Private Equity Investments - Final Paper

8/3/2019 Private Equity Investments - Final Paper

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Operational Engineering is the Key to Value Creation: Future Trends in

Operational Engineering

By

Anand Patel


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The financial crisis of 2008 revitalized the way private equity firms create value.

The credit crunch has significantly reduced the ability of firms to secure leverage.Exhibit 3

Thus it has been difficult for firms to utilize leverage to implement consolidation and

LBO strategies resulting increased deal competition, driving up prices for buyers.

Consequently, operational engineering has proved to become the main strategy PE

firmsemploy to generate high returns and create a competitive advantage.

In light of the Euro zone debt crisis, the importance of operational value-added

strategies will continue to be the key in private equity. As more PEfirmsmaster

operational improvement, new areas of value creation will have to be exploited to avoid

an increase in bid prices resulting from increased competition.

In this paper, I discuss the importance of operational improvement in value

creation and the strategies and frameworks top firms have employed to drive

operational enhancement. Next, I explain the growing need for PE firms to innovate new

approaches for value creation in order to differentiate themselves from competitors. I

identify the under-utilized operational improvement strategy of top-line growth,

compared with the numerous cost cutting strategies that dominated the 1990s. Included

is a framework for driving organic growth capabilities across portfolio companies.

Lastly, I discuss the opportunity for value creation from business wide focus on

sustainability improvements. Finally, I demonstrate the success of top-line growth


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strategies and sustainability initiatives in value creation using real-world examples of

firms that have implemented said strategies.

Historically, private equity firms had relied on financial engineering for value

creation by applying leverage and multiple arbitrage strategies. The availability of cheap

debt allowed for firms to implement multiple arbitrage strategies using leverage. An

example of a successful industry consolidation strategy is exemplified by Blackstones

roll-up strategy in The Merlin Entertainment Group Case. Firms realized increased ROE

by taking on more debt.

In the 1990s, private equity firms discovered the benefits of operational

enhancement for value creation in portfolio companies. Even during the boom of credit

in the mid 1990s, top firms relied on operational improvements to create value. A 2005

McKinsey & Co. study of deals completed by 11 leading private equity firms revealed

that company outperformance was the main driver ofvalue in almost two-thirds of the

transactions.1 Company outperformance constituted 63% of value creation, compared

withonly 32% driven by financial leverage and market appreciation. Multiple arbitrage

created only of 5% value.

The 2008 credit crunch solidified the importance of operational engineering as

the key to value creation in private equity. Moreover, the inability of the euro zone to

solve its debt crisis in the past few months foreshadows the continued lack of available

cheap debt in the coming years. It will serve as an impetus for the continued importance


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of operational improvement as a key competitive advantage for firms to create value in

portfolio companies.

Although the idea of operational improvement has spread across the private

equity industries, top firms maintain their competitive advantage with effective strategies

and frameworks for maximizing operational value creation. Effective frameworks and

strategies incorporate basic aspects of private in creating a strong value creation

regiment. 2& Exhibit 1 Most importantly, the goal of PE is to attract investment through

financial engineering and increasingly through operational improvements that create

value. Firms should focus on companies and projects that are core to the portfolio

companys future value, utilize capabilities already available to the company, and have

the building blocks to build financial performance in the future. As a result of highly

leveraged acquisitions in private equity, these improvements should be focused on

liberating and generating cash quickly. Strategies for improving cash flow reside in the

broad value creation categories, increase profits and improve capital efficiency. To

increase profits, firms can either grow revenues through pricing and volume or reduce

operating costs in COGS and SG&A. To improve capital efficiency, firms work toward

reducing working capital and improving fixed capital. To reduce working capital, firms

can improve inventory management and improve receivables/payables terms and

timing. Firms can improve fixed capital with long-term strategic project investments.

In operational improvement, the differentiating factor is the not finding potential

opportunities, but in determining the right areas to invest. The reason is because private


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equity firms have a short investment horizon in which to make improvements. Firms

assess opportunities by comparing the level of difficulty, costs of implementation, and

estimated time required to see the desired change to the operational improvement

sweet spot to create value. Exhibit 4 The timing of enacting operational improvements is

so critically important that many firms create 100 day plans that outline in detail the

operational strategy the firm plans to implement. Ideally, the plan will detail two or three

high value/high risk and difficult projects and many quick improvement strategies that

are easy to achieve. PE managers also should religiously track certain metrics that drive

success.

