The use of private equity to fund corporate strategies is rapidly morphing into a new era characterized by reduced exit opportunities for investors, lower predictability of investee companies’ cash-flows increasing risk profile, and need to focus more on two operational levers, operating margin and capital intensity, to create sustainable shareholders’ value.
Exit opportunities by funds willing to monetize all or part of their investments have been significantly hampered over the past two years by the lack of public equity investors’ interest in initial public offerings (IPOs) reflecting concerns with private equity funds’ expected high valuation ranges for their portfolio companies not being backed by predictable corporate cash-flows. The other two monetization alternatives, trade sales and leveraged recapitalizations, widely used to upstream cash to the funds’ own investors (LPs), are no longer forthcoming. Trade buyers are in the process of reviewing external growth opportunities leading to cuts or postponements of investment decisions to prioritize deleveraging or build up cash balances ahead of unpredictable times. Leveraged recapitalizations are simply no longer a viable alternative when dealing with portfolio companies already experiencing unsustainable debt levels.
The combination of high financial leverage, low interest rates and expected expansion of EBITDA multiples when deals were completed in the heyday of leveraged buyouts has come to an abrupt end. Many funds are now left with stranded assets burdened by unsustainable debt servicing requirements stifling growth and inadequate capital structure to fund soaring working capital requirements and the need to upgrade equipment or beef up R&D.
This factual assessment leaves private equity funds facing two options:
Option 1 – Extending holding periods in portfolio companies via continuation funds and rejigging equity and debt funding structures in the hope that a lower debt burden would be enough to foster a sustainable rebound thanks to higher operating cash-flow allocation to operations as opposed to debt servicing.
Option 2 -Investing time and cash in the design and implementation of Performance Improvement Programs focused on enhancement of Gross Margin, EBITDA and optimization of capital employed (i.e. the sum of fixed assets, intangibles and working capital requirement).
While Option 1 requires primarily financial skills and the ability to bring in new private capital providers such as special situations funds able to invest new money across all layers of a portfolio company’s capital structure, Option 2 may only be pursued by both existing shareholders and managers with the assistance of hands-on consultants hired as Project Managers. Their scope of work will be to dissect corporate Sales, Purchasing, Manufacturing and R&D processes in order to identify improvement opportunities and to recommend an actionable Performance Improvement Program which execution they will subsequently lead jointly with the relevant managers.
This is where the ability of the Project Manager to work under tight deadlines with all the company’s stakeholders is of paramount importance. Among the two key sets of expertise required are (i) prior knowledge of the industry in which the company operates in order to be operational from Day 1 and be credible when dealing with the company’s staff, and (ii) understanding of private capital funds’ expectations if new money needs to be raised on a stand-alone basis or under any Commercial Court-supervised process.
The Project Manager must both deliver quick wins allowing the company to achieve free cash-flow breakeven before it runs out of cash and engineer structural process improvements paving the way to the return to value creation. Too many corporate restructurings focus on fixing over-indebtedness through debt rescheduling and haircuts overlooking the fact that value may only be created by any company when the return on capital employed (Operating profit after tax / Assets employed to run the business) exceeds the weighted average cost of debt and equity (the latter being the return demanded by equity investors).
Private equity funds invested in companies facing operational or financial challenges may thus be expected to turn to consultants with strong industry, operational experience and ability to access pools of private capital (special situations funds, family offices) when considering strategic alternatives to turn around a business.Bruno Rigal – Senior Advisor Executive Partners Group