Working capital: A key to private equity investment strategies

Many private equity firms have reliable playbooks for creating value in their portfolio companies.

So-called active management strategies vary from firm to firm. But what they often have in common are tried-and-true practices for growing companies, improving operational efficiency and increasing profit margins over time.

PE investors need such strategies for guiding enterprises over long hold periods that may see big shifts in markets. Studies by McKinsey & Co and others have suggested that the best-performing GP teams are those which possess the attributes for generating alpha in good times and in bad times.

So after years of refining active management strategies, do PE professionals have anything new to learn? The answer is yes.

In 2014, Deloitte published a report on working capital. Released in installments, the report looked at how companies govern their finances. Its authors, including Deloitte Partners Adam Bryk and Patrick Thibault, were interested in how organizations manage working capital and how that impacts cash positions. Research dug deep into the workings of accounts payable, accounts receivable, inventory and cash management systems.

Based on this research, the report concluded that businesses do not always effectively manage their working capital. In fact, a lot of cash ends up getting trapped on balance sheets.

Bryk and Thibault believe this situation should concern companies and the PE firms that invest in them. Trapped cash, they argued, is money that is not being used to enhance competitiveness, to maintain financial flexibility, and to pursue growth opportunities.

In short, it’s not working capital, it’s stagnant capital.

“It sounds simple, but it’s actually complex in the details,” Thibault said. “Many mature companies have big inventories and big cash systems. But they often lack the information necessary to understanding the significant value that may be hidden there.”

To uncover cash and put it to productive use, the Deloitte report recommends that businesses implement working capital optimization plans. These plans focus on changes in organizational cultures to give higher priority to cash management, streamlining financial systems, and the adoption of drivers and metrics for achieving results.

Bryk and Thibault said PE firms should also account for working capital in their active management strategies.

“It is very important for private equity firms to assess the level of cash that exists in a business in which their investing,” Bryk said. “Some make these assessments and some don’t. If you don’t, you might be vulnerable to additional risk or find yourself on the hook for more investment capital.”

Bryk believes PE firms should address the issue throughout the investment process, such as in due diligence, when GPs are accumulating knowledge about a company; during the first 100 days post-closing, when operational plans are being finalized; in monitoring activity; and in advance of an exit, when residual value may be extracted.

The ultimate goal of PE firms should be to fully comprehend the state of an enterprise’s working capital, to identify gaps, and to introduce remedial policies and programs. These steps, said Thibault, are “piece and parcel” of ensuring sound financial oversight in PE-backed companies, and especially those that have ambitious growth agendas.

When it comes to freeing up cash flow, Bryk and Thibault said companies and PE investors benefit from appreciating the best practices of industry leaders. This will serve organizational benchmarking, which the Deloitte report concludes is a key tool of working capital optimization plans.

“Best practices are essential to getting results,” Thibault said. “You need to benchmark against yourself, against competitors and against the industry as a whole.”

To download all installments of Deloitte’s “Make your working capital work for you: Strategies for optimizing your cash management,” please click here.

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