Driving Value Creation in Newly Acquired Portfolio Companies

Over the past few years, market conditions have created significant returns for investors, often with fewer proactive efforts than were historically required to achieve target valuations. Further, given the attractive cost of capital and high volume of companies looking to transact, private equity sponsors were able to achieve meaningful multiple expansion by rolling up smaller, less mature companies into larger entities. But given current interest rates, debt markets, and economic uncertainties, PE firms must now take more deliberate actions to rapidly ensure that investment theses are realistic and on track. The most successful investors are taking steps earlier in the deal process to drive value realization more quickly. This involves a combination of more detailed planning during the diligence process as well as pulling forward and enhancing typical value-creation levers.

Four of the most common themes we’ve observed recently involve disciplined operating model design and execution, immediate stand-up of quick, integrated financial reporting, real-time insight generation through business performance visualization, and targeted actions to improve working capital. Thoughtful execution against these levers enables accelerated value realization and strong performance earlier in the hold period.

1. Operating Model

Rather than waiting until a deal closes, private equity sponsors and portfolio company management teams can establish detailed revenue expectations, cost envelopes, and anticipated synergies as part of the deal thesis. To achieve these objectives, sponsors and management should align on a target operating model ahead of the deal close so that the company can begin implementing changes to quickly and effectively capture savings. Doing so enables faster execution of high-value labor savings prior to or immediately following the close. It also ensures that key functional leaders are in appropriately defined positions with the necessary headcount to support the most critical business activities.

Too often, companies approach these efforts with top-down savings targets deployed by function, e.g., each corporate function should identify 15-20% cost reductions with realization timelines that stretch months after the deal closes.  Instead, management should apply zero-based budgeting principles to determine the “minimum viable” support model for each key business function.  By approaching this with a clean-sheet mindset, companies typically identify more significant savings opportunities and quickly begin eliminating low-value activities to achieve a sustainable operating model. Further, it is important to drive organizational change ahead of perfecting the end-state processes, otherwise transformation efforts tend to atrophy and revert to status quo. By pivoting to the target operating model early in the process, companies can create important momentum and urgency to streamline business processes.

As companies work to achieve target operating costs, there are common decisions management teams often address as they execute transactions and scale their operations. Examples include centralization of shared services functions, redesigning processes, automation of high-volume, low complexity tasks to eliminate manual efforts and outsourcing non-core functions to low-cost providers. Synergy achievement often significantly impacts the headcount needed to scale. These are a few of the levers companies can use to help accelerate costs savings while mitigating the risks from those labor actions.

2. Financial Reporting

Timely and dependable financial information is critical for private equity sponsors to make informed decisions about how to focus and prioritize resources to drive improvements in core financial and underlying operating metrics.

The first aspect of building a solid foundation for accurate financial reporting is getting the opening balance sheet right. The finance leadership of the go-forward company should have a defined, integrated plan to accomplish this ahead of the transaction close, and it is critical to execute this work as soon as possible. Waiting can result in loss of key information and institutional knowledge, particularly since it is common to experience both voluntary and involuntary attrition of legacy resources. Further, recreating balance sheet information can be particularly challenging if data is not captured accurately at close. For example, if inventory observation is not completed at close, alternative procedures such as inventory rollback can be difficult and expensive to perform.

Efficiencies in setting up the opening balance sheets can be gained by using knowledge obtained during buy-side diligence. Financial due diligence teams gain valuable insight into existing accounting practices, and this knowledge can be helpful in preparing the closing balance sheet, which then informs the opening balance sheet. Further, timely preparation of the closing balance sheet brings efficiency to the working capital peg true-up. One team working on both the opening balance sheet and the working capital peg true-up is more efficient than two separate teams working on each effort at different points in time.

Also, the effort to complete a year-one audit can be a significant burden on management teams. If a year-one audit stretches finance and accounting personnel too thin, the business can suffer. Finance and accounting personnel must balance this audit support with their day jobs – delivering valuable financial information to run the business. Many firms choose to engage experienced third-party service providers to lead year-one audit readiness efforts. The investment in dedicated audit assistance often pays for itself through a combination of faster financial information, fewer disruptions to on-going business, and lower audit costs.

We work with many private equity firms and portfolio companies that successfully stand up efficient financial reporting processes quickly. Some common traits we see among these clients are (1) defining reporting requirements and KPIs early in the process, (2) preparing a detailed integration strategy prior to transaction close, and (3) engaging across stakeholders and third-party advisors early. Planning early and mobilizing quicky helps companies minimize the lag time to “catch up” post close and focus on running the business. Prepared management teams gain valuable visibility into the business immediately post-close, track performance in a manner consistent with historical data, and make needed operational and/or reporting improvements on an accelerated timeline.