To sustain the ability a firm to improve performance, the firm must have

permanent access to operations experts. As we learned in class, the Operating Partner

Model is one of the most effective and widely used methods. The model has three

variations of implementation strategy. The Elder Statesmanvariation involves

maintaining long-term relationships with retired executives on industries on the

investment horizon. The In-House Consultingvariation obtains a full internal staff with

deep industry expertise in specific functions. This model works for large PE firms that

can absorb the overhead costs. Lastly, the Integrated Partnermodel is a hybrid that

combines characteristics of the two previous models with the internalization of a group

of former industry executives.1

Finally, in order to ensure that the senior management team in a portfolio

company is aligned with the PE firms strategy, PE firms need to incentivize company


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managers with performance based compensation based on aggressive performance

targets. This strategy is known as getting Skin in the Game, because it matches

managers financial compensation to the performance of the company.

In the 1990s, the majority PE firms had become so adept in financial engineering

that the benefit was going to sellers instead because of increased competition among

buyers. This led to PE firms moving toward creating value through operational

improvements. This involved process improvements, outsources, restructuring, or

anything involved with cost cutting. As a result of the emphasis on operational

improvements in the 1990s, PE firms have also mastered the art of driving operational

enhancement in their portfolio companies.

The fact that the majority of PE firms are highly experienced and skilled in both

financial and operational engineering coupled with the overall reduction in PE funding

and available debt to PE firms has resulted in aggressive competitive bidding that has

driven up the price of acquiring companies and making deals. Rather than paying huge

price premiums to secure deals on bargain/distressed companies, PE firms need to look

towards new approaches of value creation. I identified two growing trends for additional

value creation: focus on organic top-line growth and the capitalization of ESG issues to

create a competitive advantage.

In the advent of operational improvement, the majority of PE firms focused on

bottom line improvements and overlooked the value of organic growth creation.


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Revenue growth is an age-old strategy, but in response to current economic conditions

top line growth can lead to increased returns for PE firms and attract investors. In order

to engineer organic growth in portfolio companies, PE firms need to add new growth

capabilities, restructure interaction with portfolio companies toward growth, and ensure

growth is created net free.

Methods of creating organic growth capabilities depend on the specifics of the

PE firm and the industries in which it invests. However, PE firms can apply two general

growth capabilities across all portfolio companies, better pricing ability and improved

sales force practices. Also, it is vital that PE firms make organic growth the main focus

of value creation for portfolio companies, so growth initiatives are not undermined by

cost-cutting measures. One concept PE firms use to refocus portfolio companies on

organic growth is headroom. This framework involves assessing switchers, customers

that could potentially switch companies, and what would it take to attract those

customers to switch. Most importantly, PE firms must ensure that investments growth

initiatives are net free. This means that cash invested in growth capabilities come from

savings attained elsewhere in the portfolio company. Another positive aspect of organic

growth enhancement is the positive impact on the fund raising and deal making

process. GPs will be able to improve fundraising by selling a history of organic revenue

growth in previous portfolio companies. Moreover, firms that master organic growth

early on will be able to win more deals and provide rich returns for investors. A real life

example of the effective use of organic revenue growth is KKRs management of Dollar

General. From the beginning, KKR primarily worked on initiatives that were meant to


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increase revenues, specifically by increasing volume. Before KKRs acquisition, Dollar

General based store product selections and assortments on individual profit margins of

SKUs. KKR implemented a strategy that looked at margin per linear foot, a measure

that takes into account profit per dollar of sales, but also how quickly the product sells.

KKR also improved store standards and sourcing of products, while expanding the

private label business. KKR bought the company for $7.6 billion in 2007 and by the end

of the 2010 fiscal year, revenue grew by 37% to $13 billion and adjusted EBITDA grew

126%. Dean Nelson, head of KKR Capstone said, And 80 percent of that was growth; it

wasnt getting better terms from P&G or Kraft.

8

Since 1950, the global population has increased from 2.5 billion to 6 billion.

Cumulative world GDP has increased 6 times over the same time period. This GDP

growth has been accompanied by the growth of environmental degradation, including

but not limited to deforestation, over-fishing, ozone layer depletion, global warming etc.5

Over the past 20 years, there has been a growing importance of environmental, social,

and corporate governance (ESG) issues. The growth is rooted in the growing presence

of ESG issues comes from the realization that the Earths resource are limited and will

become more constrained in the future stemming from ESG megatrends including

population growth, increasing resource consumption of developing markets, and climate

changes. These megatrends present huge obstacles for society to overcome. ESG

issues have resulted in the tightening of government regulation and changing consumer

demand. 4


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The recent global crisis pointed out the drawbacks of short-term profit maximization.

