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Etude

Is Your Portfolio Company’s Value Creation Plan Still on Track?
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By all rights, a 32% plummet in second-quarter GDP should send building supply companies running for cover. But not this summer.

From April to mid-August, while the coronavirus was precipitating the worst economic downturn since the Great Depression, Home Depot foot traffic was running at least 35% above last year’s level. Short supply of everything from lumber to roofing materials drove up prices sharply.

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“All of the historical benchmarks that we’ve used to think about the business . . . like GDP and housing . . . none of that has a correlation anymore,” Home Depot Chief Executive Craig Menear told the Wall Street Journal. Like countless other CEOs and business owners around the world, Covid-19 left Menear scrambling to adjust to a new normal.

How long this kind of broken correlation will last is anybody’s guess. But it’s clear that Covid-19 has already altered the business landscape in profound ways. For Pinterest, that meant doling out close to $90 million to break the lease on a new 490,000-square-foot San Francisco showcase headquarters. Once it saw that remote working schemes worked just fine during the pandemic, the company decided that bunching talent in a single hyperexpensive geography simply no longer made sense. Amazon’s Whole Foods and other grocers, meanwhile, have been sprinting to invest in online-only “dark” stores that are optimized for pick and pack and barcode scanning. How else to cope with the rapid growth of a new delivery channel that had been difficult to make profitable under the old model?

Time for a refresh

As the Covid-19 pandemic drags on, private equity firms face this sort of critical decision point for every company in their portfolios. Much remains uncertain in the current environment, but fund managers can count on one thing—the value creation plans they had in place in January are now suspect if not completely irrelevant. Faced with multiple levels of both short- and long-term change and disruption, firms need to ask themselves whether the assumptions that originally underpinned their value creation plans still hold true. Is what you underwrote still valid? Are the strategies you were counting on to drive returns still the right ones?

Companies have already reacted to the immediate impacts of Covid-19, but it would be a mistake to assume that the hard work is over. Not only has the pandemic continued to reverberate in ways that no one saw coming but Covid-19 has also accelerated a number of important megatrends that are roiling industries much sooner than anticipated.

Pinterest is hardly the only company to blow up old assumptions about where its employees should work and live. The declining cost of distance due to technology is rapidly challenging almost any assumption regarding how people shop, play, communicate and take care of themselves. These forces have been at work for years, but Covid-19 has essentially been a large-scale consumer beta test, pulling forward sampling and behaviors that might otherwise have taken years to materialize.

The same can be said for automation. Amid chronic turbulence and uncertainty, companies are doing whatever they can to become faster, smarter and more agile, and that often involves taking humans out of the equation. Traditionally, that has meant using robotics to automate production lines or some aspect of service delivery. But increasingly, companies are using bots, artificial intelligence (AI) and machine learning to zero-base internal processes and automate activities across the organization from sales to warehousing to human resources.

Covid-19 has also accelerated the retreat from a third megatrend: globalization. Until recently, supply chain managers have focused on establishing lean and efficient operations, heavily embracing globalization to gain scale and cost advantages. But geopolitical developments such as the US-China trade war have upended those business models, and the Covid-19 shock has only dialed up the pressure to build supply redundancy, bring operations back on shore, and strike a new balance between resilience and cost efficiency.

Any of these shifts can change the competitive dynamics in an industry, and this can spell opportunity for firms willing to be bold. History shows that more market share changes hands during periods of turbulence than at any other time. Firms that acknowledge the world is changing and take action first have the best chance of kicking the performances of their portfolio companies into a higher gear. That starts with diagnosing change quickly and reshaping your value creation plan to ensure that your strategy mix still matches the market opportunity. Consider how three PE-owned companies broke down Covid-19’s short- and long-term effects before quickly tailoring their plans to reflect the new reality.

Building a new strategy

When the pandemic arrived and cars suddenly disappeared from the nation’s highways, the impact on one collision repair company was immediate. Fewer cars meant fewer accidents. And as demand fell off the table, the company scrambled to conserve cash and adjust operations. The real question as business stabilized, however, was what to expect post–Covid-19. The PE investors’ original deal thesis rested on building scale—both through mergers and acquisitions and opening new stores. That would improve the company’s standing with the insurance companies that dictate 70% of customer referrals, since insurers favor companies with outlets wherever their customers are located.

But Covid-19 ushered in another big concern. There was every reason to believe that the nation’s forced experiment with working from home would convince many employers that grueling hours spent in traffic are counterproductive. That could cut into urban highway volumes permanently, which would likely add considerable downward pressure on repair volume over the long run.

That remains to be seen, of course, but the company’s careful scenario analysis led it to make several proactive decisions to shift its strategy. First, it dusted off a set of adjacency bets it had defined but deprioritized prior to Covid-19. These included expanding into the windshield repair business, which would provide a hedge against a decline in collisions stemming from in-town driving—urban commute reductions (fewer collisions) mean increased suburban and highway driving (more flying debris that damages windshields). Declining volume also meant that the company had to become more cost conscious. It accelerated efforts to centralize back-office activities, such as billing and invoicing, and adopted digital technologies, such as bots, to automate repeatable tasks. Finally, considering that there were still many unknowns regarding how consumer behavior would evolve, management wanted to enhance its test-and-learn capabilities. So it adopted a new, more agile planning process to evaluate strategic options quickly and decisively.

