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8/3/2019 Private Equity Investments - Final Paper
1/18
Operational Engineering is the Key to Value Creation: Future Trends in
Operational Engineering
By
Anand Patel
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The financial crisis of 2008 revitalized the way private equity firms create value.
The credit crunch has significantly reduced the ability of firms to secure leverage.Exhibit 3
Thus it has been difficult for firms to utilize leverage to implement consolidation and
LBO strategies resulting increased deal competition, driving up prices for buyers.
Consequently, operational engineering has proved to become the main strategy PE
firmsemploy to generate high returns and create a competitive advantage.
In light of the Euro zone debt crisis, the importance of operational value-added
strategies will continue to be the key in private equity. As more PEfirmsmaster
operational improvement, new areas of value creation will have to be exploited to avoid
an increase in bid prices resulting from increased competition.
In this paper, I discuss the importance of operational improvement in value
creation and the strategies and frameworks top firms have employed to drive
operational enhancement. Next, I explain the growing need for PE firms to innovate new
approaches for value creation in order to differentiate themselves from competitors. I
identify the under-utilized operational improvement strategy of top-line growth,
compared with the numerous cost cutting strategies that dominated the 1990s. Included
is a framework for driving organic growth capabilities across portfolio companies.
Lastly, I discuss the opportunity for value creation from business wide focus on
sustainability improvements. Finally, I demonstrate the success of top-line growth
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strategies and sustainability initiatives in value creation using real-world examples of
firms that have implemented said strategies.
Historically, private equity firms had relied on financial engineering for value
creation by applying leverage and multiple arbitrage strategies. The availability of cheap
debt allowed for firms to implement multiple arbitrage strategies using leverage. An
example of a successful industry consolidation strategy is exemplified by Blackstones
roll-up strategy in The Merlin Entertainment Group Case. Firms realized increased ROE
by taking on more debt.
In the 1990s, private equity firms discovered the benefits of operational
enhancement for value creation in portfolio companies. Even during the boom of credit
in the mid 1990s, top firms relied on operational improvements to create value. A 2005
McKinsey & Co. study of deals completed by 11 leading private equity firms revealed
that company outperformance was the main driver ofvalue in almost two-thirds of the
transactions.1 Company outperformance constituted 63% of value creation, compared
withonly 32% driven by financial leverage and market appreciation. Multiple arbitrage
created only of 5% value.
The 2008 credit crunch solidified the importance of operational engineering as
the key to value creation in private equity. Moreover, the inability of the euro zone to
solve its debt crisis in the past few months foreshadows the continued lack of available
cheap debt in the coming years. It will serve as an impetus for the continued importance
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of operational improvement as a key competitive advantage for firms to create value in
portfolio companies.
Although the idea of operational improvement has spread across the private
equity industries, top firms maintain their competitive advantage with effective strategies
and frameworks for maximizing operational value creation. Effective frameworks and
strategies incorporate basic aspects of private in creating a strong value creation
regiment. 2& Exhibit 1 Most importantly, the goal of PE is to attract investment through
financial engineering and increasingly through operational improvements that create
value. Firms should focus on companies and projects that are core to the portfolio
companys future value, utilize capabilities already available to the company, and have
the building blocks to build financial performance in the future. As a result of highly
leveraged acquisitions in private equity, these improvements should be focused on
liberating and generating cash quickly. Strategies for improving cash flow reside in the
broad value creation categories, increase profits and improve capital efficiency. To
increase profits, firms can either grow revenues through pricing and volume or reduce
operating costs in COGS and SG&A. To improve capital efficiency, firms work toward
reducing working capital and improving fixed capital. To reduce working capital, firms
can improve inventory management and improve receivables/payables terms and
timing. Firms can improve fixed capital with long-term strategic project investments.
