By Andrew Dunn, One Equity Partners
Every business requires a tailored approach when it comes to value creation. The key for private equity investors looking to drive growth is understanding how to use the right tools and strategies, at the right times, to achieve their desired outcome.
Before I became an investor, I used to compete at the international level in the sport of rowing. I often think about value creation within our portfolio companies in the same way as I approached preparing with my team for competition. Rowing races are increasingly won or lost by narrower and narrower margins and winning a 2,000-meter race can come down to taking an extra inch against your opponent with every stroke of the oar.
Classic private equity value creation levers like add-on acquisitions and operational improvements are like the core building blocks of athletic conditioning. But others have likely done the same training, so to speak, and that means digging deeper to win those extra inches: finding other, less common strategies for driving growth. Two that have been particularly effective, in my experience, are transformative combinations and research & development optimization.
A transformative combination is not simply an acquisition that grows revenues, expands the company’s geographic footprint, or adds products. A truly transformative combination — for example, with a large competitor or a leader in a complementary sector — can make a step-change in the company’s scale and growth trajectory.
These deals can result in myriad immediate benefits that boost profitability, from improved operating leverage and greater access to capital to strengthened supply chain capabilities, market share growth and revenue diversification. But what makes a transformative combination particularly effective is that it can be completed in less time than integrating multiple smaller add-on acquisitions, while instantly enhancing scale and reducing customer concentration.
The consolidation of two like-sized companies almost always diversifies the existing customer base of each, while allowing the management team of the merged organization to generate additional opportunities to cross-sell products and services to the combined group of customers, supercharging the business’s rate of growth. The combined company is then typically able to command a higher price at exit, resulting in the significant multiple expansion that a private equity investor is looking for.
For most investors, R&D is a black box: you know you need it, but you’re not sure exactly what’s going on in there, how to measure it, or how to improve it. As a result, in my experience, many firms tend to ignore this area entirely.
As an investor, you should think about breaking R&D into two parts: effectiveness and efficiency. Effectiveness revolves around a set of strategic questions that address whether you are investing in the right products to fit your target market segments, and whether those segments are large enough to yield an outsized return on that R&D spending. Efficiency relates to operational excellence: the need to relentlessly measure through-put, quality and performance to get more output for the same dollars spent.
To satisfy an effectiveness analysis, you must perform detailed reviews of spend allocation and stack-rank projects based on potential ROI to prioritize products and re-allocate capital to emerging growth areas as necessary. To evaluate efficiency, you need to take a close look at the quality of R&D, and then develop solutions that support rebalancing spending to focus on what best suits the business now and in the future.
R&D is notoriously tricky to measure in real time; designing a custom set of metrics and processes to measure R&D spend is the key to observing how a company is trending. With a commitment to R&D optimization, private equity investors can expect to see R&D spend as a percentage of revenue decrease, while the company’s product output is maintained or improved.
I’ve seen a focus on R&D generate significant results in recent investments. For one portfolio company, we formed an R&D Committee of the Board to implement optimization tactics alongside the company’s management and operating partners. R&D spend relative to revenue was reduced from 50% to nearly 20%, yet the company saw no negative impact on its product output level. This was accomplished through measures including bringing in new R&D leadership with superior cloud competency, eliminating non-core products, and implementing KPI tracking to measure performance and incentivize improvement.
Straightforward operational improvements and enhanced financing will always be essential components to improving profitability and growth. But less-common strategies like transformational combinations and optimizing R&D can find those extra inches that set you up to win, and further enable private equity investors to build businesses that are operationally sound and attractive to future potential buyers.
Andrew Dunn is managing director at One Equity Partners