If there's one thing the economic downturn taught the industry, it's to use debt sparingly. Although lending markets are open and private equity firms are still leveraging their deals, there is more focus today on creating value through operational improvements. Mergers & Acquisitions convened a special roundtable to discuss the benefits and challenges associated with different strategies to create value in today's market. McGladrey LLP sponsored the event and the excerpted discussion that follows provides a range of perspectives from key players who are working in and with portfolio companies. Participants included private equity investors, a consultant and operating partners.
Fugazy (Moderator): This used to be called the leveraged buyout business. Now there's talk of not using leverage, and instead doing other things to enhance value. Would you say that's accurate?
Griswold (Argosy Partners): It's true that many funds today are not over-leveraging. Back in the 1980s, funds used to make money buying companies at five times Ebitda, selling them for five times and financing them with leverage of four times. And the deals generated 20 percent internal rates of return. Today, lots of funds are finding other ways to add value. Firms are building up their operating partner programs and identifying processes that consistently enhance their portfolio companies.
We invest in the lower middle market and the average senior debt we put on our companies is 1.7 times Ebitda, so it's relatively low leverage. If we're going to create value, it has to be through growing revenue and improving operations. We do that through operational improvements and professionalization. The old buyout industry is evolving and today there is less use of leverage as the primary tool to generate returns, which frankly means less risk.
Kelsall (LLR Partners): We are much more focused on growing businesses, rather than doing financial engineering or taking complete control. We are very comfortable doing minority investments, so partnering with management and any other PE firms involved up front is critical, and then we make decisions together.
We do put some leverage on companies, but we try to be reasonable with the amount of leverage, depending on the type of business. We invest in companies that have strong management teams, that have strong business models and strong markets, and we help them accelerate their growth plans.
Noonan (McGladrey): We've been paying close attention to the evolution of the operating partner, and it is amazing how many people have committed to that strategy in a big way. It is a sign that financial engineering is a thing of the past. If you can't figure out how to create success through industry expertise, operating expertise and a strong management team, your likelihood of staying in the business will be dramatically diminished.
Durbin (Vestar Capital Partners): If you can find an interesting security or a way to make money through leverage, of course, you'll do that. But value now needs to be created through growth, and that's where our focus is.
Masto (FFL Partners): When we got started 16 years ago, we had this idea that it could be really impactful to bring diverse skills together and to focus on active company improvement. There was a community of firms that did that back then, but it was much smaller.
Today, everyone says operating improvement is a part of their strategy, and it has to be. But there are a lot of different ways people approach that exercise, and with varying degrees of capabilities and experience. Financial engineering was a straightforward concept; there are more flavors of operational expertise.
Fugazy: When you're readying to buy a company, what are some of the first ideas that you implement when you take control?
Logan (The Riverside Co.): The first thing we do is to establish what we call an operating rhythm, which is basically a process of the monthly operating review, quarterly board meeting and then an annual plan, and a human resource review and a strategic plan. Many of the companies we buy are entrepreneurial and they never had any of those processes. We can help companies through their teenage years and teach them some of these processes, which are helpful in the future.
Masto: And maybe the most important thing is trying to really be thoughtful about where we are going to take the business, and where the greatest needs and opportunities are for us to engage and make changes in the company. It's critical in our view to assess the unique situation of each company and be very focused in where we work to help make things better, whether it be fixing a problem or making an OK piece of the business world class.
Griswold: Every company is unique with a thousand factors that will determine its level of success. We start with strategic mapping and opportunity assessment. The first step is to figure out what the company does well and what needs work. The next step is to prioritize and, working with management, figure out what actions will have the greatest impact.
Fugazy: What is a specific process you would put in place?
Griswold: There are a couple of opportunities we see fairly often. One of them relates to good financial controls. Every company gets the taxes done, and gets a financial statement out, but the level of sophistication of tracking costs by product line, for example, may be lacking. Smaller family businesses often have not focused on that level of analysis.
Another opportunity we often see, and it's sort of surprising, is smaller businesses that have done well over a long period of time without a lot of proactive sales and marketing efforts or a thorough understanding of their competitors. It's always interesting to sit down with management after we've done our due diligence and a market study. Going through that process allows us to partner with management to figure out what we want to emphasize in a 100-day plan or strategic plan.
The sales organization is often another area of opportunity. For example, one of our companies was run by several partners who started their business together. They decided everybody should work on marketing, which meant nobody worked on marketing. So in that case, hiring a marketing professional to be solely responsible for marketing had a big impact.
Durbin: One of the things we like to do, if possible, is start the process of value creation at the first meeting with management during the due diligence process. We start sharing ideas with potential partners that we may invest with, and behind, during the diligence process. It's really about ideas, and that's what we find our management teams are really looking for. And that's what we help to professionalize.