In operational improvement, the differentiating factor is the not finding potential
opportunities, but in determining the right areas to invest. The reason is because private
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equity firms have a short investment horizon in which to make improvements. Firms
assess opportunities by comparing the level of difficulty, costs of implementation, and
estimated time required to see the desired change to the operational improvement
sweet spot to create value. Exhibit 4 The timing of enacting operational improvements is
so critically important that many firms create 100 day plans that outline in detail the
operational strategy the firm plans to implement. Ideally, the plan will detail two or three
high value/high risk and difficult projects and many quick improvement strategies that
are easy to achieve. PE managers also should religiously track certain metrics that drive
success.
To sustain the ability a firm to improve performance, the firm must have
permanent access to operations experts. As we learned in class, the Operating Partner
Model is one of the most effective and widely used methods. The model has three
variations of implementation strategy. The Elder Statesmanvariation involves
maintaining long-term relationships with retired executives on industries on the
investment horizon. The In-House Consultingvariation obtains a full internal staff with
deep industry expertise in specific functions. This model works for large PE firms that
can absorb the overhead costs. Lastly, the Integrated Partnermodel is a hybrid that
combines characteristics of the two previous models with the internalization of a group
of former industry executives.1
Finally, in order to ensure that the senior management team in a portfolio
company is aligned with the PE firms strategy, PE firms need to incentivize company
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managers with performance based compensation based on aggressive performance
targets. This strategy is known as getting Skin in the Game, because it matches
managers financial compensation to the performance of the company.
In the 1990s, the majority PE firms had become so adept in financial engineering
that the benefit was going to sellers instead because of increased competition among
buyers. This led to PE firms moving toward creating value through operational
improvements. This involved process improvements, outsources, restructuring, or
anything involved with cost cutting. As a result of the emphasis on operational
improvements in the 1990s, PE firms have also mastered the art of driving operational
enhancement in their portfolio companies.
The fact that the majority of PE firms are highly experienced and skilled in both
financial and operational engineering coupled with the overall reduction in PE funding
and available debt to PE firms has resulted in aggressive competitive bidding that has
driven up the price of acquiring companies and making deals. Rather than paying huge
price premiums to secure deals on bargain/distressed companies, PE firms need to look
towards new approaches of value creation. I identified two growing trends for additional
value creation: focus on organic top-line growth and the capitalization of ESG issues to
create a competitive advantage.
In the advent of operational improvement, the majority of PE firms focused on
bottom line improvements and overlooked the value of organic growth creation.
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Revenue growth is an age-old strategy, but in response to current economic conditions
top line growth can lead to increased returns for PE firms and attract investors. In order
to engineer organic growth in portfolio companies, PE firms need to add new growth
capabilities, restructure interaction with portfolio companies toward growth, and ensure
growth is created net free.
Methods of creating organic growth capabilities depend on the specifics of the
PE firm and the industries in which it invests. However, PE firms can apply two general
growth capabilities across all portfolio companies, better pricing ability and improved
sales force practices. Also, it is vital that PE firms make organic growth the main focus
of value creation for portfolio companies, so growth initiatives are not undermined by
cost-cutting measures. One concept PE firms use to refocus portfolio companies on
organic growth is headroom. This framework involves assessing switchers, customers
that could potentially switch companies, and what would it take to attract those
customers to switch. Most importantly, PE firms must ensure that investments growth
initiatives are net free. This means that cash invested in growth capabilities come from
savings attained elsewhere in the portfolio company. Another positive aspect of organic
growth enhancement is the positive impact on the fund raising and deal making
process. GPs will be able to improve fundraising by selling a history of organic revenue
growth in previous portfolio companies. Moreover, firms that master organic growth
early on will be able to win more deals and provide rich returns for investors. A real life
example of the effective use of organic revenue growth is KKRs management of Dollar
General. From the beginning, KKR primarily worked on initiatives that were meant to
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increase revenues, specifically by increasing volume. Before KKRs acquisition, Dollar
General based store product selections and assortments on individual profit margins of
SKUs. KKR implemented a strategy that looked at margin per linear foot, a measure
that takes into account profit per dollar of sales, but also how quickly the product sells.