3. Management Reporting & Performance Visibility

In addition to accurate financial reporting, rapid and reliable management reporting is also key. Effective management reporting provides visibility into the true performance of the business in real time. Again, the buy-side due diligence process can provide much of the baseline for this reporting process. Often, however, the historical data and analyses used in the diligence process are not scalable or sustainable. Thus, quickly implementing a timely, repeatable reporting process is crucial.

Remember, very fast and good enough are often better than late and near perfect. As an immediate and interim solution, successful companies define key performance metrics early, build processes quickly to collect data, and report on those metrics as close to real-time as possible. Even if the data is imperfect, getting the reporting in place quickly will accelerate data clean up. More robust iterations of reporting packages can be developed over time, but successful management teams move to rapidly gain insights on their most valuable metrics.

Historically, the aggregation and standardization of data across disparate systems throughout the organization was costly and slow. Because of that, earlier standard practices dictated that systems enhancements, migrations and/or optimization efforts were often a pre-requisite to enhanced performance visibility. Now, however, low-code technologies and new best-practices can help firms realize the immense value of early automated performance reporting, without the need for expensive or extensive systems investments.

For PE teams to gain rapid visibility into the operational performance of portfolio companies, they must work with portfolio companies’ financial planning and analysis (FP&A) teams to address data quality issues, insufficient governance, and lack of integration with automation. An automated reporting solution can accelerate this process by allowing FP&A teams to aggregate data from disparate sources, reduce manual work through automated reports, and enable real-time performance analytics. By implementing this type of solution, company management and sponsors will be able to make faster, data-driven decisions.

4. Working Capital Optimization

In addition to establishing visibility into performance across core business metrics, companies typically need to identify levers to improve working capital. Given current market conditions, including inflation and supply constraints, most executives expect increased liquidity needs, making working capital optimization a high and immediate priority. Successful efforts increase value by enhancing cash-flow while reducing capital outlays in parallel.

It is important to create a 13-week cash flow model as early as possible to understand the current situation and major drivers impacting the company’s working capital. Some of the most common improvement levers involve order-to-cash, procure-to-pay, and inventory management process improvement. Within each of these processes, there is typically a mix of “quick win” actions as well as longer-term structural opportunities. Near-term actions include focused collection efforts against large, aging receivables, rapid optimization of inventory levels across raw materials, work-in-process, and finished goods, and contraction or delay of non-critical uses of cash.

In addition to immediate working capital improvement actions, companies also need to identify and define core process optimization opportunities that typically involve more execution complexity. These include improving invoice accuracy and timing, material planning and production scheduling, and standardizing contract and payment terms. Most companies have an opportunity to realize significant value by redesigning key process across the working capital lifecycle in a way that ensures clear accountability and greater visibility into key performance drivers.

An additional lever that companies can typically accelerate is product or offering rationalization, particularly where multiple companies are being merged. Many portfolio decisions can be made during the diligence and planning phase so that integration activities are already in-flight when the deal closes. Standard SKU analyses around volumes, profitability, required customization, and customer concentration can be leveraged to prioritize offerings. Streamlining the product portfolio to eliminate less-profitable SKUs quickly can reduce parts and finished goods inventories, simplify production and delivery processes, and strengthen sales-force effectiveness through a less complex offering catalogue.

Other common levers for companies to focus on are planning, production scheduling, warehousing and distribution networks. In-house teams or third-party advisors can help distributors address issues with inventory management and planning accuracy by focusing on optimizing warehouse operations and improving demand and supply planning processes. By implementing inventory improvement accuracy programs, redesigning forecasting processes and optimizing both the warehouse network and operations, the distributor will recognize lower inventory levels and improved planning accuracy.

As an illustration of the themes noted above, Riveron recently worked with a PE portfolio company that was created through the carve-out of more than a dozen disparate business units from a large technology company. Prior to the close of the transaction, key stakeholders and executive advisors aligned on the desired future-state operating model and began putting their plan in motion, which included the need for a centralized, consolidated shared services function as well as automation of core processes. Given the complexity surrounding a multi-unit, multi-national carve-out, much of the designed framework required a bottom-up build of these functions. This bottom-up approach included the creation of an efficient and effective consolidated financial reporting function, encompassing management reporting, lender reporting, and full financial visibility across the organization. With this approach, the company was able to simultaneously build these functions in the desired form, identify permanent executive leadership, and subsequently transition operations to go-forward in-house personnel. Upon deal completion, the company was then able to prioritize and implement several impactful working capital initiatives early during the hold period.

A key objective of private equity investments is to drive accelerated and enhanced value creation. Through thoughtful, proactive actions, private equity sponsors and management teams can lay the groundwork for improved decision making and synergy realization ahead of the transaction close. This creates significant momentum upon deal close and a more defined path to effectively deliver against the deal thesis earlier in the hold period.