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As inflated interest rates and valuations that remain stubbornly high continue to pressure multiples, delivering sustainable transformation is now a requisite if private equity is to achieve on-target returns.
If the history of private equity could be divided into distinct phases, we’re now entering the third, and in many ways most momentous one – private equity 3.0.
The main value levers in phase one were operational rationalisation and cost reduction. Phase two marked the highpoint of financial engineering as private equity firms were able to take advantage of low-cost finance and steadily rising valuations.
Raising the bar
Uncertainties over future cash flows in a fragile and rapidly changing economy are making deals hard to value. Once acquired, there are fewer easy wins on costs, while high interest rates are putting pressure on exit multiples. As a result, conventional buy and hold is giving way to more transformational buy and build. If this was a house, you would need to think about a loft extension or even full redevelopment of the site if you want to sell it at a profit.
The good news is that the opportunities for transformation and taking value creation to a new level have rarely been greater. A combination of technology, digital and data insights and changing customer expectations are driving innovation and opening up game-changing new business models. In addition, investors’ growing focus on environmental, social and governance (ESG) performance offers a whole new arena to deliver and prove sustainable value creation.
Target-rich market
With many cash-strapped companies struggling to make headway on transformation, there are also going to be plenty of potential targets for private equity acquisition and turnaround. The findings from our latest CEO Survey underline the disruptive pressures. Nearly a quarter of UK CEOs (22%) believe that their business won’t be economically viable within a decade on its current course, while 10% believe they have less than three years. It’s also telling that 40% of UK CEOs believe their company’s tech capabilities lag behind the demands of their strategic objectives, and the gap will only widen without concerted investment in talent and technology. With dry powder still plentiful, private equity is in prime position to step in with the necessary investment.
“Technology can be both the catalyst and enabler for operational and business model transformation.”
Transacting to transform
Technology can be both the catalyst and enabler for operational and business model transformation. Depending on the sector, the possibilities range from automating and decarbonising production to unleashing the full value of data to create fully customised products, services and experiences.
The particular challenge within private equity is how to identify and realise the transformational potential within time-limited hold periods. Robust diligence on the full potential value of transformation during the dealmaking process is key; this in turn allows for fast, confident decisions making post acquisition. Further M&A can continue to drive transformation. By divesting non-core operations, it’s possible to raise funds for operational modernisation, with many of the potential buyers likely to be other private equity funds. In turn, acquisition may be the fastest and most effective way to bring in the talent and technology needed to move the business forward and prepare it for sale.
Ultimately, there is only so much that can be achieved within typical private equity hold periods. Articulating the future opportunity for the next ownership cycle may be necessary to pass the baton of transformation to the next acquirer as part of a longer value horizon within private equity.
Realising the potential
While transformation opens up significant value creation opportunities, it can also take your firm into new strategic territory and present heightened challenges and risks. So how can you realise the potential? Three priorities stand out:
- Build the transformational potential into your investment case
Put the openings for operational modernisation and development of new business models at the centre of your acquisition targeting and valuation. Similarly, when preparing a portfolio company for sale, it’s important to identify further opportunities for transformation and seek to apply hard numbers on the uplift potential as part of your marketing to potential buyers. - Take a step-by-step approach to transformation
Even with longer hold periods, it’s still important to be realistic about what you can achieve before the company is sold on.
The first step is strengthening resilience in areas such as shoring up supply chains and dealing with immediate competitive threats to the business.
Step two is creating the launchpad for transformation. For example, moving systems onto the cloud can boost operational flexibility, while providing the basis for sharper insight, decision making and performance evaluation.
The foundations in step two can help you or the acquirer to judge where the business has the right to win and build the transformational capabilities needed to succeed. - Bring in fresh talent and expertise
Taking portfolio company turnaround further and faster is likely to require new and expanded expertise in areas such as operational modernisation and ESG. Competition for this kind of talent is intense, so it’s important to think about what you can offer beyond the basics of pay.
If you would like to discuss any of the issues raised in this article or find out how you can unleash the transformational potential within your portfolio, please get in touch.
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