Furthermore, the recent financial fraud has increased demand for transparency in

corporate governance. In addition, increasing demand for transparency in corporate

governance and operations have stemmed from consumers demanding for information

on how production and consumption of goods affects the environment. The result of

growing government regulation, resource scarcity, investor and consumer demand have

put a growing premium on businesses that implement ESG initiates across all business

operations. 4

During the late 1980s to mid 1990s, PE firms took a regulatory and compliance

stance in response to ESG sustainability. Managers only considered only on site-

specific risks (e.g. safety or health conditions) to protect investors from regulatory,

financial, and reputational risks relating to ESG. During the late 1990s to mid-2000s,

PE firms began to use sustainability to generate revenue and reduce cost. Recently, a

few top firms have been able to identify potential operational opportunities, by using

sustainability as a source of continuous business innovation, risk reduction, and

financial performance improvement. Exhibit 2and Exhibit 5

Under sustainability efforts, companies can realize cost savings to drive value

creation. The implementation of eco-efficiency in energy, water, packing, waste

reduction, and resource use will increase operating efficiency and reduce those costs.

In 2007, KKR partnered with Alliance Boots, an international pharmacy-led health and

beauty group. Both companies believed corporate governance and sustainability can


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create value. Before 2007, Alliance Boots already committed itself to achieving ESG

initiatives. Alliance Boots sought to attain eco-efficiency savings in store design and

transport. Presently, eco-efficiency initiatives in transportation reduced the road

kilometers driven by 8.5 million and have reduced transport emissions by 4.78%, saving

1.6 million Euros in fuel cost. 3

PE firms that enforce sustainability management systems and sustainable practices

can reduce operation costs across portfolio companies. Additionally, firms can reduce

resource procurement costs through secure sourcing of energy, water, and raw

materials. Sustainability training and development programs for employees can improve

productivity.

Not only can sustainability initiatives improve operating margins, but can also

create significant top-line growth with product differentiation, product development, and

increased market access. Companies can advertise its sustainability efforts to increase

consumer awareness. Through the development of new products, companies can fill the

demand for unmet ESG needs. In addition to new products, companies can command a

price premium with added sustainability features to current products. Also, companies

can create new revenue streams by recycling waste. Lastly, sustainability efforts can

improve the reputation of a company with consumers, supplies, and regulators to open

up access to previously closed off markets.


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Finally, sustainability initiatives can protect companies from value erosion by

reducing legal, financial, and reputational risks. Green initiatives improve brand image

and reduce possibility of bad publicity, regulatory risks, and pressures from investors.

Firms achieve lower financial risk rating reducing the costs of capital. Most importantly,

sustainability programs help mitigate risks from changes in the environment, regulation

and stakeholder sentiment. The most recent example of value erosion from the lack of

risk management is BPs loss of $90 billion dollars in market capitalization after the

2010 Deepwater Horizon oil spill. 9 & Exhibit 6/7

There are still challenges with the growth of value from sustainability improvement

initiatives. First, PE firms traditionally have a short-term financial focus, but to reap the

full benefits of sustainability improvement measures usually requires a longer

investment horizon. Secondly, businesses also have to create ways of quantifying ESG

initiative impacts to show to investors. No standard metric exists for valuating social and

environmental improvements on the bottom-line. Exhibit 8 Implementation of sustainability

initiatives requires a new set of human talent and resources. Lastly, because the

business of sustainability for value creation is new, the talent pool for human talent is

limited. This may limit short-term growth in the implementation of sustainability

initiatives.

Doughty Hanson has been a long-time proponent of sustainable business practices.

Therefore, his sustainability initiatives have already shown results. Hanson was the first

to appoint an in-house head of sustainability. In February 2007, Hanson acquired


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Avanza, the largest bus operator in Spain.Avanzas business model is related to many

ESG issues, because public transport can combat air pollution. The company has ESG

issues regarding the use of alternative fuels and engines to meet regulatory standards.

Qualitatively, Hanson worked with management to find specialist in advanced fuel

management outside the firm. The enhancement of environmental and social issues

resulted in being certified to international standards of good practice. Quantitatively,

Hanson established fuel reduction targets and arranged driver training. Initiatives are

expected to reduce fuel consumption by 2.5$ to 5% over two years or .7 million to 1.4

million Euros a year. Even more so, Hanson is investigating the potential for solar power

that is estimated to generate 150k Euros a year. Last but not least, health and safety

initiatives in streamlining systems have resulted in savings of 200k Euros a year. 3

Private equity is a highly dynamic investment strategy that actively creates value for

investors. The ability of a PE firm to be innovative in its value creation strategies is the

key to sustain competitive advantage and create attractive returns. The advent of

financial engineering in the 1980s and operational improvement in the 1990s were

innovative solutions to create value in a maturing industry. Ample opportunities for

potential value creation still exist through operational improvement in portfolio

companies. Value generation requires expertise, experience, and process. The

Operating Partner model incorporates the experience and expertise required; however,

a few successful firms have developed the framework for consistently determining the

right operational improvement opportunities to pursue.


