Private equity takeovers are increasingly common. Yet most practitioners are still in the dark about them and the huge opportunities they present for the profession.
By Fredrik Henzler and Martin Högel.
Over the past 20 years, Private Equity (PE) has developed from a niche player into a major source of economic activity in the western world. According to data
from the European Private Equity and Venture Capital Association (EVCA), PE investments between 2006 to 2010 accounted for between 0.2 to 0.8% of European GDP; in some countries, like the UK, up to two per cent.
Yet, despite considerable efforts by the PE industry to create more transparency about their activities, little is still known about it. Public perceptions about PE (‘asset strippers’, ‘job destroyers’) also extend to procurement and supply chain matters in this area (‘supplier squeezers’, ‘short-termist’).
Having supported over 50 procurement and supply chain optimisation projects in the PE arena, we think it time to review some of those perceptions and create more transparency around the practices and importance of procurement and supply chain in this field.
How does PE work? PE groups generally make their money by increasing the value of their portfolio companies while retaining part of the generated value by the time they exit the investment in the company at a higher financial valuation.
The acquisition of all or part of a future portfolio company is financed via a combination of (a) capital out of the specific PE fund and (b) debt typically raised from commercial banks. While the latter is served by the acquired company, the former constitutes the equity that the PE fund holds in the company.
PE groups raise capital for these funds (so-called limited partnerships) from private and institutional investors, like pension funds or insurance groups. These give the PE group the task of investing the money, managing the portfolio companies and returning an appropriate profit on the investments. In return, the PE group keeps part of the generated fund profit, in addition to certain fees it gets paid for its services.
Procurement value Today, the procurement and supply chain function has an increasingly pivotal role in a company’s competitiveness, product innovation and environmental and social footprint. In the PE environment, with its leaning on high debt leverage financing and accelerated value creation, procurement and supply chain often serve two important additional tasks in a corporate context through:
- Short term (first 12 months): a strong cash flow contribution to meeting debt obligations under the financing terms
- Medium term (next 12-36 months): a dedicated and measurable effort to swiftly and sustainably improve EBIT (earnings before interest and taxes) and associated company valuation.
Due to their direct P&L impact and associated high EBIT-lever with substantial opportunities to affect company cash flows short term, procurement and supply chain are ideally suited for these two tasks.
The nature and timing of a dedicated procurement and supply chain effort in this context depends on the relevance to the firm’s operations (asset light service businesses versus material product businesses), the company’s cash flow, ownership and cycle, and, not least, its existing
procurement and supply chain maturity.
The bulk of PE investment takes place in companies with turnovers of up to
€800 million (£682 million). As those companies tend to have a lower procurement and supply chain maturity than their peers in the Blue Chip segment, the opportunities are larger, but their harnessing can be more challenging and requires a specific approach.
Procurement efforts Cash is king – especially in the first 12-18 months of a buy-out (which make up the lion’s share of PE investments). Unfortunately, this can also be the case at a later stage – the servicing of debt obligations (covenants) often assumes a critical role for the portfolio company. And even if debt servicing is firmly under control, it still makes sense to improve cash flow and cash flow management, for example as a means to fund growth.
Procurement and supply chain typically play a key role in this for a number
of reasons:
- By releasing supply chain-related working capital, tied up in unnecessary inventories or unfavourable payment terms, a sizable share of the debt can be reduced in a period of six to nine months. Our experience suggests that up to 30 per cent of working capital can be released through a dedicated cross-functional working capital initiative, contributing to a significant debt reduction (or the availability of growth capital,.
- Through a focused tactical procurement effort, price competitiveness can be established with the most suitable suppliers, typically leading to like-for-like annual company spend reductions of three to six per cent. Due to the mostly direct and immediate impact of procurement price savings on EBIT, specifically on cash flow, this can constitute a key cornerstone in a company’s debt servicing plan.
While these are certainly general practices generally applied in companies, it is the focus on results and transparency that often distinguish these efforts within the PE environment.
