For the third consecutive year, private equity firms have fallen short of their typical value benchmarks, with 2024 seeing payouts fall short by 50%. Unfortunately, the various geopolitical events and economic tremors since 2020 have weakened or negated many tried and true methods for generating ROI. In this blog, we’ll explore the private equity value creation levers available to firms and explain how operating partners can utilize them no matter what the economy does.
The importance of value creation levers in private equity
In an ideal world, portfolio company value would always increase as a natural result of doing business. But sometimes, PE investments need more hands-on treatment from operating partners. This is especially true when economic factors slow sales and inflate costs, as we’ve seen over the past four years. In these situations, private equity value creation levers allow firms to take control of operations and drive them in the desired location.
Categories of value creation levers in private equity
Luckily, firms have several ways to get involved and create value. Below, we’ve briefly explored each lever for value creation and how firms should approve it in the current economic climate.
Investment selection
ROI is determined at the beginning of an investment, not at the end. No amount of intervention can pull value out of a poor investment decision, so choosing assets strategically is foundational to successful private equity. To make these decisions, operating partners leverage a mix of sophisticated formulas and qualitative judgement, including:
- Discounted cash flow
- Earnings before interest, taxes, depreciation, and amortization (EBITDA)
- Leverage ratios
- Market cap potential
- Market trends and conditions
- Exit opportunities
- Synergies with the existing portfolio
However, even the best investments may need help producing value, which is where the rest of our list comes into play.
Management incentivization
One way to get more value out of a portfolio investment is to start at the top. Management incentives give executives personal stakes in the company’s performance to keep them bought in and bringing their best ideas to the organization’s problems. They’re also great for preventing turnover early in a firm’s relationship with a company or during challenging stretches. Incentive options may include:
- Performance-based bonuses
- Equity, including stock options, restricted stock units, and phantom equity
- Profit sharing
- Carried interest
- Cliff vesting
- Golden handcuffs
However, firms should be careful with how they implement these programs. Incentives can work against long-term goals by keeping executives on for the wrong reasons or fostering a short-term gain mentality among the executive team.
Resources and capital to support growth
Sometimes cash or capital injections can fund new revenue streams that accelerate value creation. This lever is as simple as funding the right investment. But it relies on thorough planning to succeed.
First, the firm needs reliable ROI predictions so it can estimate and justify the value of the additional investment. Secondly, the capital or resources should only fund pre-defined initiatives. Blanket capital is prone to waste, inefficiency, and value leakage. Finally, all processes related to the investment and new program, whether they’re new or pre-existing, should be as efficient as possible.
Unfortunately, the current state of the economy has made funding rounds riskier, so capital and resource injections may not be the most strategic value lever. However, they aren’t obsolete. By keeping a close eye on costs and leveraging spend management best practices, firms can offset the cost of additional investments, making them more likely to produce ROI.
Operational improvement
When a company isn’t producing value, internal inefficiencies are often to blame. Unfortunately, business leaders may be too busy or too close to the problems to see them. But operating partners have an outside perspective that makes inefficiencies easy to spot. More importantly, they have the authority to prioritize fixing them.
Many of these optimizations are part of the normal proceedings when a PE firm invests in a company. However, they’re by no means comprehensive. In fact, most firms overlook the most concentrated source of unclaimed value: unmanaged spending.
Most companies can cut operational spending by at least 20% with relatively low-effort tactics such as:
- Implementing contracts in key categories
- Cracking down on maverick spend
- Reducing supplier fragmentation and tail spend
Firms can also apply these tactics across the portfolio, leveraging their purchasing volume to secure discounted prices with suppliers or group purchasing organizations. Alternatively, operating partners can undertake more involved operational improvements related to sourcing, such as cost avoidances and risk management.
However, to maximize the value of time, firms can equip portfolio company procurement teams with comprehensive spend intelligence so they can take a more mature, holistic approach to managing spend. In the long run, these perpetual spend management improvements can produce millions in EBITDA growth yearly.
Strategic M&A
Sometimes, another business has exactly what a portfolio company needs to gain a competitive advantage and scale its market cap. In these situations, mergers and acquisitions can be one of the most powerful levers for private equity value creation.
Strategic M&As come with challenges, though. Aside from the well-known issues of consolidating teams and working through legal structures, mergers also require the company to consolidate two or more supply chains and supplier relationships into one. Each independent company came with its own contracts and vendor relationships that need to be consolidated to prevent redundancies, bloated spend, and supply chain gaps that create disruptions. However, finding these consolidation opportunities can be difficult as the data environment post M&A is usually a mess of different systems.