KKR also improved store standards and sourcing of products, while expanding the
private label business. KKR bought the company for $7.6 billion in 2007 and by the end
of the 2010 fiscal year, revenue grew by 37% to $13 billion and adjusted EBITDA grew
126%. Dean Nelson, head of KKR Capstone said, And 80 percent of that was growth; it
wasnt getting better terms from P&G or Kraft.
8
Since 1950, the global population has increased from 2.5 billion to 6 billion.
Cumulative world GDP has increased 6 times over the same time period. This GDP
growth has been accompanied by the growth of environmental degradation, including
but not limited to deforestation, over-fishing, ozone layer depletion, global warming etc.5
Over the past 20 years, there has been a growing importance of environmental, social,
and corporate governance (ESG) issues. The growth is rooted in the growing presence
of ESG issues comes from the realization that the Earths resource are limited and will
become more constrained in the future stemming from ESG megatrends including
population growth, increasing resource consumption of developing markets, and climate
changes. These megatrends present huge obstacles for society to overcome. ESG
issues have resulted in the tightening of government regulation and changing consumer
demand. 4
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The recent global crisis pointed out the drawbacks of short-term profit maximization.
Furthermore, the recent financial fraud has increased demand for transparency in
corporate governance. In addition, increasing demand for transparency in corporate
governance and operations have stemmed from consumers demanding for information
on how production and consumption of goods affects the environment. The result of
growing government regulation, resource scarcity, investor and consumer demand have
put a growing premium on businesses that implement ESG initiates across all business
operations. 4
During the late 1980s to mid 1990s, PE firms took a regulatory and compliance
stance in response to ESG sustainability. Managers only considered only on site-
specific risks (e.g. safety or health conditions) to protect investors from regulatory,
financial, and reputational risks relating to ESG. During the late 1990s to mid-2000s,
PE firms began to use sustainability to generate revenue and reduce cost. Recently, a
few top firms have been able to identify potential operational opportunities, by using
sustainability as a source of continuous business innovation, risk reduction, and
financial performance improvement. Exhibit 2and Exhibit 5
Under sustainability efforts, companies can realize cost savings to drive value
creation. The implementation of eco-efficiency in energy, water, packing, waste
reduction, and resource use will increase operating efficiency and reduce those costs.
In 2007, KKR partnered with Alliance Boots, an international pharmacy-led health and
beauty group. Both companies believed corporate governance and sustainability can
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create value. Before 2007, Alliance Boots already committed itself to achieving ESG
initiatives. Alliance Boots sought to attain eco-efficiency savings in store design and
transport. Presently, eco-efficiency initiatives in transportation reduced the road
kilometers driven by 8.5 million and have reduced transport emissions by 4.78%, saving
1.6 million Euros in fuel cost. 3
PE firms that enforce sustainability management systems and sustainable practices
can reduce operation costs across portfolio companies. Additionally, firms can reduce
resource procurement costs through secure sourcing of energy, water, and raw
materials. Sustainability training and development programs for employees can improve
productivity.
Not only can sustainability initiatives improve operating margins, but can also
create significant top-line growth with product differentiation, product development, and
increased market access. Companies can advertise its sustainability efforts to increase
consumer awareness. Through the development of new products, companies can fill the
demand for unmet ESG needs. In addition to new products, companies can command a
price premium with added sustainability features to current products. Also, companies
can create new revenue streams by recycling waste. Lastly, sustainability efforts can
improve the reputation of a company with consumers, supplies, and regulators to open
up access to previously closed off markets.
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Finally, sustainability initiatives can protect companies from value erosion by
reducing legal, financial, and reputational risks. Green initiatives improve brand image
and reduce possibility of bad publicity, regulatory risks, and pressures from investors.
