Reading some of the news headlines of recent weeks, driven by a refinancing bonanza and a return of dividend recaps, it has almost been possible to imagine we were back in a different time. One where money was easy to come by and PE firms could handily generate returns.
However, while improved conditions in the leveraged debt markets may have given squeezed PE firms some respite in recent weeks, investors should not expect the cost of finance to be reduced significantly or dependably in the short term.
PE firms should remain focused on the long game if they are going to succeed in the current environment, while avoiding the temptation to chase shortcuts. A renewed focus on the meat and potatoes of value creation should be central to their approach.
I recently read a paper on this topic published by Goldman Sachs Asset Management in October, “The new math of private equity value creation,” and it resonated with me. Its central message is that in the next decade, big PE returns will be harder to come by but still achievable, particularly for those firms willing to invest time and capital in operational improvements.
This approach also goes with the grain of a trend that was happening even before the more recent exits logjam. For the last five years the median holding time for currently held US PE-owned companies has crept upwards, according to PitchBook analysis. Last year the median hold time for US PE-owned companies that were sold was 6.4 years, the first time it had breached the six-year mark since 2015.
Hope is building that 2024 will provide more fertile ground for exits globally. For instance, I wrote this week about optimism building in Europe after three recent IPOs. However, one swallow doesn’t make a summer and three IPOs don’t make an IPO wave. The recovery in IPO and M&A activity is likely to be tentative, and there is also a big backlog to get through. In the near term, at least, firms are likely to need to hold onto assets longer than they’d like.
Hunting for added value
So, how can PE firms squeeze more operational value out of assets? There is very little new under the sun—much of what it takes is common sense and a dusting off of old tactics.
For instance, zero-based budgeting — an approach in which a new budget is set every accounting period and every dollar must be justified, rather using previous figures as a starting point— is making a comeback, suggests Scott Jones of Alvarez & Marsal’s Private Equity Performance Improvement Unit, alongside more disciplined capital allocation. This isn’t merely as a cost-cutting end in itself. Rather, it’s a tool to help companies find capital they can re-direct to areas where they can still generate meaningful growth in the current climate.
He says that although some of these cost savings will be used to boost EBITDA margins, much of the freed-up capital “will be reinvested to drive growth in some of the core markets or faster-growing parts of the business.” He adds: “it’s about allowing portfolio companies to continue or double down investments in their highest priorities segments, (while reducing) investment in some of the speculative initiatives that were greenlit during the hyper-growth period from mid-2020 to early 2022.”
Savings can also be found in relatively mundane places. PE-backed firms, like any business, will have contracts with multiple suppliers and vendors of core business services such as telecoms, IT and HR platforms. Getting these suppliers to compete for business can be a surprisingly significant lever for EBITDA improvement, said Blake Wetzel, CEO of AuctionIQ, a procurement consultancy which counts multiple large PE houses among its client base.
“We are seeing private equity firms hold onto companies longer, pursuing multiple rounds of expense reduction, while trying to grow EBITDA and ultimately maximize exit value,” he said.
Being willing to invest in the right technology and platforms is also likely to be a significant differentiator, as without access to rigorous data and insights PE firms will be flying blind when it comes to defining and implementing value creation strategies.
It wouldn’t be 2024 without mentioning AI in this context. Glenn Mincey, global and US head of private equity at KPMG suggests that effective value creation begins with PE firms utilizing AI-powered data analysis from the due diligence stage onward.
“AI can analyze large amounts of data such as financial statements, market trends, customer behavior and industry benchmarks, helping [firms] to identify potential risks, growth opportunities, and value creation strategies,” he said. And it should be used consistently thereafter to identify areas for operational improvements, create models for forecasting future performance, and understanding changing customer behaviors, he adds.
These are just a few examples of ways to add value. Clearly the approach will need to vary considerably by PE firm and portfolio company.
But ultimately PEs should be prepared to “put in more effort and elbow grease to succeed in a competitive market,” said Mincey.
This, he adds, will help them stay focused on the long-term: “Rather than investing solely based on the current market cycle, successful PE firms [will] focus on the long game and invest through cycles.”
Featured image by Chloe Ladwig/PitchBook News
