April 2022 Issue
A primary objective of private equity (PE) firms is to create value. Historically, cost reduction and financial engineering were key methods of generating value across portfolio companies. Financial leveraging was perhaps the main tool used to boost the internal rate of return (IRR).
But in recent years, the PE industry has grown and matured, both geographically and in sophistication. It has moved beyond the leveraged buyouts which defined its ascendance to embrace a wide array of investment strategies and asset classes operating in most countries around the world. According to Preqin, in 2021 private equity and closely related asset classes were estimated to manage more than $4.4 trillion of investor capital — an amount expected to double over the next five years.
And while the industry has evolved, so too have the challenges it faces. PE has been forced to move with the times, adapting to regulatory, technological and environmental issues, among others. In a more mature and competitive space, firms must be able to differentiate themselves from the competition to create value.
Beyond buy-and-build
Value creation in the PE space has had to evolve, with the process moving beyond pure financial engineering. Operational improvement is now a key component. PE firms must evaluate their portfolio company’s current performance, comparing its year-on-year earnings, looking at its position within the market, and using current trends to project future performance. They then apply their industry expertise to implement changes to the portfolio company’s existing strategies and operations.
The buy-and-build strategy has been popular in the past, offering firms a clear path to value via a strategy that does not rely on tailwinds like falling interest rates and stable GDP growth. It can accelerate revenue and expand margins by unlocking synergies. It can also create expectations for continued portfolio company growth, translating into higher exit valuations. However, PE firms have realised the importance of moving beyond traditional value creation techniques, turning to technology investment and digital transformation to augment the process.
The onset of the coronavirus (COVID-19) pandemic has been one catalyst for this shift. It has fundamentally changed operating models for many organisations, including portfolio companies. These shifts will continue to have an impact across supply chains, cost structures and human resources. The pandemic has also increased the focus on sector-specific expertise to adapt, evolve, innovate, manage risks and capitalise on potential opportunities.
During the COVID-19 pandemic, companies had to respond to dramatic changes in supply and demand for products, services and people. They had to rethink how to operate. With guidance, many portfolio companies were able to quickly adapt to new ways of working remotely and connecting with customers. Those at the forefront will be best placed to take advantage of the post-pandemic economic revival.
Tech transformation
Many PE firms are investing in digital initiatives earlier in the investment lifecycle, tapping into data-driven, value-creation playbooks used by the world’s most valuable digital companies. When approached thoughtfully and implemented effectively, digital transformation can increase profitability and reveal untapped potential throughout portfolio companies. Digital transformation enables businesses to evolve into data-driven enterprises by leveraging technologies such as data analytics, artificial intelligence (AI) and the internet of things (IoT), among others.
“Deal structuring and cost cutting, once staples of the PE space, are providing fewer opportunities for outperformance and differentiation. Today, firms require a deeper value creation playbook.”
Through the COVID-19 crisis, firms have been able to support their portfolio companies in making important cultural changes. This includes committing to information management, advanced analytics skills and technology investment – all part of successful digital transformation.
Digital transformation can help companies improve their knowledge and content management. Accessing, organising and sharing data boosts productivity for functions across the organisation, saving time and resources. Analytics also has a key role to play in identifying trends, creating forecasts and making decisions based on projected outcomes.
By gathering and curating data to deliver critical insights and reveal patterns, companies can make better, more informed judgements. For example, clusters of consumer data can help portfolio companies understand customer profile characteristics, to develop a more intimate understanding of what they want, which can improve customer experience and open new markets.
Portfolio companies are utilising systems that track the customer experience chain to personalise marketing campaigns, allowing better product customisation and revealing new product opportunities. A better understanding of key demographics can improve targeted sales.
To assist the transformation process, enhance efficiency and make better business decisions, more PE firms are appointing a chief digital officer (CDO). The CDO has a key role to play in value creation, ensuring that an organisation’s mindset, values and behaviour keep pace with progress in technology. The CDO acts as a thought leader, assessing the digital maturity of the organisation, driving and framing the adoption of data and analytics, and building the IT infrastructure necessary to harness it. The CDO needs to be familiar with the latest developments in the IT landscape, know what consumers are looking for, and able to drive revenue and improve ROI.
The CDO performs a range of functions. First, they should develop the end-to-end strategy for the organisation, designing and implementing a digital roadmap. Second, they should act as a conduit to facilitate greater communication throughout the organisation, bringing together other members of the C-suite to focus on digitalisation and establishing priorities for the transformation programme. Third, they should contribute to revenue generation through the company’s corporate channels. Fourth, they should lead the business through the impact of digital change, navigating the uncertainty and cultural sensitivities that are part of the process. Finally, they should track efficiencies when replacing manual processes with technology, to monitor cost savings and revenue generation over the long term.
