Private Equity as a Maturing Asset Class

How investors can survive and thrive

In the last 20 years, the world in which private equity firms acquire, build, and sell businesses has changed drastically. Access to proprietary deal flow is more limited than ever before. Worldwide, the days of purchasing high-quality, consistently profitable companies at low multiples are gone. Financial engineering is a thing of the past and new strategies are needed in order to stay alive in this  evolving world of private equity.

Today, there are more firms with more capital buying businesses than ever before. Current estimates are that more than 3,000 private equity firms are headquartered in the United States alone. Globally, there is more than $2 trillion available for leveraged buyouts. Because owners of middle market businesses are fielding ever increasing solicitations from investment bankers, private equity groups, and family offices, they are becoming smarter about identifying their true market value. This stiffer competition has resulted in rising asset prices and higher acquisition costs, cutting into returns. A private equity prospectus of 20 years ago typically offered limited partner returns of 25 to 30 percent—today’s targets are closer to half that.

So, what does this mean for business buyers? To turn a profit, investors know they must work harder and smarter to build Enterprise Value in companies when higher purchase multiples are the order of the day. Investors also know realize they need to raise their game and lead with market-facing strategies, employ operational and IT improvements, and execute firm-wide integration to build significant value.

To increase investment returns, many private equity firms are deploying a more sophisticated buy-and-build strategy. In fact, in 2019 more than $250 billion was spent by private equity firms on buy-and-build strategies, which involves purchasing a foundation company, then buying and integrating additional (usually smaller) companies over time. This increases asset value by building both scale and economies of scale—which attracts larger and more profitable customers. This value creation strategy will continue throughout the next decade.

The key to this buy-and-build strategy of reaching down to smaller, middle market companies—that have the potential to integrate with your platform company—is to improve their portfolio companies’ internal leadership focus / sophistication, financial / profitability analytics (by customer, product & geography) and cross-functional processes. However, many investors—especially those who acquire  across multiple industries—often don’t have the specialized industry, marketing, innovation and/or operational experience to identify and guide these changes, and the leadership team at the platform company may lack the experience, time, and/or motivation required for significant transformation. And these integrations that fail to achieve the planned investment returns are common throughout the PE landscape.

Fortunately, there are proven resources, with demonstrable success across many industries able to guide the management teams and assist in successful integrations.

Common buy-and-build roadblocks … and the Solution

FortéOne has worked with hundreds of middle market firms to assist with portfolio company integration / expansion.  This includes assessing what is required and then working inside these companies to  implement  the necessary changes required to maximize enterprise value.

In almost every instance we find portfolio companies struggle with one or more of the following issues:

1. A “steady as she goes” strategy… false sense of comfort until failure is evident

Many investors expect that a profitable company can continue to prosper by providing growth capital and maintaining a “steady as she goes” strategy. However, increases in size, geographic complexity, and competition with a  “business as usual” approach is  a flawed strategy—and investors find themselves frustrated when some portfolio companies can’t seem to move forward because past practices are no longer adequate. They need to change course and establish a revised strategy that is authored and embraced by the leadership team—that becomes the litmus test for all critical future decisions.

But most middle market portfolio company executives need help authoring transformational strategies. Too often, they have never developed one- and three -year strategies. Their plan is often a continuation of past practices, with department heads having widely differing opinions on the firm’s direction and no meaningful expertise or experience on how to succeed.

A transformational strategy should identify unique competitive strengths, targeted opportunities for growth, financial and operational processes that can be scaled and streamlined, specific high-margin products/services for investment, and multiple initiatives for margin improvement. If you plan to grow the geographic reach of the company, what’s the plan for rolling out new markets? Do you know how your product or service will perform there? What is the timeline—and process—for acquiring and integrating new companies? Are the company’s financial tracking and analyses robust, sophisticated, and accurate enough to make the right decisions by customer, product, geography, and production line?

Transformational strategies require out of the box and experienced thinking. This usually requires external guidance from proven resources who can provide the objective planning and implementation which works best in that industry. FortéOne engagements begin with this strategic assessment, expert guidance, and proven leadership-assisting implementation that encompass these very elements.

