James R. Corey, Managing Partner of Blue Ridge Partners May 23, 2016
Nearly 60% of all value creation over a five-year holding period comes from revenue growth. Cost reduction only generates about 20% of value creation over the same timeframe¹. If revenue growth is so important, why do most private equity firms lack a systematic and repeatable approach for pushing management’s thinking on growth acceleration in Year 1? In most investment cases, management can’t just continue doing what they did before close—they need to do something different to accelerate profitable revenue growth and thereby optimize exit value.
While some aspect of revenue growth is incorporated into the vast majority of value creation plans, many PE firms simply accept management’s direction regarding growth at the outset of the holding period. As a result, cost-reduction efforts often take center stage while revenue growth considerations are under-represented. It is not until Year 3 or 4, as disappointments emerge on the top line, that many PE sponsors get serious about helping management with growth issues. The problem then is the remaining runway is simply too short to consider growth initiatives that require a multi-year time horizon.
The question isn’t whether a company should focus on cost reduction or revenue growth—typically, they both need to be done. Over the entire holding period, the best targets might be getting 80-100% of the cost reductions, 70-80% of the quick wins in revenue growth and 30-50% of the bigger step-out growth initiatives to come through. While there might be a natural instinct to focus early on the cost reductions, the impact of revenue growth is 3x (60% vs. 20%) so it deserves at least equal emphasis in the value creation plan. While the growth initiatives must be skillfully selected, starting aggressively in Year 1 will have the greatest impact on value creation.
When PE firms postpone thinking about revenue growth until later in the holding period, they significantly narrow their options. By Year 3 or 4, roughly half the levers—and many of the most powerful ones—that could be pulled to drive growth are no longer available as there simply isn’t enough lead time to achieve results during the ownership period. For example, when only a year or two remains in the holding period, it’s more difficult to consider entering new end-markets, launching new products, upgrading sales talent and sales management, expanding into new geographies or transforming the go-to-market sales model. Instead, what’s left are more tactical options related to sales force effectiveness and pricing. These initiatives can certainly drive stronger revenue and EBITDA growth but they won’t have nearly the same impact as the full set of revenue growth levers that are available in Year 1.
Waiting on revenue growth has two corrosive impacts on exit valuations. First, there is the compounding effect—growth early has much greater impact on EBITDA than growth later. Early boosts in revenue build on themselves if growth rates can be sustained throughout the holding period. This is particularly true in businesses with strong recurring revenue streams and high customer lifetime value. Second, exit multiples are often higher for larger EBITDA businesses giving early growth a double impact—higher EBITDA levels and higher exit multiples on that EBITDA.
When we ask private equity firms why they wait so long to address revenue growth as a value driver, the number one answer we hear is: “We leave it to our CEOs to generate improvements in revenue because this is within their purview and they know their business better than we do.” Firms also tell us that cost reduction efforts are easier to implement and measure; therefore, the deal team and operating partners are more comfortable and confident with those initiatives. As a result, they tend to focus immediately post-close on activities such as building a relationship with the CEO, establishing standardized financial reporting and launching some of the cost reduction initiatives. Certainly, we understand the need for these initiatives but under-emphasis on growth inevitably leads to years of lost opportunity and value.
Revenue growth is extremely complicated with many moving and interrelated parts that cannot be addressed in isolation. Only the rare CEO can spot all the important paths for growth. No matter how well they know their business or how effective they have been in the past, few management teams have the ability to drive the kind of growth PE firms are looking for. Compounding the CEO’s challenge is that 83% of these leaders have no direct experience in managing sales and marketing organizations². Coming from finance, legal and operations backgrounds, the vast majority of CEOs are nervous about making material changes in the sales organization for fear of losing key sales reps or customers. They are hesitant to disrupt a status quo that might be preforming okay, but not great.
We also see many cases where PE firms have invested time and money during due diligence to understand potential growth opportunities for the business but that growth doesn’t materialize post-close. The problem could be mis-called opportunity during due diligence, de-prioritization of growth in favor of other initiatives or simply poor execution by management—or some combination of all three. But the end result is still the same: lost years of opportunity to optimize the exit value of the business.
With so much at stake and such a narrow window to seize it, PE firms need a systematic and repeatable approach for defining revenue-based value creation initiatives early in their relationship with a company. The approach should begin pre-bid, evolve during due diligence and culminate in a value creation plan prepared in the first 120 days. This approach should be driven by the deal partners, operating partners, senior advisors and the CEO. And for this value creation approach to be repeatable, we believe it should be codified in a PE firm “Revenue Growth Playbook” for helping management teams think through growth acceleration in a systematic way.
The Playbook should identify common indicators of opportunity for accelerating growth and initiatives that might be taken by the management team to capture that opportunity. It should also include questions to ask of the management team, data to be requested and analyses to be performed. While a detailed look at all those components of the Revenue Growth Playbook is beyond the scope of this piece, here is a high-level look at each phase.