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Appendix: Exhibits

Exhibit 1: Basic Principles of Private Equity

Exhibit 2: Three waves of sustainability


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Exhibit 3: Decline the use of Leverage in the 2008 credit crunch

Exhibit 4: Risk/Return Tradeoff of Potential Operational Improvements


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Exhibit 5: Graph showing Changing Business Response to Sustainability

Exhibit 6: Potential Areas of Sustainability to Create Business Value


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Exhibit 7: Model of How Sustainability Drives Business Value

Exhibit 8: Reporting of Sustainability Initiatives


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References:

1. http://www.morganstanley.com/views/perspectives/files/Operational_Improvement_JUL09%5B1%pdf

2. http://www.booz.com/media/uploads/BoozCo-Value-Creation-Tutorial-Private-Equity.pdf

3. http://www.unpri.net/files/PE%20case%20studies%20FINAL.pdf

4. http://www.wwf.org.uk/what_we_do/press_centre/?uNewsID=5404

5. http://www.wto.org/english/res_e/booksp_e/special_study_4_e.pdf

6. http://www.capitalinstitute.org/sites/capitalinstitute.org/files/docs/20110425%20D-Propper%20PEI%20article.pdf

7. http://www.cedarbridge.com/cedarbridge/press/LongTerm_Value_Creation_Report_Modified.pdf

8. http://www.kkr.com/ar/downloads/kkr_annualreport_2010.pdf

9. http://www.reuters.com/article/2011/02/15/us-bp-lawsuit-idUSTRE71E0JI20110215
http://www.morganstanley.com/views/perspectives/files/Operational_Improvement_JUL09%5B1%5D.pdfhttp://www.morganstanley.com/views/perspectives/files/Operational_Improvement_JUL09%5B1%5D.pdfhttp://www.morganstanley.com/views/perspectives/files/Operational_Improvement_JUL09%5B1%5D.pdfhttp://www.booz.com/media/uploads/BoozCo-Value-Creation-Tutorial-Private-Equity.pdfhttp://www.unpri.net/files/PE%20case%20studies%20FINAL.pdfhttp://www.wwf.org.uk/what_we_do/press_centre/?uNewsID=5404http://www.wto.org/english/res_e/booksp_e/special_study_4_e.pdfhttp://www.capitalinstitute.org/sites/capitalinstitute.org/files/docs/20110425%20D-Propper%20PEI%20article.pdfhttp://www.capitalinstitute.org/sites/capitalinstitute.org/files/docs/20110425%20D-Propper%20PEI%20article.pdfhttp://www.capitalinstitute.org/sites/capitalinstitute.org/files/docs/20110425%20D-Propper%20PEI%20article.pdfhttp://www.cedar-bridge.com/cedarbridge/press/LongTerm_Value_Creation_Report_Modified.pdfhttp://www.kkr.com/ar/downloads/kkr_annualreport_2010.pdfhttp://www.kkr.com/ar/downloads/kkr_annualreport_2010.pdfhttp://www.reuters.com/article/2011/02/15/us-bp-lawsuit-idUSTRE71E0JI20110215http://www.reuters.com/article/2011/02/15/us-bp-lawsuit-idUSTRE71E0JI20110215http://www.reuters.com/article/2011/02/15/us-bp-lawsuit-idUSTRE71E0JI20110215http://www.kkr.com/ar/downloads/kkr_annualreport_2010.pdfhttp://www.cedar-bridge.com/cedarbridge/press/LongTerm_Value_Creation_Report_Modified.pdfhttp://www.capitalinstitute.org/sites/capitalinstitute.org/files/docs/20110425%20D-Propper%20PEI%20article.pdfhttp://www.capitalinstitute.org/sites/capitalinstitute.org/files/docs/20110425%20D-Propper%20PEI%20article.pdfhttp://www.wto.org/english/res_e/booksp_e/special_study_4_e.pdfhttp://www.wwf.org.uk/what_we_do/press_centre/?uNewsID=5404http://www.unpri.net/files/PE%20case%20studies%20FINAL.pdfhttp://www.booz.com/media/uploads/BoozCo-Value-Creation-Tutorial-Private-Equity.pdfhttp://www.morganstanley.com/views/perspectives/files/Operational_Improvement_JUL09%5B1%5D.pdfhttp://www.morganstanley.com/views/perspectives/files/Operational_Improvement_JUL09%5B1%5D.pdf

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Private Equity Investments - Final Paper