2. Lack of guidance systems… where bad data leads to bad decisions & poor R.O.I.

Another important factor commonly missing in middle market firms is a data-driven guidance system that monitors the critical internal and external financial and operational “drivers” that predict performance. Many firms naïvely assume past performance is a suitable guide for the future. But past performance is often a false indicator; you need forward-looking systems as well as highly accurate current indicators, then to set metrics to identify trends and track performance. These processes may seem excessive, but this is what your competitors are doing.

As more middle market firms are purchased by sophisticated investors, they are developing full dashboards for their leaders. These are then utilized to fine tune profit improvement decisions. In portfolio companies: How often is leadership looking at their sales funnel, reporting it to you with a proven historically accurate projection? What about commodity prices?…and other competitive indicators? Are your innovation and new product efforts profitably growing the business incrementally? What is your NPS (Net Promoter) score with key clients, and how is it changing over time?

It’s essential to find tools that can track the important internal metrics and external trends and compile them into a company dashboard you view daily and review with your team weekly. This dashboard should guide every key decision your organization makes from analyzing suppliers to deciding where to spend marketing dollars to determining when and which markets to expand. Without hard data and metrics on the profit drivers, decisions are too often based on past practice which is akin to whistling past the graveyard in a fast-paced world.

3. An inability or failure to make data-informed decisions… better data = better decisions = better profits

Many middle market companies simply do not understand the importance of ensuring they capture and use critical data within their companies. With all the refined technology available to businesses today, there are no longer good  excuses for not ensuring your decisions are backed by accurate data. A lack of data-driven decisions within an organization is often due to one (or more) of the following: an outdated IT system that no longer provides reliable data, a CEO/CFO team who lack a detailed understanding of statistics, cost accounting and/or managerial finance, and/or an executive team that chooses to ignore data in making decisions.

In our experience, most middle market companies focus most of their investment on customer facing products, infrastructure, and sales resources. Investing in new technology and systems is often neglected or tabled because it is can be expensive and disruptive. Often, it can expose embarrassing past decisions recommended by the management team to its private equity owners. Most importantly, without reliable data the ability to make informed leadership decisions that produce increased Return On Investment is lost.

Why is accurate data so critical? All growing businesses eventually hit a point when complexity of the business becomes exponential and beyond the “grasp” of original management. Without the proper technology in place (providing accurate data), the business becomes unmanageable and growth stalls. Investing in an ERP (Enterprise Resource Planning) system is like building the foundation for a large house. The challenge for growing businesses is that when the business (house) is small, you can “get by” with unconnected systems and spreadsheets, but then the business (house) grows bigger year by year. And soon you hit the tipping point and find yourself with a larger, more complex business that you can no longer manage because the IT system (foundation) is inadequate. Then the decision for IT investment becomes more difficult because the business now needs to weigh the investment and the short-term business development impact against the efficiency and scalability enabled through updated systems. The decision over the long term is usually not if, but when and how.

During times of change, founders and people who have been with an organization for many years may have trouble letting go of “comfortable” practices that are no longer profitable, including old marketing tactics, vendor relationships, or products. If your business leaders are not making data-driven decisions, FortéOne has repeatedly found it’s vital to do one or more of the following: change the culture to make that a focus and invest in the systems to provide them with reliable data or if that fails replace key players with people who understand the value of data, and how to interpret it correctly. We often say, “the facts are our friends”—and with data to guide decisions and build alignment, major initiatives that would fly in the face of past practice have a much better chance of succeeding, and creating the step change required to build value.

4.Poor grasp of profit dynamics… “garbage in, garbage out”

Most middle market companies have only a vague notion of the cost of business activities and the real overhead associated with serving each of their customers. Nor do they know their true margins by product/service, geography and production line. To ensure a company remains profitable once you start to scale, understanding the true cost-to-serve is extremely important,  requiring accurate cost accounting for product, customer, and operational margins. Until you understand the true cost-to-serve each customer (or groups of clients with similar attributes / geography), you will not know which current customers are profitable, and it will be impossible to accurately set pricing/margins for new and existing products and services.

FortéOne often works with companies that have complex businesses with many products and customer groups. We find there is insufficient understanding of how much and whether these products and customers are contributing to the bottom line. When we work with PE clients, our track record across industries developing accurate “Cost-to-Serve” data, and then applying this to measuring and improving the above (in terms of existing product price increases, customer/SKU optimization, new product “pricing to value,” purchasing, inventory and other operational dynamics) is eye-opening to company management. In all cases, it materially changes which products they retain/produce, how they price products in various markets, and which clients they target.

