This year has ushered in a dramatic change in the economic landscape. The previously large flows of cheap capital, along with significant events such as the war in Ukraine and the sustained economic symptoms of COVID-19, including clogged-up supply chains, have led to inflation reaching levels not seen in the last 40 years. As expected, central banks have reacted to this by increasing interest rates, halting the party of near-free capital that has raged on for the better part of the last decade.
A changing environment for private equity funds
Our new reality has changed the deal-making and portfolio management landscape for private equity funds. Some levers of return are no longer as reliable as they were, requiring funds to work more closely with their portfolio companies to drive value. One critically important lever for funds is to ensure that their portfolio companies have a robust value creation plan (VCP). The goal of a VCP is to align executives on the company’s operational and financial objectives and prioritize the initiatives that will best contribute to those objectives through a cohesive, robust plan. With an ever-changing environment and an uncertain future ahead, now is the time for private equity firms to rethink their portfolio strategy and prioritize value-creating initiatives.
The top 4 reasons why now is the time to develop a value creation plan
1. Funds can no longer rely on multiple expansion
From 2016 to 2021, multiple expansion accounted for 56% of the total returns generated by private equity funds. With interest rates rising the way they have through 2022, it is unlikely that multiples will continue to expand in a way that will generate the types of returns seen in the past. Basic finance dictates that the higher the interest rate, the more future earnings are discounted, putting pressure on exit multiples. While this bodes well for potential buying opportunities, it puts a lot of pressure on existing portfolio companies whose entry value is locked in. In fact, it is well documented that deals made leading up to a downturn perform significantly worse than those made shortly after. For example, the internal rate of return (IRR) was 9% for deals made from 2007 to 2008 compared to 24% in 2009.
With the challenge of multiples moving in the wrong direction, private equity funds need to focus on the other side of the earnings multiple equation: earnings themselves.
2. Economic growth is slowing
We established that funds need to focus more on the profitability of their portfolio companies. Now, let’s look at each component of profitability, beginning with revenue.
Unfortunately, portfolio companies’ top lines also face headwinds due to the overall slowdown in economic growth. GDP in the US has declined for two quarters in a row. While we are not here to debate the definition of a recession, this is not a positive signal for economic activity or companies’ revenues. Tellingly, the Consumer Confidence Index (CCI) is lower now than it was during the great financial crisis in 2008-2009.
Companies cannot rely on chance to overcome these macro challenges. Proactive leaders will re-evaluate their growth levers and adjust them to better align with current economic trends. This exercise is a central component of the VCP process.
3. Inflation has brought intense cost pressures
We looked at revenue; now, let’s explore the other side of profitability: costs. Factors such as supply chain disruptions and aggressive expansionary monetary policy have led to the increased levels of inflation we see today. For organizations, this means an increase in many cost line items. Recent studies have shown that labour costs comprise as much as 70% of total US business costs. These costs continue to rise, with average hourly wages in July 2022 up by 5.2% year-over-year compared to approximately 3% the year before.
While quick fixes like passing off increased costs to customers through price hikes can provide temporary relief, this is likely to affect demand adversely and is not a viable long-term strategy. Instead, a savvier approach for management is to develop a set of strategic initiatives that sustainably reduce costs, such as implementing intelligent automation, redesigning process workflows, and renegotiating with vendors.
4. The pandemic and its after-effects have disrupted core sources of value
It has now been over two years since the start of the COVID-19 pandemic. During its peak, the pandemic shook the world and created new habits for consumers and workers alike. Now that things are beginning to normalize, companies should re-evaluate their core sources of value in light of the changes our society has experienced. New trends have created opportunities to redefine business and operating models, such as the shift to click-and-collect for retailers. In 2019, total US sales in click-and-collect were ~$30B. That number rose to ~$80B in 2021 and is expected to continue to rise aggressively. Powerhouses like Wal-Mart and Home Depot capitalized on this trend by updating their operating models to accommodate this convenient and contactless form of shopping. As a result, they have captured large portions of the market – ~25% and ~12.5%, respectively.
The truth is that most industries have been affected in some way by the pandemic and will continue to be affected as things shift back to a new flavour of “business as usual.” Management must discover how their business has shifted through thoughtful analysis of the changing landscape. Once management develops a thesis on what the future holds, they should devise a plan to adjust the company’s objectives and strategies accordingly.
Adapting to change
Between the pandemic and the more recent events related to spiking inflation, many companies have experienced extreme changes in a short period. Although there are challenges that come with change, forward-looking management will see it for the opportunity that it is. By designing and executing a value creation plan, leadership can identify opportunities and devise a plan to take advantage of them to usher their company into a brighter future.
Burnie Group has extensive experience helping private equity funds and their portfolio companies establish and execute value creation plans. To learn more about how we can support you, please reach out to us.
By: Graeme Hartlen, Strategy & Operations Practice Leader, Jesse Castiel, Engagement Manager & Gursimran Raina, Senior Associate