Plugging Profit Leaks in Private Equity Deals

Plugging Profit Leaks in Private Equity Deals

Private equity firms should be aware of four different issues can cause the bucket of profits to spring leaks.

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Plugging Profit Leaks in Private Equity Deals

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With strong returns and ample liquidity in recent years, the private equity model appears to be working just fine, creating value and profitable exits for investors. A look beneath the surface, though, reveals a less rosy picture of recent performance, which we explore in Bain & Company’s newly released Global Private Equity Report 2017.

For the subset of deals in Bain’s proprietary database invested after the global financial crisis, we compared deal model forecasts for revenue and EBITDA margin expansion with the results that each portfolio company actually achieved over the holding period. Most portfolio companies, we found, had relatively accurate projections of revenue growth. However, most did not attain the projected higher profit margins. This breakdown in execution had not come to light sooner because it was masked by macroeconomic factors, notably multiple expansion. Since the global financial crisis, acquisition multiples have risen significantly around the world—which is not what PE funds anticipated. In their deal models, funds penciled in restrained expectations for multiples upon exit. For the sample of deals Bain analyzed, funds assumed an average multiple at exit of 8.8 times EBITDA, but the realized exit multiple turned out to be much higher, at 10.9 times EBITDA. General partners (GPs) had the good fortune to make up the shortfall in margin expansion through unforeseen multiple expansion.

PE funds will not be so lucky with future deal returns, we believe, as few scenarios support a case for further multiple expansion. Much of the recent expansion was fueled by record-low interest rates, which greased the wheels of debt and therefore supported higher deal prices. Unless interest rates decline further, multiples likely will top out. Future returns for PE funds will have to rely more on operating-margin expansion, which requires highly engaged, active ownership.

PE firms often assume that once the deal is done, profit margins will increase—just because they should increase. But it rarely turns out that way. Examining those deals that failed to achieve expected margins reveals four issues that many GPs do not cover sufficiently in their deal models: price erosion, cost inflation, capital expenditures or reinvestment in the business, and a possible shift in product mix and volume over the holding period. Each of these issues can cause the bucket of profits to spring leaks.

Price erosion. It’s dangerous to assume in a deal model that prices for a company’s products will do anything but go down. Except in monopoly or oligopoly markets, prices fall in every industry. Typically, the industry starts with a product development phase, characterized by scant competition and the ability to command high prices. Wide margins early on make any business a prime target for greater competition. With increased competition comes increased supply, and as companies accumulate experience, prices inevitably decline. Any due diligence, therefore, should map out the relevant price experience curve for the target industry, plot the industry’s products on the curve and realistically project how prices will change over the holding period.

Costs. Many funds assume that they will manage down all costs over the holding period. Yet like it or not, some costs will rise. For example, in a labor-intensive business such as a brick-and-mortar retail chain, it’s not realistic to peg labor as a percentage of revenue and hold it constant. Managers will need to aggressively reduce costs in those categories that lend themselves to cutting to compensate for the categories that will stubbornly remain flat or rise.

Required investment. The third key issue that emerged in our analysis involves misjudging the required investment in a business over the holding period. For example, companies may need to invest in marketing and sales resources in order to increase revenues. Or they may have to make capital expenditures in order to achieve or maintain a low-cost position. And any cost savings achieved could easily be diverted to the demands of the business before the savings have a chance to flow into margin expansion.

Product mix and volume. There’s a good chance that a company’s product mix and volume could change substantially over the holding period, which in turn could alter its margin profile. Companies in fast-moving consumer goods or fashion retailing, for example, have to contend with sudden shifts in consumer taste that can reshuffle their product mix in a matter of months or weeks. Managers can’t precisely predict every shift, but they can anticipate the risk through a version of scenario planning that lays out a best and worst case for each product line.

While an individual portfolio company might not have to contend with all four challenges, the odds are high that at least one will apply. Investors and management teams have to figure out how to refill the margin bucket faster than the leaks that will make it run dry.

The practical route to accurately assessing and realizing the margin expansion opportunity starts with operational due diligence combined with commercial due diligence. Together, they provide a robust, realistic view of the target’s full potential. Whereas commercial due diligence provides a perspective on how fast the target company’s market will grow and whether the target could increase revenue faster or slower than the market, operational due diligence assesses the opportunity for the target to expand margins. In our next installment, we’ll show how this works.

Hugh MacArthur, Graham Elton, Daniel Haas and Suvir Varma are leaders of Bain & Company’s Private Equity practice.


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