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Private equity

The future of portfolio company value creation
Decorative
  • Report
  • 10 minute read
  • October 28, 2024

Private equity firms, like other market participants, are hoping that a central bank rate decrease can open the way for more deals. However, successful investors know that there are other paths helping drive return beyond the rate environment.

 

As funds look to succeed in this market, the new models of value creation — beyond cost reduction and financial engineering — can play an integral role in helping drive returns that meet the expectations of limited partners (LPs).

Where are PE firms struggling in today’s economic environment?

PE firms continue to buy companies at multiples that do not reflect public market movements

Aside from a few outliers, historic PE deal multiples have reflected the movements of the public equity market. However, over the past four years, many PE firms have been paying a higher premium than the public market, relative to revenue growth trends (see chart below).1 This can put PE firms at risk of overpaying for an asset and finding it challenging to exit at a valuation that drives an acceptable return. Industry leading firms are changing how they approach value creation during the hold period to help overcome the higher-multiple environments.

Longer hold times and higher multiples often impact the median allocation at the LP level

Due to these higher valuations creating a longer hold time for portfolio company (portco) exits, LP investors are dealing with a larger percentage of their investment allocation dedicated to these private investments. The shift in allocation will likely put more pressure on PE firms to achieve the kinds of returns that help justify the increase in allocation.

The longer the realization of those investments takes, the harder it can be for firms to raise incremental capital. To put it simply, LPs who are considering participating in future funds typically want to know what improvements are being made to help value creation plans so they can earn the return they expect.

Competition for future fundraising will only increase over time

Many firms are already going to have a more difficult time fundraising. Adding to these issues, PE firms’ targeted capital, the average dollars PE firms have tried to fundraise each year, has remained consistent (if not lowered) over the past few years, while simultaneously the number of funds raising capital has skyrocketed. Meaning that more PE entities are going after the same, limited LP investment dollars. This raises the question. How can PE firms stand out to LPs in this crowded market?

The future of value creation for PE portcos

To help drive the kinds of return profile that LPs demand, many industry-leading PE firms are evolving beyond standard cost reduction and financial engineering to the future of value creation. PE has traditionally focused on value creation to help drive return, but industry leaders are becoming more innovative in identifying the areas of value creation that can have an outsized impact and finding clever ways of quickly making changes.

Many successful PE firms are reinvesting in their business to help drive growth through either pivoting to new business models, changing consumer experience (e,g,, digital transformation), or finding a more effective path to go to market. As shown above, the data suggests that multiples and valuations are more likely to be buoyed by companies with strong revenue growth, not just cost containment.

All firms do not have to apply all of the following techniques to their portcos, but we want to illustrate some examples where PE firms have found success. These examples are helpful for both the portcos and to help demonstrate strengths to LPs in future fundraising proposals.

What industry leading PE firms are doing to help create value at their portcos?

Leadership and organizational diligence are important to having an informed perspective on how well the team at acquisition can execute a value creation plan. Many industry leaders are working on these management changes in advance of the deal to allow for quick movement on the value creation plan and limit impacts to time to exit. As hold periods get longer, value creation plans can change drastically over the course of the hold period. Industry-leading PE firms are looking for portco management with the ability to help drive operational change while building trust with the workforce.

Example

A PE firm is considering buying a large manufacturer. As part of diligence, the PE firm looked at the prospective portco’s executive leadership team. The company currently has executives who know the industry but aren’t familiar with the kind of global scaling they included in the value creation plan. It’s a tough decision, but the PE firm replaces the executive team with one who may have less specific industry experience but has experience both in global expansion and working with employees through a transition. As a result of the change, they are ready to hit the ground running the second the deal is closed, saving time on execution and providing support to legacy staff through the acquisition.

Many sectors are bringing transformative change through GenAI implementations, with the more digitally mature portcos innovating their operations with the knowledge they have built over time. In addition to the kinds of use cases that PE firms are applying across their portcos (customer service, software development, legal, etc.), firms are developing point solutions for business function specific problems, where it makes sense. But industry leaders are also encouraging their portcos to rethink their processes and systems, centering them around the GenAI technology, rather than trying to apply a GenAI solution to outdated processes.

Example

The manufacturer that decides its approach to sales and marketing isn’t producing the kind of results the company will need to scale globally. Instead of applying the GenAI point solutions to an ineffective sales and marketing organization, leadership is rethinking the strategy of sales and marketing to build it from the ground up using GenAI. For example, GenAI can help sales teams quickly localize language for international markets, reducing workloads on local marketing teams. Further, GenAI content development based off a targeted concept from the marketing team could also help reduce outsourcing costs for small-form content.

PE firms have historically focused on cost containment, where it's easier to predict a direct margin change. With the easy cost cuts already made at more portcos, firms are looking above the line to get a better handle on pricing. Using techniques that have been developed across industries outside of the PE world, industry-leading firms are finding plenty of opportunities to improve revenue growth without impacting other value creation efforts.

Example

The manufacturer decides to overhaul pricing by starting with building a holistic strategy based on a detailed market overview and setting prices across multiple its lines of business. The portco then implements its strategy with its sales teams, by providing specific rubrics based on regional data and its understanding of the customer bases. This gives the sales teams the flexibility they need to adjust pricing, while simultaneously preventing fluctuations that are outside of C-suite expectations. Lastly, the portco uses a lightweight tech solution to monitor pricing live and adjust on the fly as market conditions change.

