In 2021, private equity was experiencing a robust phase, characterized by exceptional fundraising and a surge in deal activity. Investors had rebounded swiftly from the uncertainties caused by the pandemic, with the U.S. seeing an 87 percent increase in the number of private equity deals, and the total transaction value soaring to 2.5 times that of the previous year. What resulted was a highly liquid environment, driven by increased demand that pushed prices higher and was characterized by low interest rates, heightened investor demand, strong economic growth, and elevated valuations.
However, challenges have since emerged in the form of inflation, rapid increases in interest rates, and a cloudy macroeconomic outlook, creating a dampening effect on the private equity market. Although deal count itself has remained consistent with historical averages, the aggregate transaction value has declined and a noticeable shift has occurred, with a focus on recapitalizations, restructurings, follow-on investments, and secondary sales rather than full company sales or exits. Prices have decreased, and the availability of capital has become constrained.
As challenges such as a decline in quarterly exits, a historically low exit-to-investment ratio, and increased difficulty in exit transactions persist in 2024, strategic and operational improvements must be recognized as one of the largest sources of private equity returns.
“With market tightness and a shift towards alternative exit strategies, strategic improvements are vital for enhancing the attractiveness of portfolio companies to potential buyers or investors,” said Mark Hauser, managing partner at Hauser Private Equity. “Operational enhancements have to play a crucial role as well, particularly as the focus shifts away from traditional exits.”
Historically, private equity funds have shown resilience and outperformance in challenging market conditions, displaying an ability to navigate market volatility and access less efficient market segments. Pursuing long-term value creation can be a proactive measure to position portfolio companies for success, and a nuanced approach involves finding the right balance between short-term cost reductions and long-term growth strategies.
Opportunities across key business functions
The four- to six-year holding period that private equity firms maintain for their investments is a crucial transformation window. Within this time, opportunities across key business functions must be identified and leveraged in order to maximize value creation. In sales, the focus may be on expanding market reach, optimizing sales processes, and identifying new revenue streams. Marketing efforts could involve rebranding, targeted campaigns, and market positioning to enhance the company’s competitive edge. Operational enhancements become a cornerstone, involving improvements in efficiency, supply chain optimization, and overall process streamlining. On the financial side, strategic financial management, capital allocation, and risk mitigation strategies are best prioritized. The transformational initiatives undertaken within this window are not isolated but interconnected, forming a holistic strategy aimed at fortifying the business from various angles.
“Private equity firms must recognize the interdependence of these key functions and leverage the transformation window to implement changes that drive operational excellence and enhance the overall value proposition of portfolio companies,” said Hauser.
Rapid diagnostics for value creation
Making quick, targeted assessments of a business to identify its strengths, weaknesses, and areas of opportunity will continue to be a strategic imperative for value creation. Firms must leverage advanced analytical tools alongside cutting-edge data-driven insights to swiftly evaluate KPIs, market positioning, and operational efficiency in order to gain a comprehensive understanding of a company’s current state.
In particular, a critical focus on narrowing down opportunities that directly impact EBITDA allows investors to implement targeted interventions that enhance the operational profitability of portfolio companies. Hauser emphasizes that by swiftly identifying and honing in on opportunities that contribute to EBITDA growth, private equity firms can enact targeted interventions. “Revenue enhancement strategies, cost optimization measures, operational efficiencies— these all directly influence the bottom line,” said Hauser.
PE firms can also leverage this diagnostic approach to gain a nuanced understanding of the interconnected factors influencing a company’s financial health. This includes evaluating revenue streams, cost structures, and capital allocation strategies. Clarity around top-line growth involves identifying avenues for revenue expansion and market capture. Simultaneously, a focus on bottom-line profitability entails pinpointing cost drivers and efficiency improvements. Capital efficiencies are optimized by aligning investment strategies with business objectives.
Understanding true cost drivers and taking action
Recognizing the underlying factors that significantly impact a business’s financial health and operational efficiency is essential, as it allows investors to unravel the complexities of a company’s cost structure and make informed decisions that yield tangible and sustainable improvements.
“Whether rooted in operational inefficiencies, supply chain intricacies, or market dynamics, identifying the true cost drivers provides a foundation for strategic interventions that go beyond surface-level cost-cutting to address fundamental aspects influencing a company’s economic viability,” said Hauser.
Armed with insights into the true cost drivers, private equity firms can be equipped to take strategic and targeted actions that drive value and efficiency. One effective strategy involves implementing operational optimizations that streamline processes and eliminate redundant activities, thereby reducing costs without compromising essential functions. Supply chain restructuring is another avenue, wherein firms can identify and mitigate vulnerabilities, negotiate favorable contracts, and enhance overall supply chain resilience. Additionally, strategic pricing adjustments, grounded in a deep understanding of market dynamics and consumer behavior, enable firms to navigate pricing pressures while maintaining profitability. Beyond operations and supply chain management, firms may choose to explore innovative technology solutions to automate processes and optimize resource utilization.
“Collaborative efforts with portfolio company leadership play a pivotal role, fostering a culture of cost-consciousness and aligning the entire organization toward a common goal of sustainable cost management,” said Mark Hauser.
Prime areas of focus in 2024
Optimizing third-party spend can be a pivotal avenue for cost management and value creation in the new year. Investors should recognize that meticulous scrutiny of third-party spend can uncover opportunities for cost efficiencies, supplier negotiations, and overall financial optimization, whether through strategic sourcing, renegotiating contracts, or leveraging economies of scale to achieve cost savings.
Additionally, developing and implementing effective pricing and promotional strategies can better position portfolio companies to maintain a competitive edge and navigate market fluctuations. Investors should collaborate closely with portfolio company leadership to refine pricing models, assess market elasticity, and align pricing strategies with value propositions. Concurrently, promotions can be crafted to enhance customer engagement, drive sales, and capitalize on market trends.
Firms should also be looking to strategically manage tax liabilities within each of their portfolio companies, optimizing their financial structure and contributing directly to their bottom line. This provides a relatively simple means to increase profitability without compromising operational efficiency or market competitiveness. The enhanced financial resilience achieved through tax savings offers portfolio companies additional resources for strategic investments, operational improvements, or debt reduction, ultimately fortifying their overall value proposition.
The landscape of private equity has encountered substantial challenges in recent years, there are optimistic indications suggesting that a positive turnaround may be on the horizon. Regardless of the market conditions that lie ahead, private equity remains inherently resilient, with the capacity to adapt to changing environments. The key lies in recognizing that, even in the face of adversity, there are enduring opportunities rooted in the core tenet of private equity: value creation. This foundational principle emphasizes the strategic and operational enhancements that private equity firms can implement within their portfolio companies.
By refocusing on creating value, investors can leverage the intrinsic strengths of private equity to navigate uncertainties and emerge stronger on the other side of the current challenges.