Unfortunately, many firms and their portfolio companies prioritize everything but fixing this data environment. As a result, bloated spend takes much of the value the M&A created. We’ve even worked with companies that are left with 100+ sources of spend and sourcing data following mergers.
The good news is that salvaging this chaotic mess doesn’t have to be daunting or hands-on. To learn more about the available solutions, read our guide: Consultancy or Software for Private Equity EBITDA Enhancement.
Free cash flow generation and debt paydown
Mergers, acquisitions, and general PE investments usually rely on debt. Leveraging debt gives firms a financially advantageous way to enter deals, but paying it down is what ultimately secures long-term value and exit profitability. Generating free cash flow is how firms accomplish this goal.
Free cash flow is the money left over after paying operating expenses and capital expenditures. Firms have several ways to generate and increase this available cash, including:
- Increasing EBITDA by improving revenue or decreasing spend
- Optimizing working capital by reducing the money tied up in standing inventory or accounts payable and accounts receivable
- Lowering capital expenditures by optimizing spend on necessary investments and eliminating unnecessary or bloated spend
With the excess cash, firms can pay down their debt and increase their equity in the investment business. However, free cash flow has other uses as well. Excess cash can fund innovations without requiring capital injections. Firms can also save cash to prepare for and weather difficult economic stretches. Long-term, each of these is a profitable use of free cash, because a strong balance sheet comes with many benefits, including the next value creation lever: multiple expansion.
Multiple expansion
Multiple expansion is a way to make money when buying and later selling a company by raising its perceived value in the eyes of potential investors. A valuation multiple is a way to describe what an investor is willing to pay for a company by comparing its long-term value compared to its yearly EBITDA. So if a company generates $20 million a year with a multiple of 5X, that means the company is worth approximately $100 million. For PE firms, buying companies at a low multiple value and increasing it is a guaranteed path to significant profits.
There are many factors that influence multiple expansion, and not all of them are within a firm’s control. Factors that operating partners can influence include:
- Product and service innovations
- Market share
- Profitability
- Operational efficiencies
- Growth trajectory
- Reduced risk (third party, supply chain, and cash)
- Optimized cost bases
Factors that operating partners have little to no influence over include:
- Market direction and macro-economic factors
- Competitors and their success
- Geopolitical risk and disruptions
- Investor sentiments and preferred synergies
Expanding multiples can be a complex game of balancing aggressive growth and careful protection of existing value. The best way to achieve this balance is to understand each portfolio company from three perspectives: spend, risk, and revenue. Firms that focus on optimizing spend and mitigating risk as much as increasing revenue don’t just expand multiples. They protect them long-term.
Cross-portfolio strategic sourcing
In an investment-shy economy, the best way to create value is to cut spending. We’ve already touched on the power of a mature procurement organization, but what if we zoomed out and applied that approach to the entire portfolio?
Just like a single company, a portfolio’s spend is bloated by redundancies and inefficiencies. And just like a single company, firms can slash this spending by managing the portfolio as a single entity instead of a collection of independent businesses. The best part is that consolidating spend at this scope is far easier than it seems.
By organizing 100% of each portfolio company’s spend into a comprehensive picture, also known as a cube of cubes, the relationships between spending reveal themselves. From there, firms simply have to institute programs such as
- Cross-portfolio contracts and leveraged purchasing programs
- Group purchasing organization sourcing
- Contract and vendor consolidation
Common challenges and risks in applying value creation levers
Most private equity value creation levers rely on increasing spend, which is risky even in the best situations. But when the market is volatile, securing ROI can be hard even with the best plans.
At the same time, firms must strike the right balance between short-term wins and sustainable value. It’s easy to boost EBITDA by reducing headcount or jumping on “the next big thing”, but the increased value may be short lived if it limits or misaligns the company.
Finally, firms must understand their risk profiles at all times. Corporate social responsibility (CSR) and ESG concerns are more important than ever both for regulatory compliance and reputation with consumers. Overly aggressive value generation that ignores these concerns can prove catastrophic over time.
Conclusion
Despite the challenges of boosting EBITDA in today’s economy, there’s one private equity value creation lever that’s perfect for the world PE firms find themselves in. Instead of spending more, strategic sourcing at the portfolio level focuses on getting the most out of what already exists. The best part is that it rarely requires scaling back any programs, slashing headcount, or restructuring portfolio companies.
There’s a world of value sitting untapped in almost every private equity portfolio. See how your firm can capitalize on it with little effort in this expert guide from SpendHQ.