Bringing precision to sales

Anyone who visited a grocery store during the first few months of the Covid-19 pandemic likely was stunned by the sheer velocity of sales. Traditionally slow-moving goods were flying off the shelves, and stores couldn’t refill them fast enough. Behind the scenes, the mad rush to backfill pantries was roiling a staid, once-predictable business. Upstart insurgent brands that had been making inroads with their on-trend offerings suddenly couldn’t keep up with demand. That forced grocery stores to simplify their assortments, which usually meant defaulting to incumbent brands with more staying power (see Figure 1).

Figure 1

Insurgent brands captured a significantly smaller share of growth during the peak of the Covid-19 crisis compared with prior periods

While upstarts clearly have the wherewithal to rebound—and may even emerge stronger—this immediate disruption made it difficult for many in the grocery value chain. Consider the effect on one PE-backed manufacturer of the labels affixed to consumer packaged goods (CPGs). Label companies have to be strategic about where they place their bets because a CPG brand typically has one primary label manufacturer and a couple of backups. Since the primary label supplier reaps the majority of the printing volume, every manufacturer vies for the pole position. The original investment thesis for this company was to outgrow the overall market by winning with the brands that were taking share from others, including upstarts, and using a world-class sales organization to seal the deal. The trick was finding brands that were well-established enough to have a strong growth outlook without being so big that they could drive the hardest bargain on price.

As brands such as these were sidelined during the pandemic, the label company discovered that it needed to be more focused on its commercial strategy. Instead of giving reps carte blanche to pursue new accounts as they saw fit, the company built a system that used data to spot the best market opportunities while also alerting the company to changes as the market evolved. Leadership redefined its sales pipeline process by building a database that helped the company estimate its share of spending at all possible CPG clients vs. its competitors. The company then layered on what’s known as a propensity modeling tool, which identifies the best prospective brands to target (be they insurgents or incumbents) by using AI to segment and rank accounts based on their growth potential. Combined with the collective knowledge of the sales team, the company could rapidly shift focus to the strongest growth prospects and proactively tailor sales efforts to meet the needs of those accounts. The new system left it nimbler and better suited to manage future disruption.

Dialing in automation

Covid-19 has also roiled a promising PE-owned company that makes light-duty construction equipment. Before the pandemic, the deal thesis was a straightforward scale play: Merge with one of its larger competitors, absorb struggling independent dealers, and turn them into exclusive suppliers of the company’s brands. Increased scale would give the company the ability to buy at better and lower costs, helping it to expand its footprint geographically. And building a digital marketing capability would help it reach new customers in new ways.

Fortunately, Covid-19 actually increased demand for the company’s products, but the operation couldn’t keep up with the business boom. The shutdowns and quarantines produced a labor shortage at the factory, which led to long order backlogs at the few stores that managed to remain open. Faced with this demand shock, the company made a number of key decisions to pull forward aspects of the value creation plan that had until then been lower priorities. First, it ramped up investment in robotics to automate manufacturing where it didn’t have the human labor necessary to do the job. It also prioritized products based on popularity and profitability, while favoring its largest and longest-standing dealers in the shipping queue.

The digital channel rose to the top of the agenda as well. To help customers cope with scarcity and inventory dislocations, the company rapidly built out a capability that allows customers to view stock across the dealership network, to interact with the sales reps and then to purchase online before picking up at the dealership. The digital investments amounted to a no-regrets move. If Covid-19 has made anything clear, it’s that customers are demanding nothing less than a seamless omnichannel shopping experience.

Refreshing for a new future

What these examples demonstrate more than anything else is how critical it is for PE firms to engage with every portfolio company. That starts with a few questions.

  • What are your customers buying, how are they buying it, and how have their purchasing criteria changed?
  • How has demand shifted already, and how will it continue to change amid the range of plausible future scenarios?
  • Are the ways you have differentiated your company from competitors as valid as they were before Covid-19? Does your company need any new capabilities to outgrow the market?
  • Given these findings, are the strategies you have in place today still the ones that will deliver the returns you need to set the company up for a strong exit?

Firms have done an admirable job so far of working with their management teams to respond to a historical period of upheaval. And it would be a mistake to shift back to autopilot. Because Covid-19’s impact is both targeted and unpredictable, the critical next step is to reassess whether the tenets of your original investment thesis still hold up in the post–Covid-19 world. The good news: This largely involves assessing the company with the same rigor you applied during due diligence. By looking at the market, customers and competitors, it is possible to glean actionable insights about how you should pivot strategy to deliver a positive outcome for your portfolio investment as well as outsized returns for your investors.

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