By Allen Schaar and Srin Subra
Uncertainty. Has there ever been a word that more accurately captures the current state of mind and market? Or a word so overused as a result?
Uncertainty is, in many ways, the 2020 version of value creation, in that its ubiquity has threatened to overshadow its importance. That’s a big problem because, individually, uncertainty and value creation are critical to understanding market context and investment potential. And when linked (in a way they’ve never been prior, but must be going forward), they’re critical to driving investment performance.
Playbooks, Plans, Pivots:
PE has a playbook: Sponsors acquire a company with an investment thesis, develop a value creation plan (VCP), execute on that plan, and exit the investment at a higher multiple. The playbook’s success is inextricably tied to the validity of the VCP, which is created just before or after the deal, and is rarely revisited thereafter. In the face of uncertainty, VCPs must be much more dynamic than has been the norm.
Sponsors have tried to hedge against uncertainty by underwriting for different scenarios, installing management teams who can capably pivot, investing in annual planning, and conducting quarterly forecasts. While all of those activities are critical, none of them serve as the north star of the investment in the way a VCP does.
We have long-said that value creation needs to be dynamic – not a plan, but a planning exercise. COVID has put the exclamation point on that perspective. Uncertainty is the new normal and sponsors must manage accordingly. We believe they can do so effectively by leveraging a value creation planning plus (VCP+) framework.
How it works
VCP+ is a redesigned approach to planning (long-range, forecasting and budgeting). A dynamic model anchored around value impact, VCP+ enables portfolio companies to anticipate change and modify their VCP in order to mitigate or exploit new market realities. It incorporates these critical principles:
Focus on four: Most companies have their traditional three-statement financial model: income statement, balance sheet and cash flows. What many don’t do is integrate the output of those models into a returns model. It’s that fourth model that ties strategy to expected investment value. The four-statement model differs from traditional planning by anchoring discussions of initiatives to their impact on value, and shifting the forecasting focus from financial projections to investment returns.
KPIs(x2): VCP+ leverages two types of KPIs – key performance indicators and key predictive indicators. The former are critical for understanding business performance and aligning to operating metrics. The latter represent the external and internal drivers of company fortune (e.g. segmented transaction volume trends for e-commerce companies, or miles driven for logistics organizations). These KPIs can be used to predict performance and drive revenue/cost forecasts, which can be empirically tested against results.
Probability projections: Financial projections are created in a deterministic fashion, arising from point estimates or human-informed hypotheses around potential scenarios. This approach oversimplifies the possible range of outcomes and constrains effective business planning. VCP+ is based on a probabilistic framework that leverages analytics around historic volatility of KPIs(x2)– incorporating standard deviations and confidence intervals– to project cost and/or revenue ranges. It’s not only more accurate, it better exposes the uncertainty that needs to be actively managed.
Automated agility: Traditional planning has a defined cadence (annual budgets, followed by quarterly reforecasts) that is insufficient for uncertainty – there’s no mechanism to revisit the evolving path of KPIs or to modify actions in real-time. To be agile in decision-making, companies must be agile in planning, too. VCP+ recognizes the criticality of automation to agility, understanding that the planning model must be easily updatable for it to be effective.
PBB to ZBB: Precedent-based budgeting (incrementalism), which extrapolates from historical data, is the traditional archetype for planning, but it overlooks powerful spend levers. VCP+ uses select zero-based planning techniques to rebuild key spend items from the bottom up. This focused use of decision packages during planning reviews (e.g. classifying spend as strategic vs. non-strategic, defining the link between spend and KPIs) drives quick and more responsive results.
VCP+ is a new paradigm for navigating certain uncertainty. But, in order for it to be successful, portfolio companies must have the acceptance of, and commitment to, managing uncertainty. This isn’t an annual planning exercise, it’s ongoing agile management. They must also have an FP&A team capable of causality analytics and complex modeling. And the companies must invest in time, executive resources and enabling technology.
VCP+ is not only the answer to COVID-induced volatility, it’s the approach that will enable sponsors to navigate their portfolio through this black swan event and the inevitability of the next perfect storm, market correction or unexpected business hiccup.
Allen Schaar and Srin Subra are managing directors at Accordion, the private equity-focused financial consulting and technology firm.