Financing and the return expectations with PE mostly require the achievement of very ambitious targets, both in regards to absolute numbers and to time lines. This necessitates a clear understanding of short and medium term opportunities and underlying resource requirements. It also means a relentless execution focus including challenging conventional assumptions and the early identification and removal of roadblocks supported by specific governance structures in the company. If you are driving an ambulance, you simply cannot afford to sit in too many traffic jams or breakdowns.
Likewise, especially in tight financial situations, it is pivotal that the true P&L and cash flow impact of procurement initiatives be understood and made transparent. In contrast to the annual procurement and supply chain savings reporting typically taking place in companies, the reporting focus in PE environments tends to be more around P&L and cash flow effective savings. This not only requires a good grasp of accounting, but also a detailed understanding of spend structure changes during the year and a considerable resource effort to track and report the resulting P&L and cash flow effective savings.
In some cases, the effect of completed savings initiatives is also measured on a monthly basis to monitor deviations from the original plan as early as possible in order to take corrective action. To ensure that procurement and supply chain savings hit the bottom line, some PE companies also incorporate the respective targets into the EBIT-targets for each
business units.
It is this results focus and transparency that many companies outside the PE
environment can learn from.
So far, this all sounds more like short-termism and price pinching. And there is no doubt that this exists in the PE space. It is often necessary and can be hugely
beneficial, as long as it is balanced with more sustainable measures medium
term. And contrary to intuition and general public opinion, PE-owned companies have a strong interest in doing so for two reasons:
- A lasting and recognisable improvement of their procurement and supply chain capabilities can have a considerable effect on the sale price of the company. If the buyer knows that the house is in order, he or she will generally pay more.
- Many of the dedicated procurement and supply chain efforts to substantially improve EBIT require a more comprehensive and sustainable approach. Topics like cost engineering, supplier development or supply chain relocation are typically not done over a period of 12 months, but their benefits can nevertheless be harnessed within the typical investment period of four to five years.
What it means for the CPO
The demands and value generation expectations on procurement and supply chain in a PE-owned company can be massive. For successful chief procurement officers (CPOs) in PE-owned companies, this often requires a diverse skill set.
This can be an ability to execute ambitious targets or drive through fast change, a “can do” mentality, a strong commercial nous, an innate understanding of procurement and supply chain matters, ease at transparently communicating results and their financial and strategic relevance and an ability to balance short-term cash flow interests with substantial and sustainable improvements to the overall supply chain medium term.
It is certainly not a role that suits every senior procurement and supply chain executive. For the right candidates, however, this can be a very satisfying role.
Inside PE firms The increased appreciation of procurement and supply chain in the PE space is also a reflection of a general trend taking place. Owing to the continued subdued financial markets environment, there are currently only very limited opportunities to profit from ‘riding the equity markets’ (that is, benefiting from a general surge in equity valuations in regards to the financial valuation of the portfolio companies).
A stronger focus on value generation and associated higher financial valuation through operational improvements in their portfolio companies is a natural result. Many PE firms have added operational expertise to their legacy finance orientated teams over the last years for that reason.
In that context the largest PE houses have taken procurement matters to yet another level: through the establishment of procurement platforms they strive to harness spend synergies (mostly in indirect materials) and best practice across the portfolio companies – not dissimilar to a corporate procurement function in a larger Blue Chip.
Summary Procurement and supply chain have clearly arrived in the realm of PE. This owes much to the recognised impact that procurement and supply chain can have on cash flow and EBIT improvement for companies. Contrary to public perception, PE-owned companies typically have
a strong interest to balance necessary short-term activities with longer term measures to sustainably improve their supply chain operations.
The results orientation and financial transparency typically deployed thereby could serve companies outside the PE space well.
☛ Fredrik Henzler is partner and managing director, BrainNet's Financial Investors Practice and Martin Högel is partner and managing director, BrainNet UK and Ireland