Phase 1: Pre-bid. During this phase, the goal is to assess overall investment attractiveness including potential value creation plays/risks. Insights will come from the CIM, public information, senior advisors, analysis of competitive sales models, and sometimes from conversations with executives at the target. During this phase, a PE firm’s Revenue Growth Playbook should include key questions that help identify whether there might be either a revenue acceleration or cost realignment opportunity in sales and marketing. Some of those questions might include: What growth opportunities is the management team pursuing and how real are they? What is the definition of “your market” and are opportunities available from a sharper definition? Where is your sweet spot in the market? Are the competitive dynamics of the market changing in any material way and is the company gaining or losing market share? Where do you make money and lose money? Why do you win/lose? What share of wallet do you have with current customers? What percentage of revenue last year came from new customers? How strong is customer retention?
At this stage, the types of growth opportunities that one might consider include expanding the company’s geographic presence (whether on-the-ground, through partners, or by leveraging digital channels), cross-selling into their existing customer base more effectively, selling to a new end-customer market, capturing premium pricing opportunities, building new lead generation capabilities, improving customer retention and others.
Phase 2: Due Diligence. In due diligence, PE firms should have a systematic approach for answering the same types of questions as in Phase 1 but with greater clarity and confidence due to the greater access to management, data and customers. In addition, more revealing questions might be asked such as: What are the best-selling/worst-selling products and why? How disciplined and analytic is the sales organization? These are two common weaknesses in sales organizations that limit revenue growth. How strong are the sales skills and sales culture? Are there different roles outlined for hunters and account managers? Are the management layers and spans of control appropriate in the sales organization? What is the quality of pipeline data and how accurate are revenue forecasts 30, 60 and 90 days out? Inaccuracies can be symptomatic of many underlying issues that, if identified and fixed, can lead to stronger growth. What does the market think of the company, its products and its sales effectiveness compared to competitors? How useful are the company’s metrics of sales performance? Is the sales compensation plan motivating the right type of behaviors? How effective are their pricing processes?
The deal team, operating partners and the firm performing the commercial due diligence can typically gather this type of information. The time available in due diligence doesn’t always allow for answering these questions but where they can be addressed, they might illuminate important revenue-growth opportunities for the business.
Phase 3: First 120 Days. The first four months post-close is a critical time. This is when the value creation plan is typically finalized and agreed upon by the leadership team and the Board. This phase provides a tremendous opportunity for operating partners to assist—and sometimes challenge—the management team in defining new growth initiatives to include in the value creation plan. As with the earlier two phases, the Revenue Growth Playbook should include questions which help guide companies to the most potent opportunities for growth.
Some good questions for Phase 3 include: How do you express your value proposition and how does that compare to the way customers articulate your value proposition? Often there is misalignment between what customers value most and what the company is pitching. Bringing those into alignment can lead to growth. What improvements in the company’s products/offerings will protect core revenue and drive growth? What percentage of sales rep time is spent actually selling? Companies are often surprised to discover how little time their reps spend selling. A good target is 65-70%, but we have seen companies where reps are spending as little as 25% of their time selling. What percentage of sales reps hit their quota last year? What’s the compensation cost of sales relative to peers? How effective are sales supervisors? Where in the pipeline are opportunities being lost? Is the company providing sales reps and sales supervisors enough guidance on market segmentation, messages, specific customer targets, how sales time should be allocated, and which products to promote? These are the types of questions which often lead to new growth opportunities.
It’s important to state that our emphasis on revenue isn’t exclusively about growth. While one typically considers revenue in the context of driving profitable growth, the fact is that “base revenue” cannot be taken for granted. While some companies achieve pockets of growth, the positive impact can be offset by an eroding base. The negative consequences of this can be significant. It’s important to establish the structure, metrics, discipline, and practices from day one so that there are no such surprises.
What all this looks like when it is codified will be different for every PE firm, but the bottom line is this: private equity sponsors should develop their own bespoke approach to ensuring that deal teams and management teams identify the big revenue growth opportunities and include them in the value creation plan so they can be pursued as aggressively as other value creation levers. The vast majority of CEOs need help in driving accelerated growth in their business. There is an opportunity and need for deal partners, operating partners and senior advisors to aid them in this process. It doesn’t matter how it’s done so long as there is a systematic and repeatable approach to considering growth acceleration early in the investment lifecycle. Otherwise, years of value creation will be lost.
¹ Source: Eric Olsen, Frank Plaschke & Daniel Stelter, Threading the Needle: Value Creation in a Low Growth Economy, 2010.
² Source: Spencer Stuart, Leading CEOs: A Statistical Snapshot of S&P 500 Leaders
Jim Corey is the Managing Partner and co-founder of Blue Ridge Partners. For 35 years he has assisted companies in North America, Europe and Asia accelerate profitable revenue growth. Jim has advised more than 250 companies on revenue-related issues including growth strategy, pricing, sales and marketing management, customer segmentation and messaging.