Noonan: The notion of creating value from the outset is incredibly important. If I can provide information to help create value earlier in the transaction process, that's incredibly powerful.
Logan: One of the first things we look at is our potential for add-on acquisitions. Many companies have not thought about who they could acquire, which can be very important for growth.
Fugazy: When you're looking at companies to buy, are you already thinking about what companies you can potentially add on?
Kelsall: More than half our deals have included acquisitions as an important part of the thesis. We also invest in some companies that are multi-unit businesses, such as a restaurant or an urgent-care chain. It may not necessarily need an acquisition, but instead it will build a new unit and we can add similar value there based on experience.
Durbin: If you think add-on acquisitions may play a role, you need to get the capital lined up for that, so that should be part of the diligence. Add-on acquisitions are frequently part of our longer-term strategy, but I'd like to note that we've found a lot of value in spinoffs.
For instance, we owned a company called Sunrise Medical, which had been built over the years through a series of acquisitions. However, over time, this was working against them. One salesperson was trying to focus on all of the brands. The research and development resources were spread too thin as well. In this instance, we found greater value to be created by these divisions standing alone from a capital perspective and an overhead perspective. This created immense value for our investors and for the management teams of those companies, because instead of somebody being a division president, he or she is now CEO. The Sunrise investment was split into four companies. We're out of three of them now, and it created immense value for our investors. So, my point is that both add-ons and spin-offs should be considered.
Kelsall: I'm on the board now of one of our portfolio companies called Vector Learning, which does continuing education and online certification for several industries. And in 18 months, we've made three acquisitions and sold one of the business units. This work required a lot of resources that the company didn't have before LLR first made the investment.
Fugazy: How important it is to get the right management team, and how often to do you need to change management to get things right?
Masto: This is one of the areas where we can have the strongest impact on a company. People often say they won't change management or they always prefer to get into an investment with great management. If you could find great companies with well-developed, complete management teams that were really good and didn't need much help at all, and invest in those companies at reasonable prices, you'd love to do that all day long. Life often isn't so easy.
We don't usually like to go into situations where it's a mess and you're going to do a total management overhaul. We really like the middle ground where you have some really good people, but there's still a lot of opportunity to take the management team and the organizational structure to a higher level. Many times there are great entrepreneurial leaders who have fantastic instincts and are analytical, and are wonderful partners, but have never had any professional management experience and don't have a great sense for what their organization ought to look like, particularly as a company continues to grow. By making the right changes, you can go from a good management team to a world class team, which is pretty exciting.
Griswold: It's like when you buy a house; you want to find a house that won't be a money pit. It should have a good foundation and a solid structure. We view businesses the same way and look for a good CEO and supporting players to be on the team at the time we invest. We like to add an active and supportive board, and as the company grows we can fill in other team members, such as a great sales manager or a marketing expert. Our strategy is to avoid trying to fix a house that's falling down because of rotted timbers. We want to find something that's on a stable foundation where we can make impactful team additions along the way.
Logan: We think about management prior to completing the acquisition. We make an assessment of what we think we would have to do to help push the company forward at the board level as well as at the management level.
Fugazy: This can mean making hard decisions. How do management teams react to changes in key players?
Durbin: The goal is always to reach agreement with the management team. Prior to that, certain people may move on. In other situations, you have to pick your spots. If it's somebody who is at a lower level in the marketing department of a consumer branded company, maybe you don't care as much. For the most part, we won't shy away from those issues if they're getting in the way of value creation. We hope to uncover all of them during diligence and reach an agreement. However, if we don't, we'll take the appropriate action.
Kelsall: In my experiences, most people understand and recognize their own weaknesses.
Durbin: Oftentimes you can enhance the person. You can add resources around them, either Vestar resources or hire an advisor to the CEO or chief financial officer or head of marketing, or whoever it is that needs the skill enhancement. It absolutely doesn't always mean that the person has to leave the business.
Kelsall: Part of my role as an operating partner is to coach our CEOs, help them develop and bring in some resources around them. I am used to operating a company, so it's difficult for me. I just want to take control and do it, so you walk this fine line between taking control and coaching. Being able to stay focused on the latter is where companies and executives really appreciate some of the value brought by their investor.
Noonan: A lot of people struggle with that issue because you're walking that balance on a command-and-control spectrum, if you come in and do the work, all of a sudden it's your problem. You need to continue to keep management empowered to do what you hired or required them to do.
Fugazy: What are some of the keys to working successfully with management to have them respect you and want to work with you?
Masto: You actually have to show management you can be effective and help create value. And you have to be nice to people and have good skills dealing with people. You have to get to know management and communicate clearly. It ultimately comes back to having a good strategy and a clear plan for getting involved. We also listen to the input from the management teams on our ideas, and adjust plans accordingly.
