James R. Corey November 08, 2016
Revenue growth can be challenging. Why? Growth is complicated—most markets are highly competitive, buyers are getting smarter, digital is changing the way both consumers and business customers buy, and revenue is the output of a complicated set of interdependent components such as products, sales channels, sales force performance, pricing and many others. Growth is further complicated for private equity firms by the fact that payback on growth investments can take years. Imagine the lead-time required to implement a new go-to-market channel or to develop new products—it takes time, perhaps even longer than the investment horizon. This is the growth challenge for private equity firms.
By comparison, cost reductions are so much easier because they are discrete, reasonably contained actions—you reduce headcount, improve supply chain performance, consolidate plants or trim IT investments. In cost reduction, action translates directly into near-term EBITDA expansion.
But not so for revenue growth. There are perhaps 100 sensible sounding actions a company might take to accelerate growth, but each one can be complicated and of course no company can do 100 things so they must choose which initiatives to pursue. It’s essential for private equity sponsors to fight through this complexity to help portfolio companies grow faster because the contribution of revenue growth to value creation over a 5-year holding period is 3x that of cost reduction—approximately 60% for revenue growth and 20% for cost reduction.
In response to this growth challenge, we see the need for a repeatable and standardized technique for targeting, estimating and displaying value creation coming from revenue growth. This technique is something we call “Sizing the Prize” and it is based on answering two fundamental questions:
i. Enhance commercial and channel effectiveness
— Implement sales force productivity improvements (e.g., skills, processes, time allocation, coaching, etc.)
— Digitally enable the business
ii. Improve revenue mix
— Double down on sweet spots in the market where growth and margins are highest
— Exit unprofitable or slow growth products or markets
iii. Enhance pricing effectiveness
— Find premium pricing opportunities through segmentation and value selling
— Ensure customer compliance with contracted volumes/discounts
iv. Reduce costs in sales and marketing
— Address inappropriate spans and layers
— Reduce or make more effective the non-quota carrying support staff
v. Enter new geographies
— Follow current customers into new geographies
— Acquire companies in new, high-growth geographies
vi. Sell into new end-customer markets
— Sell existing products into new end-customer markets
— Develop new products based on existing technologies to sell into new end-customer markets
vii. Add new products/services
— Roll out new products/services already in the pipeline
— Expand the new product/service pipeline through innovation
Which of these or the more than 100 other potential actions are right for each portfolio company? Answering this requires a variety of analytic tools that operating partners in private equity firms are starting to use. These tools include benchmarks (or rules of thumb) for sales productivity, win rates, coverage ratios, percentage of sales hours that should be spent selling, volume of digital traffic, etc. These benchmarks highlight gaps in current performance and are essential for finding the 4-6 actions most appropriate for any company. For example, one PE firm discovered in due diligence that the company it was assessing had a sales productivity rate 20% below the industry average. That gap suggests a significant value creation opportunity.
But benchmarks aren’t the only analytic tool that can be used. As another example, many PE firms have developed their standard set of about 20 pricing analyses used to detect if there is a pricing opportunity in each portfolio company.
2. What is the size of the prize—in terms of revenue and EBITDA—associated with each of these potential actions? Typically, there are many gaps in performance that might ring the cash register for the business. But which ones should be prioritized into the final set of 4-6? Making that determination requires quantification of both the revenue and EBITDA opportunity. This is sizing the prize. What is the economic value of closing a 20% sales productivity gap with the competitors? Can all of that gap be closed or just a portion of it? How long might that take? What is the economic value of closing the gaps found in the 20 standard pricing analyses? How much of that value can be captured over what timeframe? When sized, these actions can be displayed in a waterfall chart that quantifies the EBITDA expansion from current performance to potential EBITDA performance.
Let’s drill down into one of these categories, (A) Commercial & Channel Effectiveness. The chart below contains some examples of the key metrics related to EBITDA expansion and some “quick math” starting points for estimating that EBITDA improvement:
Once the potential actions have been selected from among the 100 potential actions and the EBITDA impact estimated for each, another factor needs to be considered—the ease/difficulty of implementation. All these factors can be displayed in a single 2x2 matrix. An example of that is shown below.
Valuations are enhanced not just through EBITDA expansion but also through multiple expansion. Although any analysis of multiples is far from precise and they typically are heavily influenced by “macro” factors, such as the broader market environment and economic outlook (in general and at the sector level), multiples can also be influenced by company-specific factors. For example, multiples tend to be higher on larger companies, faster-growing companies, companies with a scalable platform, companies with growth potential in diversified end markets, and companies with low exposure to customer concentration. To the extent these factors require actions different than those driving EBITDA growth (many are the same), they can be defined and prioritized within the Sizing the Prize framework.
Each PE firm has a different style relative to revenue growth. In fact, that style can vary between portfolio companies sponsored by the same private equity firm. We see PE firms taking one of three paths to address revenue growth but this technique of Sizing the Prize can apply in all three.
Regardless of the pathway, the Sizing the Prize techniques equally apply. This approach is now being used by many PE firms during Pre-Bid, Due Diligence and Post Close situations, as outlined below:
The Sizing the Prize technique can be extremely helpful during Pre-Bid. Asset prices are very high in many sectors and nearly every deal is done through auction. As a result, financial sponsors are thinking hard about valuations. In some cases, understanding the EBITDA expansion available through revenue growth or cost reduction in sales/marketing is a valuable piece of information. As one PE firm observed, “We don’t normally underwrite any upside in revenue but now we are thinking differently. Might we be willing to give the sellers 10% of the upside in order to win the deal? Yes.”
Due Diligence and Post Close
Most sponsors are now developing revenue-related value creation plans during due diligence, including discussion of the key elements of this plan with the management team. In these cases, the Sizing the Prize format can be a very useful communication tool with the management team, even in “rough draft” mode. This type of discussion allows for alignment around specific revenue growth initiatives.
To the extent a value creation plan was not developed with the management team during due diligence, the Sizing the Prize technique can be used in the first 120 days. During this period, there is clearly greater access to management and data that allows for more precise Sizing of the Prize.
Sizing the Prize is a repeatable and standardized technique for addressing the growth challenge at portfolio companies. It assists in targeting, estimating and communicating the value creation potential available from sales and marketing. This may involve both revenue growth and cost reductions. Successful application of this technique depends on thoughtful use of benchmarks/rules of thumb, experienced operating partners and the discipline to adopt a standard approach for thinking about revenue-related value creation. But when done right, this approach can lead to significant value creation and successful exits.
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.
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