What a difference a year makes. Last March, credit markets were wide open and each week seemed to bring a new multi-billion buyout. At that time, the biggest challenge facing private equity firms was coping with rising multiples and the frantic pace of dealmaking.
Today, as the credit markets struggle and the economy slows, it’s a much more challenging environment for private equity firms. As this cycle unfolds, firms will have to work much harder to create value. But success is possible, and for some, this new environment will present opportunities. Based on our work with private equity firms, we’ve identified several guiding principles for creating value in this environment.
1. Focus on Core Principles
In times of economic downturn, private equity firms who outperform the competition are the ones that focus on the core of their strategic platform. An effective private equity firm focuses on its core by outperforming its competition in four realms: Adherence to investment strategy, oversight of portfolio company management, effective utilization of outside resources and reinvestment in portfolio companies.
Adherence to investment strategy
During an economic downturn, the firms that consistently return above average IRR’s to their limited partners are the firms that stick to their core strategies. Nearly every firm has a different mission statement and strategic initiative but at their core, the out performers concentrate on investing in growth and creating value. Often in downturns, there are less deals to be made, making the deals that are left on the table increasingly competitive. Some firms will feel the pressure to put their committed capital to work and in the process will sacrifice their core investment strategy. Funds that weather cyclical downturns adapt to changing economic environments without changing strategic direction.
Oversight of portfolio company management
Proper oversight of portfolio company management should be in place at all times regardless of the economic environment. However, during downturns, the proper infrastructure connecting the firm and the management team can be a differentiating factor between firms that stay afloat and firms that thrive. The professional tone of the relationship should be set immediately post close and, at the very latest, at the first board meeting. The firm and management should agree upon performance metrics which will be used to evaluate company performance. Additionally, a 100 day plan including a strategic and operational assessment should be conducted and presented to the board. Interactions between the firm and management should be ongoing and not limited to board meetings.
Effectively utilize outside resources
A characteristic of a successful firm is one that utilizes external experts on the board of directors of its portfolio companies. These individuals not only offer new perspectives but can also be valuable resources for deal sourcing if the company intends to grow through add-on acquisitions.
Reinvestment in existing portfolio companies
Deal sourcing becomes exceedingly difficult during times of economic downturn. In downturns, outperforming private equity firms devote significant effort towards reinvestments in their current portfolios. This reinvestment is often manifested in add-on acquisitions where the firm adopts to the role of a strategic buyer. Several funds hold 25% to 50% of their funds for the purpose of add-on acquisitions. This is a great way to both increase EBITDA in a portfolio company and avoid sourcing elusive deals.
2. Conduct a Rigorous Pre-Deal Due Diligence
During downturns, successful firms can rarely concentrate solely on financial engineering to add value to a portfolio company. Adding value means driving EBITDA growth through a mix of revenue growth and cost realization. With tight financing, there is less room for error in the acquisition of a portfolio company. Because of this, successful firms conduct a comprehensive due diligence of the target company assessing four key areas: market, competitive positioning, value creation opportunities and exit strategies
Firms should always thoroughly understand the market dynamics in the industries of their potential targets. This analysis should include assessment of market potential as well as the historical performance of the industry. Above all else the firm should focus on market projections over the duration of the expected holding period of the investment. This analysis should include threats and opportunities that the industry will be facing in the coming years which would force a company to make an operational or strategic adjustment.
In addition to simply understanding the market dynamics, a properly prepared firm will have a comprehensive understanding of the target’s segmented competitive positioning in its market. A successful firm will draw upon interviews with suppliers, customers, industry experts and management in order to formulate an understanding of the competitive landscape that the company is facing. Primary interviews are often the best place to start when trying to understand how a company is differentiating itself from its competitors. The outperforming private equity firm will target these who are the most knowledgeable in the given field and go directly to the source of information.
Identify Value Creation Opportunities
In times of economic downturn, it is the private equity firms who identify value creation opportunities pre-close who will profit from quick wins. Firms who delay addressing operational improvement areas and growth strategies are often the firms with lower returns and longer-than-desired holding periods.
A comprehensive due diligence program should include a mini business plan including in-depth operational improvement strategies. The plan should provide estimates for EBITDA improvements in terms of cost reduction and revenue growth and well as methods to increase capital efficiency to maximize ROE. The firm should strive to have a thorough understanding of potential improvements in materials, labor cost, working capital carrying cost and overheard as well as initial projections for revenue growth depending on identified growth factors.
By putting a value creation study into place, the firm sets itself up for a more credible initial discussion for the first board meeting and can begin optimizing its return on investment
Assessment of Exit Strategies
As the final aspect of a successful due diligence program, the private equity firm should assess how it will exit its investment in the portfolio company. This assessment should take into account the core competencies of the company and whether these lend themselves to a particular exit strategy. All avenues for exits should be initially considered. A sale to a strategic buyer might not seem realistic at closing but two years into the investment, the research performed pre-deal could lend itself to a credible strategy.
A well prepared firm prepares a working exit strategy for each portfolio company pre-close and alters that plan through the holding period as needed.
With numerous large cap private equity transactions falling through in the past year much attention has been paid to the seeming downfall of the private equity industry. What detractors fail to realize is that the industry is far more resilient than it is given credit for. Private equity has been around for over thirty years and has seen cyclical downturns, recessions and even double digit interest rates. The firms that have survived the downturns have been the ones that maintained their focus on core competencies and who made sure they are thoroughly aware of how to create value in their investments. Firms who continue to operate under these principles will continue to add value to their portfolio companies and will weather temporary setbacks in the credit market.
Petter Kilefors is a Director in the Stockholm Office of Arthur D. Little where he leads the firm’s Global Private Equity Practice. Natan Shklyar is a Director in the New York Office, where he leads the firm’s North American Private Equity Practice. Matthew Walsh is a Business Analyst in the New York Office where he works with numerous private equity clients.