houses may therefore continue to invest in their operational teams, or deepen their relationships with advisers, to be able to provide that bandwidth and support.
Rattay: Many PE firms have been more professional around exit planning, and ensuring that the value of the operational transformation is clearly demonstrated to new investors in the disposal process. Leading practice includes a full exit readiness diagnostic that not only focuses on ‘what has been done’ but also ‘what is left to do’, and a number of key housekeeping items to make sure that returns are maximised during the disposal process. Over the coming years, there will be an increased focus on the implementation of analytics to drive pricing initiatives, dashboards and automated reporting to monitor business performance, the use of RPA to automate back office processes, and the deployment of digital toolkits across the value chain.
Steele: We are already seeing a change, with greater engagement with regard to the digital customer experience, the building of sustainable analytics tools and greater automation. I only see this trend growing, starting with a greater focus at the diligence stage.
Warner: I believe that a committed value creation strategy will be a key factor in ensuring sustainable investments with successful exits. Value creation will start during the acquisition phase and will directly lead to seamless implementation projects after closing.
Dave Sharman co-leads Deloitte’s VCS team in the UK. His experience includes transformation director, CFO and COO positions, portfolio performance director and various M&A roles. He has a vast amount of experience of M&A, operations, strategy, restructuring, transformation and turnaround across many key industry sectors. Prior to rejoining Deloitte, Mr Sharman was the CEO of the global consumer luggage brand Antler, running the $50m business with over 300 employees. He successfully executed a turnaround plan which enabled Antler to be sold to a new private equity investor in 2017. He can be contacted on +44 (0)20 7007 9354 or by email: dsharman@deloitte.co.uk.
Jan Rattay is a partner in the M&A operations team at Deloitte in London with over 15 years of experience of advising private equity funds and their portfolio companies across the transaction lifecycle, including full value potential assessment prior to investment, business due diligence, carve-outs, 100 day planning, exit preparation and support. He can be contacted on +44 (0)20 7303 8973 or by email: jrattay@deloitte.co.uk.
Mark Steele leads the technology practice supporting value creation and M&A. He specialises in programmes where technology is central to organisational performance and where digital disruption is changing the way organisations work and engage with their customers. Mr Steele’s work impacts both top line growth and the cost base of the organisation. Together with his team he has delivered ecommerce, cyber security, data analytics and operational simplification programmes. He can be contacted on +44 (0)20 7303 5393 or by email: masteele@deloitte.co.uk.
Andreas Warner leads the EMEA value creation services practice, specialising in industrial turnarounds and the design and implementation of performance improvement projects. He has a strong operational track record in top line and margin improvements, but also in cost optimisation across a variety of industries. Together with his team he also executes the implementation of cost-saving measures previously identified in analytical concepts for clients. He can be contacted on +49 89 29036 8022 or by email: anwarner@deloitte.de.
Jean-Philippe Grosmaitre leads Deloitte France’s M&A operations, a team of 50 professionals dealing with value creation services in transactions and post-merger integration. He has a strong track record in operational performance improvement across a variety of industries and a deep know-how of transactions and restructurings. Before joining Deloitte in 2011, he gained more than 12 years of industry experience as general manager of a printing company under LBO and M&A vice president with a €1bn global group listed on Euronext, in addition to five years of experience in strategy and turnaround consulting. He can be contacted on +33 786 85 58 35 or by email: jgrosmaitre@deloitte.fr.
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