New York – Oct. 22, 2019 – A new report from Bain & Company finds that multiple expansion has driven half of the value creation in Private Equity (PE) for deals invested in the wake of the global financial crisis. On the other hand, the contribution from margin expansion was much lower. This was not what PE funds had projected.
According to Bain & Company’s analysis of deal outcomes versus fund projections for 65 mature buyouts invested since the financial crisis, 71 percent of deals fell short of their projected margins by an average of 330 basis points below the deal model forecast. This shortcoming was masked by unanticipated multiple expansion, which more than made up for the shortfall in earnings growth.
Bain & Company’s report, Integrating Due Diligence to Build Lasting Value, shows that PE firms are missing the mark on margin projections because of too-often siloed due diligence processes. Separating questions about the company’s strategy, commercial capabilities or cost structure limits the buyer’s understanding of how each aspect of the business relates to the others.
From the outside, the PE industry’s performance has been impressive over this cycle. PE funds produced another surge in investment value in 2018, capping the strongest five-year stretch in the industry’s history with $2.5 trillion in disclosed buyout deal value, according to Bain & Company’s 10th annual Global Private Equity Report. But a look under the hood shows robust multiple expansion has been the key driver of half of all value creation, according to data from CEPRES, a provider of investment analytics and data solutions for private capital markets. However, with multiples already at record highs and markets around the world beginning to cool, finding a way to generate growth and increase margins will become crucial for PE firms in the years ahead.
“The industry experienced an incredible run of growth and value creation over the past decade,” said Miles Cook, a partner with Bain & Company’s Private Equity practice and a co-author of the report. “This has been helped by rising valuations in the period, which are unlikely to continue. PE firms that want to capitalize on this momentum and generate value going forward need to take a hard look at their diligence processes. The firms that get it right will use an integrated approach, designing the process from the outset to build a 360-degree view of a company’s potential and avoiding knowledge siloes when assessing the strength of an investment.”
Using an integrated diligence approach allows firms to take in the entire scope of a business, specifically showing crucial interdependencies between operations and strategy, and quantify the impact of these interlocks. This holistic approach is reminiscent of the diligence process from the early 1990s, before the industry matured and deals, and PE firms themselves, became increasingly complex.
For firms looking to incorporate an integrated approach to their diligence process, Bain & Company’s report identifies a path forward by paying specific attention to three areas of interdependencies, in order to produce a single, unified assessment of value potential:
- Strategy: When evaluating strategy focus onbuilding a market perspective and assessing competitive position, while identifying market or company inflection points. Ferret out potential disruption – such as technological disruption or consolidation of suppliers, customers or competitors – that can shift profit pools. Scope out adjacency opportunities, whether they are customer segment based, geography based or product based.
- Operations: Assess the opportunities for net working capital reduction and cost management and asset optimization, all while looking for opportunities for zero-based redesign. Diagnose whether the organization’s current technology and IT systems can deliver for the future.
- Commercial excellence: Assess salesforce effectiveness while gauging the organization’s pricing, sales channel and category management opportunities. Look for ways to optimize marketing, taking full advantage of new digital channels.
Once these three areas of assessment are complete, a single value-creation thesis can be identified. This thesis does not always point to a single answer, but rather leads to a nuanced understanding of the options.
“Integrated due diligence is the only way to really understand how pulling a lever in one area of the business will affect assumptions in the other,” said Cook. “And most importantly, it sets PE firms up to succeed by spotting the most viable path to new value. As multiple expansion begins to slow in the coming years, firms that prepare their integrated diligence strategies now will gain an invaluable competitive advantage in the future.”
Any deal that is not supported by real business improvement is likely to come under pressure in the years ahead. Most industries are undergoing rapid technological disruption of one kind or another, which is shifting proﬁt pools and creating a new hierarchy of winners and losers. The ongoing boom in mergers and acquisitions can upend long-held business assumptions by consolidating a supplier base or giving a customer or competitor more market power. All of this increases the likelihood that a company will need to alter its strategy, strengthen operations and manage costs in ways that are highly interdependent.
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