5. Giving equal weight to all clients and product lines… Prioritization leads to Success

Many middle market companies treat all their clients with equal attention. As they grow, management finds themselves stretched to a point where they are unable to provide their most important customers with the attention they deserve. You as a Private Equity Owner/Investor know that when the time is not taken early on to gain a solid understanding of where portfolio company profits really are coming from, then eventually this investment/company diverts money towards customers/services and product lines that aren’t profitable.

A simple tool that FortéOne always applies is a decile analysis exercise that every company should perform. This involves dividing customers and products into 10 equal groups and then calculating the revenue (and ideally profit) in each group. We often find more than 90% of the revenue comes from the top 20 to 30% of customers/products. Equally important, often the bottom 50% of customers (the bottom five deciles) generate less than 5% of the revenue, although the cost to service these customers usually exceeds the margins gained by providing them with products or services. The solution is not simple, since some of these lower tier customers may be “baby whales” (potentially large customers) and others may simply be “minnows” (small clients who will always be small). FortéOne typically increases company profits several fold by taking actions to (i) focus resources on targeting and providing high touch services for their most profitable customers, (ii) reduce resources used to service low margin customers, and (iii) reprice unacceptably low margin products and customers to either improve or eliminate the unprofitable relationship.

Objectively redirecting company’s efforts and resources/dollars into the most profitable products and customers is an essential action to be done immediately—always resulting in excellent ROI.

6. Successful CEOs who are Assumed to be Transformational… Growth requires Proven Experience and Leadership

If you’ve invested in a successful company, there’s likely a leader at the helm who’s doing many things right. However, leading the day-to-day operations of an organically growing company and leading the transformation of a firm, essentially taking a “big little company” on the path to a professionally run “little big company” requires different skills. It takes a transformational leader with special talents to conceive and guide step changes in middle market companies. And in our experience, many otherwise successful middle market leaders don’t have this highly specialized set of skills. Assuming existing leaders can swiftly integrate companies, alter processes, and implement a growth strategy is a bit like assuming architects and builders can trade roles on the jobsite. They require two different proficiencies.

There is also the very real issue of time and focus, because it can be a full-time job to run a company and a full-time job to change a company. FortéOne nearly always finds that middle market portfolio company executives don’t have the time or bandwidth to keep the business running while incrementally instituting the  step changes required to get to the next level. Both are full-time jobs, and no amount of funding changes the fact that there are only 24 hours in a day. A proven, experienced transformational consultant working alongside your CEO for an interim period brings the analytical, change management and organizational leadership skills that payback many times—low cost insurance versus the otherwise high cost of failure.

7. When Failure is NOT an option

A good buy-and-build strategy is more complex than investing in a platform company, and then acquiring smaller companies that expand your reach or offering. To achieve the economies and market advantages that drive these purchases, it’s essential to ensure the whole is much greater than the sum of the parts. This often means changes to people, systems, operations, and often customer as well as product management. While time-consuming, in today’s world of high purchase multiples, these are the necessary requirements for  sustained growth and the ultimate “end-game” profitability/high multiple of EV within three to seven years.

Regardless of which of these seven challenges you are facing, the first step is recognizing that investment is required to move companies from an entrepreneurial mode to a professional, sustainable mode. While building these necessary foundational capabilities are an upfront investment for a few months before resulting in increased earnings growth, that investment should include experienced resources who have already guided companies through these step changes—so your portfolio company executives are not making the expensive mistakes often associated with “learning on the job.”

Many FortéOne engagements involve fixing failed integrations, where multiple companies have been purchased and changes have not been made to recognize and capitalize on the “new normal” that exists with this larger, more complex business. We like turning big-little companies into little-big companies. Although middle market companies provide the greatest opportunity for private equity firms to professionalize, unique and accurate analyses, process improvement, prioritization, and execution make that a reality.

For the past 20 years, FortéOne has partnered with business owners, private equity investors, and family offices to:

  • revive underperforming businesses
  • achieve rapid growth, and
  • realize profit improvements.

FortéOne knows what is required to transform businesses because they and have built and led for decades middle market companies across multiple industries.