Firms achieve lower financial risk rating reducing the costs of capital. Most importantly,
sustainability programs help mitigate risks from changes in the environment, regulation
and stakeholder sentiment. The most recent example of value erosion from the lack of
risk management is BPs loss of $90 billion dollars in market capitalization after the
2010 Deepwater Horizon oil spill. 9 & Exhibit 6/7
There are still challenges with the growth of value from sustainability improvement
initiatives. First, PE firms traditionally have a short-term financial focus, but to reap the
full benefits of sustainability improvement measures usually requires a longer
investment horizon. Secondly, businesses also have to create ways of quantifying ESG
initiative impacts to show to investors. No standard metric exists for valuating social and
environmental improvements on the bottom-line. Exhibit 8 Implementation of sustainability
initiatives requires a new set of human talent and resources. Lastly, because the
business of sustainability for value creation is new, the talent pool for human talent is
limited. This may limit short-term growth in the implementation of sustainability
initiatives.
Doughty Hanson has been a long-time proponent of sustainable business practices.
Therefore, his sustainability initiatives have already shown results. Hanson was the first
to appoint an in-house head of sustainability. In February 2007, Hanson acquired
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Avanza, the largest bus operator in Spain.Avanzas business model is related to many
ESG issues, because public transport can combat air pollution. The company has ESG
issues regarding the use of alternative fuels and engines to meet regulatory standards.
Qualitatively, Hanson worked with management to find specialist in advanced fuel
management outside the firm. The enhancement of environmental and social issues
resulted in being certified to international standards of good practice. Quantitatively,
Hanson established fuel reduction targets and arranged driver training. Initiatives are
expected to reduce fuel consumption by 2.5$ to 5% over two years or .7 million to 1.4
million Euros a year. Even more so, Hanson is investigating the potential for solar power
that is estimated to generate 150k Euros a year. Last but not least, health and safety
initiatives in streamlining systems have resulted in savings of 200k Euros a year. 3
Private equity is a highly dynamic investment strategy that actively creates value for
investors. The ability of a PE firm to be innovative in its value creation strategies is the
key to sustain competitive advantage and create attractive returns. The advent of
financial engineering in the 1980s and operational improvement in the 1990s were
innovative solutions to create value in a maturing industry. Ample opportunities for
potential value creation still exist through operational improvement in portfolio
companies. Value generation requires expertise, experience, and process. The
Operating Partner model incorporates the experience and expertise required; however,
a few successful firms have developed the framework for consistently determining the
right operational improvement opportunities to pursue.
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Appendix: Exhibits
Exhibit 1: Basic Principles of Private Equity
Exhibit 2: Three waves of sustainability
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Exhibit 3: Decline the use of Leverage in the 2008 credit crunch
Exhibit 4: Risk/Return Tradeoff of Potential Operational Improvements
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Exhibit 5: Graph showing Changing Business Response to Sustainability
Exhibit 6: Potential Areas of Sustainability to Create Business Value
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Exhibit 7: Model of How Sustainability Drives Business Value
Exhibit 8: Reporting of Sustainability Initiatives
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References:
1. http://www.morganstanley.com/views/perspectives/files/Operational_Improvement_JUL09%5B1%pdf
2. http://www.booz.com/media/uploads/BoozCo-Value-Creation-Tutorial-Private-Equity.pdf
3. http://www.unpri.net/files/PE%20case%20studies%20FINAL.pdf
4. http://www.wwf.org.uk/what_we_do/press_centre/?uNewsID=5404
5. http://www.wto.org/english/res_e/booksp_e/special_study_4_e.pdf
6. http://www.capitalinstitute.org/sites/capitalinstitute.org/files/docs/20110425%20D-Propper%20PEI%20article.pdf
7. http://www.cedarbridge.com/cedarbridge/press/LongTerm_Value_Creation_Report_Modified.pdf
8. http://www.kkr.com/ar/downloads/kkr_annualreport_2010.pdf
9. http://www.reuters.com/article/2011/02/15/us-bp-lawsuit-idUSTRE71E0JI20110215
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