I have spent much of my career working either directly for or as a consultant for private equity-owned businesses. In all cases, I had been brought in several years after the purchase to fix issues that included high costs, growing inventory levels and overall poor operational performance. In almost all of these cases, I could see that the roots of these problems existed at the time of the transaction. In some cases, these were known problems but the owner or management team was able to shield these items from the buyers during the due diligence process. I do understand that a business is run much differently when it is attempting to attract a purchase transaction. Compromises are often made to increase the immediate earnings to drive the multiplier while acknowledging that the longer term investments for growth as well as financial transparency could be compromised. It is a courting relationship and not all secrets are shared.
In almost all of my situations, the scenarios were similar in that the investment group typically stepped back after the purchase and allowed the management team to run the business. They might call each week to discuss sales and earnings projections and would visit the business once or twice a quarter to have a face to face meeting. They typically did not get involved in the details until the performance started to deteriorate and that was where I would come in. However, I am of the opinion that had they been more proactive in running the business, most of these performance issues would have never occurred. In fact, I believe that if they had been more involved in the business from day one, the performance of the business would have been substantially better thereafter.
Given these predictable conditions, what should be done? I would recommend the following:
During the due diligence process, have an operations expert audit the following:
- Validate the cost numbers driving product and overhead costing.
- Validate the inventory values and review how much excess and obsolete inventory exists.
- Review potential environmental risks and exposure, especially if purchasing property.
- Evaluate the effectiveness of the manufacturing quality and production processes.
- Evaluate the effectiveness of the production and materials management team.
- Utilize this information to add to the understanding of the business as you create the value for the business and start negotiations.
After the sales process, immediately begin working with the management team to evaluate how to improve business performance.
- In today’s economy, every business should be proactively going after waste in every area. Every department, process and position should be evaluated.
- Insure that each function that drives cost is providing a measurable return.
- Optimize the accounts receivable and payable process to increase cash generation.
- Work with purchasing and materials management to drive purchasing cost reductions as well as reduce inventory levels and increase inventory turns.
- Work with production to improve productivity.
Just as everyone should get a routine physical checkup, a business organization is no different and yearly audits should be performed to check on the health of the business to see if follow-up work should be performed.
I understand that this is a much different role than what many private investment groups are comfortable with. Typically, they purchase businesses that meet a threshold of earnings and have a credible management team. They are comfortable to stay at arm’s length with respect to the details of the business. However, based on my experience, a more-engaged approach could easily move 5% or more from COS to the bottom line on a $20M business. This $1M added to EBITDA each year would add $5M or more to the sales amount at the transaction point. This would be a sizable upside on the transaction of a business of this size.
I am of the belief that if a business is not moving forward in improving its performance, then it will actually lose ground and I have seen this scenario manifested consistently throughout my career. In the case of a future transaction, this lost momentum could delay it, or at a minimum reduce its value. I believe it is much better to take the proactive role and have the high potential of an upside than to take a hands-off approach that has a high likelihood of reducing the rewards at the transaction.
Of course, the question would be how to pull this off without alienating the management team of the purchased business. First of all, it is important to acknowledge that you are the new owners and you have every right to get involved in the details. It is not for their approval but it is only for their information. The second point is that there is an excellent way to capitalize on these opportunities while still allowing the private equity managers to continue to focus on running their business. This approach would be to partner with an operations consulting group with a track record of success in working alongside management in these situations. This group would exhibit the following behaviors in working with the management team.
- This group will insure that the ideas are created, owned and implemented by the management team.
- This group will insure that the management team gets the credit for the positive changes.
- This group will help create an incentive or bonus program for these key managers to insure that they are rewarded for their proactive behaviors.
I encourage you to start today. Give us a call and we can discuss our successes in these sensitive situations. In these roles, we have consistently delivered dramatic improvements in operating performance that positioned the portfolio companies for a more profitable future transaction.