With today’s high cost of debt and investors’ lower appetite for risk, an equity value creation plan plays a heightened role in translating your investment thesis into value. Letting a portfolio company run as-is post-acquisition and expecting — hoping — equity gains will materialize is a passive investment strategy in a market that requires active attention to end up on top. Once the deal closes, it requires follow-through to turn your investment thesis into an actionable, monitored operational plan to achieve the future value and realizable gains.
Translating private equity groups’ investment plans into performance management tools post-close is often challenged by the common disconnect between investment teams and portfolio company management and operations. For (valid) reasons of confidentiality, there’s typically a lack of insight into the nuances and objectives underpinning the investment thesis. Equity value creation measures tend to remain siloed from overall business performance and financial reporting. As a result, gains and losses are reported in isolation from, rather than as part of, the financials and don’t match what’s reflected in the bottom line. This leads to an inaccurate picture of operational issues, management, and business performance, including EBITDA and value created.
Inaccurately measured value creation initiatives create risk
Failure to accurately measure initiatives creates several, potentially costly challenges: It masks performance issues, delays corrective action, wastes resources on remediating incorrectly identified issues, and depletes capital you otherwise could use to pay down debt. Additionally, EBITDA addbacks can indicate higher-than-actual enterprise value, and investment firms may not notice costs that have been concealed by reporting deficiencies until a sale approaches. In many cases, investment groups are left with little choice but to pull the entity off-market, shouldering sunk costs and narrowing future sale opportunities. Inaccurate reporting also risks triggering debt covenants, while lengthened holds and investor dissatisfaction can put future fundraising at risk.
For example, consider the chief financial officer of a newly acquired business, incentivized to reduce labor costs. The CFO reduced headcount, responding to demand fluctuations with temporary labor when needed. However, the “lower cost” flex labor included agency premiums, overtime, and production inefficiencies. Despite the labor savings, EBITDA declined month over month in the same period.
Develop a post-acquisition performance management framework
Requiring gains from individual initiatives to reconcile at the bottom line allows you to focus resources on the right issues and solutions. Identifying expenses that offset initiative measures lets you modify those initiatives as needed to achieve expected gains earlier. Ask your team the following questions:
1. Do we have a communications channel to minimize siloed information?
Consider the private equity firm challenged to track reported performance against bottom-line gains several months post-acquisition. The investment group expected rapid gains from economies of scale and preferred supplier pricing, but the three teams — the investment team, the operations team, and company management — didn’t all participate in conversations about achieving said gains. Post-close, the operations team hit the ground running as did portfolio company management. While the ops team and management focused on production efficiencies or modifying products with alternative materials, they delayed the very simple investment plan of sourcing materials based on portfoliowide purchasing power with preferred vendors.
Discussions around realizing gains in particular areas should bring all three parties together, and these conversations should be specific. Instead of, “Add $10 million in EBITDA in five years,” you want to communicate in detail: “We want to hit a 2% reduction of materials as a percent of sales — 1% from sourcing, 0.5% from reduced waste, and 0.5% from reformulating — and $3 million in additional organic sales or market reach — $1 million in current customers, $1 million in current market new customers, and $1 million in new geography.”
2. How will we measure expected gains against plan?
Hold whiteboard sessions that include your investment, operations, and management teams to determine the true costs of garnering specific gains or cost reductions. It’s not enough to measure top-line improvements; you also need to measure the costs to get there. For instance, measuring material costs only, when a deterioration in quality increases labor costs for necessary rework, can quickly create a disconnect, with “material savings” not landing in EBITDA.
Communicate specific segments where you aim to realize savings and define how gains will be measured. You can do this without giving away the methods of the investment — for instance, “We’re tracking the trailing 12 months to changes in these explicit line items in your operations … ” For the material cost initiative, you could apportion some gain to sourcing and some to material usage (reduction of waste or use of alternatives or dilutions). For labor, you could apportion some gain to efficiencies (output per labor hour, i.e., faster production, fewer production interruptions, etc.) and some gain to labor costs (costs per hour for wages, benefits, taxes, etc.)
Pay particular attention to efforts to maximize EBITDA addbacks. You want to make sure you’re managing performance and not merely presentation of the numbers. Analyze addbacks with the skepticism of a potential buyer to ensure you maintain visibility into positional risks around transaction classification.
3. What tool will we use to bridge the investment thesis with post-acquisition operational performance?
Does your firm or the portfolio company have the expertise and bandwidth to stand up an EBITDA bridge to show performance of each initiative and how it ties into overall net financial performance on an ongoing basis? For example, trailing 12-month EBITDA at acquisition plus gains or losses from Initiative 1, Initiative 2, and Initiative 3, plus or minus the change in base business. Management must be able to speak to the costs of each initiative.
4. Are all initiatives accounted for in our bottom line?
Initiative gains or losses should be reflected in your financial statements. If Initiative 2 led to $100,000 in savings, but you don’t see $100,000 in increased EBITDA, the value erosion should be visible in the wider financial analysis whether as a lack of performance on an initiative or a deterioration of base business performance.
The effective value creation plan in action
The organizational stakeholders of a recently acquired business were responsible for defining the measures of the equity value creation plan. They were given the financial segment — sales, labor, material, etc. — and the target percentage change they were expected to hit by the investment team. Otherwise, for the sake of confidentiality, stakeholders remained unaware of the value measures in the investment thesis. This is common, and yet it creates the risk that stakeholders will measure their segment performance without considering impacts outside the segment.
To remedy this, the private equity team integrated investment thesis measures into the financial reporting package, leading to an EBITDA bridge by equity value creation measure. This enabled visibility into and discussion about each initiative distinct from base business performance. With the new EBITDA bridge, stakeholders were able to speak to all wins and losses with respect to the bottom line and deploy resources to the appropriate areas of focus.
The investment thesis of another private equity firm included a labor plan with increased per-head labor costs for the first six months post-acquisition but a planned decrease in labor cost per sale dollar over the investment period. The firm planned to achieve this by converting portfolio company temp labor into internal staff. Although the cost of temp labor was lower per hour, the firm anticipated savings through reduced training needs, greater knowledge and experience, and less wasted production. Despite increased costs per head, top-line sales and salable inventory rose. With an effective post-acquisition performance management framework in place, incremental savings and more effective production can lead to lower labor costs per revenue dollar.
Realizing your investment thesis
An effective private equity value creation plan should include an acquisition performance management framework and tools to bridge value creation measures with overall business performance and financial reporting. Initiative gains should fall through to the bottom line, and gains that are less than increases in EBIDTA require thorough analysis to explain the dilution.
You’ve already done significant planning — your investment thesis laid out the basis for the future value and realizable gains of the company you acquired. Follow through once the deal closes with an actionable and monitored operational plan to achieve the results you expect from your investment.
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Our private equity experts can help align your key teams for initial conversations about the steps to take to monitor your equity value creation plan. Begin translating your investment thesis into equity gains today.