PE firms have often performed commercial due diligence to sieze the market opportunity but may not have assessed whether the company’s revenue engine (sales, marketing, customer success, etc.) can meet the challenge. Industry leading firms are evaluating prospective portcos’ actual go-to-market (GTM) model at diligence and work immediately after the deal closes on improving their commercial function. These leaders take quick action to help increase share of wallet, expand top-of-funnel interest and market visibility, promote cross-selling, improve win rates and boost new customer acquisition.

Example

Previously, our manufacturer had ambitious growth projections but made no major changes to its GTM strategy to support growth. To help address this, the acquiring PE firm adjusted its value creation plan during diligence to cover key commercial effectiveness changes. Some of these moves included prioritizing the customer base for highest revenue potential, better alignment of portco resources to sales opportunities and making targeted investments in commercial capabilities (such as an analytics-based commercial operations function). They also included in the plan a change in sales incentives to align compensation with benchmarks and motivate better performance. As a result, the portco was ready to execute the plan immediately post-close, significantly accelerating the company’s growth potential.

Many firms are moving beyond simple operational changes (e.g., cost-reduction and procurement) to create an operations transformation built around a combination of strategy, tech and analytics — a simple fix can sometimes drive an outsized impact on the business.

Example

Our manufacturer builds products in four separate facilities across the US. Each facility was purchased in a separate acquisition; as such they used different inventory management and production software. The portco had avoided a unified system to save the cost of implementation and training, but the operations team found that the value creation plan couldn’t be executed with accuracy without a basic unified enterprise resource planning (ERP) system. A quick and simple implementation and transition unlocked the ability to create improvements and analysis (e.g., consistent materials pricing across facilities, analysis of margin per product sold by facility, etc.) over the hold period of the portco that were even outside of the scope of the value creation plan.

Throughout the portco life cycle, significant domestic and international tax changes can occur. As a result, the tax liabilities and attributes at close can differ substantially from those at exit. Industry leading PE firms view tax considerations as a value driver, actively monitoring the evolving tax landscape to assess its impact on its portcos. They identify opportunities for cash tax savings, mitigate risks and consider corporate restructuring for an improved tax position. These proactive measures may result in increased liquidity and better post-tax returns on capital.

Example

Our manufacturer originally had no plans to change its tax approach after the deal was executed, which its PE firm noted was a missed opportunity for cash savings. As part of building out the value creation plan, the firm reviewed the portco’s tax structure to identify opportunities for current tax savings. Specifically, the firm found that their research and development studies could provide meaningful tax credits. They also performed a state and local tax apportionment review and determined that there were opportunities to change apportionment from high-tax states to lower-taxes states based on recent changes in each state’s apportionment rules in which they operated. By going through this level of analysis, the portco was able to find unexpected cash flow, which funneled into further aspects of the value creation plan.

What to do next

Again, to help succeed with value creation, firms typically don’t have to focus on every single area listed above; the key is to find the specialty or skillset that your firm wants to develop and bring down those improvements to your portcos. Here are some thoughts on how to get started:

  • Be decisive and fast with talent changes. Making big talent shifts mid-execution of a value creation plan can waste time and slow progress, possibly costing returns. Invest early in understanding your leadership team and their ability to execute, so you can make an informed decision sooner.
  • Focus on those areas where GenAI can prove value within a short timeframe. GenAI technology is rapidly developing, and the models that were used a year ago are not nearly as advanced as what we have now. Find those areas where you can apply the technology to get benefit out of it now, because after you implement and onboard your staff, the technology may go through another substantial advance. Industry leaders are often finding success with solutions that can prove their value within a few months and have real EBITDA impact quickly afterwards.
  • Think about who controls pricing. If something goes wrong, who is responsible for fixing it? Setting up a structure with accountability can have a direct impact on a portco’s revenue discipline.
  • Determine if your operations or cost-reduction plan could impact top-line growth. Success will likely be determined by portco growth, and the cost structures that are often ideal for your portco are the ones that can support market growth. A simple assessment of your cost-reduction plan for topline impact can help produce a better margin result than just slashing expenses broadly.
  • Use your industry knowledge to find the easy fixes, use advanced technology to improve on them. Portco leadership knows their industry, but they may not know what is out there in terms of technologies and strategies for improvement. Deals present an opportunity for PE operations teams to leverage the knowledge of their portcos to find quick wins and then use their cross-industry knowledge to bring in operation innovations beyond the fast fixes.
  • Monitor tax changes throughout the hold period. Domestic and international tax regulations are continuously evolving. Analyzing the impact of these changes on the portco can potentially unlock additional value and help proactively manage unforeseen tax risks.
  • Expand what you look at in your diligence phase. Oftentimes, when companies are struggling through value creation, it is with issues that could have been solved for in the diligence phase. Having a thorough diligence on any prospective portco can help solve a ton of headaches far in advance.
  • Build a multi-specialty solution. While any one of these has the potential to create value, real opportunity comes when these areas converge. When pricing talks to operations or when the GenAI team works with a commercial excellence subject matter expert, you can go further with your value creation plan, and often in less time than you think.

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Kevin Desai

Kevin Desai

Deals Deputy Platform Leader and Private Equity Sector Leader, PwC US

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