Cyber security is another key aspect, certainly in terms of value preservation. A data breach can quickly destroy value for companies by negatively affecting confidence in an organisation, not to mention the potential for compromised assets and regulatory fines. A strong cyber defence framework, supported by expert external advisers, can help PE firms protect their investments. The CDO should also take the lead in analysing the existing data and tech landscape and any regulatory risks and data security vulnerabilities.
ESG considerations
Significant value is increasingly driven by nonfinancial factors. As PE firms have begun to learn in recent years, one area that can make a notable impact on value creation is environmental, social and corporate governance (ESG). Customers, employees, regulators and limited partners (LPs) are demanding more sustainable, socially conscious corporate behaviour from PE firms and their portfolio companies. PE firms that can deliver on ESG are reaping the rewards.
Though ESG can be difficult to define, there is a growing feeling throughout the PE space that investments in sustainability, social welfare and good governance can be hugely beneficial. A JP Morgan survey published mid-2020 suggests that the COVID-19 pandemic could have a positive impact on ESG investing, with 71 percent of participants responding that it is “rather likely”, “likely” or “very likely” that awareness of ESG investing will increase. As ESG investing matures in the coming years, leading firms and their portfolio companies will be able to utilise these benefits to create better working environments, engage employees and improve market share.
Indeed, consumers, particularly millennials and post-millennials, are increasingly attracted to companies they believe act responsibly. A 2020 Capgemini survey of 7500 consumers and 750 executives globally found that 79 percent of buyers were changing their preferences based on sustainability. In addition, a Bain survey of more than 12,000 consumers in the US and EU revealed that 44 percent agree or strongly agree that sustainability will be even more important in the wake of the pandemic. Going forward, PE firms and their portfolio companies are more likely to embed ESG initiatives into their value-creation plans.
On the fundraising side, a growing number of LPs are demanding to see ESG performance, too. According to the ‘2020 Edelman Trust Barometer Special Report: Institutional Investors’, 88 percent of LPs globally use ESG performance indicators in making investment decisions, and 87 percent said they invest in companies that have reduced their near-term return on capital so they can reallocate that money to ESG initiatives. Accordingly, ESG is fast becoming a central factor for general partners (GPs) seeking to raise new funds.
There are already signs PE firms are acting on the increased demand for ESG considerations. This can be seen through new investment mandates, ESG-focused thematic funds and alignment of processes. Furthermore, many GPs are increasingly transparent on ESG, publishing performance reports at both fund and portfolio levels.
Trends such as the drive toward equality, action on climate change and enhanced human rights will impact all sectors. As such, PE firms will need to make sound decisions based on the additional risks and opportunities these trends create. This requires firms to move beyond basic compliance toward broader risk management, then flipping the switch to opportunity-seeking. A top-down approach ensures that ESG is prioritised from the beginning of the deal lifecycle, from sourcing professionals through to operating teams.
Going forward, ESG is poised to be a key differentiator when attracting capital allocations in the post-pandemic era. Many investors have declared their commitment to ‘building back better’ and advancing social and environmental goals will be vital to that process. Despite the various challenges companies have faced over the last two years, ESG has remained a key focus, with an increasing emphasis on social and governance factors. As such, making ESG a consideration across all aspects of the investment process can be advantageous for PE firms.
There is, however, still work to be done in integrating ESG into PE, particularly with respect to climate change and diversity. According to an Aberdeen Standard Investments survey in 2021, only 36 percent of GPs surveyed have processes to manage climate-related risks, and only 40 percent of co-investments monitor carbon footprint. Responses to diversity-related questions were also underwhelming, with only 23 percent of GPs having diversity targets in their portfolio companies – though 47 percent were planning to incorporate them in the near term.
Playbook
Deal structuring and cost cutting, once staples of the PE space, are providing fewer opportunities for outperformance and differentiation. Today, firms require a deeper value creation playbook.
The COVD-19 pandemic has been seismic in many ways, but the emergence of ESG and the growth of digital transformation are two of the most important factors influencing PE. Technology, through newly accessible data sets and analytics capabilities, is vital for value creation. Arguably, PE firms may not maximise portfolio company returns unless they take full advantage of data and technology solutions.
Value creation plans should be tailored to the needs and circumstances of each individual portfolio company. Ultimately, their success is a key driver of future investor returns. Specifically, digital transformation and ESG are set to be notable contributors to PE value creation. Businesses that are tech-enabled and demonstrate strong ESG ethics are likely to command a higher valuation on exit.
© Financier Worldwide
BY
Richard Summerfield