Logan: The skill that an operating partner brings is to listen well and elicit from a management team what the real issues are in the business, so that you can work on some of the risks constructively. I serve as chairman of three of our portfolio companies, but I'm not the CEO. I spend a lot of time in the CEO offices with my feet kicked up, talking about the business. And it's an advise and support type of role.
Kelsall: Skill is important but respect and trust is critical. If you don't have that with your management team, you're not going to be successful. Also, using your own networks to help portfolio companies is really helpful. So for example, in my operating partner role, I've been to a lot of education conferences and know the industry very well. I know what is happening on the technology side, so as we see our education portfolio companies run into certain challenges, I can share with them the things I see out in the industry that they don't have time to focus on because they're running the day-to-day business. This can be exceptionally valuable to the team.
Griswold: We have the perspective of working with different management teams, and seeing how various issues are handled over a long period of time. That perspective can be very helpful if it's shared with management teams the right way. We believe it's the job of management to run the business. We can support them and help them assess and analyze what they're working on from a different perspective. If management has the benefit of multiple perspectives, then success breeds success, and you build strong relationships.
Additionally, our strategy for value creation requires revenue growth within our portfolio companies. If we're going to ask for growth, then we need to support the management team to grow. Several corporate orphans we've invested in were previously starved for cash. To be successful with a plan for growth, the resources-whether it's cash, equipment or external operating experts-need to be there to fuel that growth.
Durbin: We make a point to demystify the private equity process for our portfolio company management teams. I found that sometimes people don't really understand what we do, and who we are, who our investors are, or what fiduciary responsibilities we have, and therefore they don't see why we ask for the routines or the rhythms. When we explain the role that we play, and how we're incented and how our incentives align with their incentives, it helps tremendously to remove a lot of the confusion, uncertainty or distrust that might exist when someone from the outside comes in.
Noonan: At McGladrey, we strive to be that trusted advisor and listen to the client. It's interesting because at the end of the day we all have to deliver value. If we can't connect the dollar spent on a consulting engagement to five dollars or ten dollars worth of enterprise value, then we shouldn't have a conversation. You have to listen to get there. You have to be attentive, understand what they're faced with every day, and understand what they are trying to bring to market. Our perspective is deep. You've got 10, 20, 30 or 65 portfolio firms; we work with a thousand private equity firms, so we should have a much broader perspective.
Fugazy: Are there any things that you do right away to make management feel comfortable with you?
Kelsall: We find them great board members. For our education platform, for example, we've been able to recruit executives at Kaplan as board members who really have been able to help bring a global perspective. Our CEO really values the opportunity to have dialogue with two or three outside board directors who know about the industry.
Also, if you can help the CEOs align and provide equity to their key managers and provide incentives so that as the company does well, the team does well, that can really help establish credibility right off the bat. It shows that we're here and we're working together from the start.
Griswold:The easiest way to make CEOs look good is to help them reach their goals, and the easiest way to do that is to bring them a customer. If you can show up and have a customer in your back pocket or bring some good prospects through your network, you're helping him or her hit their numbers and jump-start growth.
Masto: Right up front, you have to begin that process of getting to know the management teams, developing trust and establishing what you can bring to the table. It's the way you conduct yourself and the questions you ask that people take away. Management teams want to understand how you think, how you approach decision-making, the accomplishments you've had and your perspective on their business.
In terms of quick hits, one of the things we do to get off on the right foot is to go through a detailed review with the management team of the work that we've done in our due diligence process and discuss thoughts that came out of that in terms of strategy and opportunities to impact the business. That can be very validating for a management team, and bring some pretty exciting, new opportunities to that table that they didn't see.
Fugazy: How important are third-party consultants as a resource, and how much value do they add?
Griswold: We use third-party consultants during our diligence process and post-closing in most of our deals. We turn to third-party experts for the experience and perspective they have, and I think one of the things Dave mentioned is their ability to analyze a company based on the average or best practices of all of the comparable companies in their database so you can see where your company stacks up. Making comparisons to industry averages is a huge value. The caveat, of course, is you have to find the best experts. There are a plethora of consultants out there. We all get pitched all the time. It's important not to waste resources, and most importantly, the management team's time, with a third-party expert that turns out not to be an expert at all.
Logan: However, oftentimes we would be willing to make a decision to spend more on a third-party advisor than a small firm would. So a business owner may not know what a pricing consultant is and he says: "Well I'm not going to spend $10,000 to have some guy come and spend two days working on my pricing." A lot of times it seems that private equity firms are willing to spend more money than a privately funded entrepreneur would to get results.
Noonan: You have to feel confident that it's a straight line to some realization on the back side of the return.
Fugazy: What are the biggest challenges private equity firms face when trying to create value today?
Masto: The biggest challenge is being able to build value in a lower-growth economic environment. You may get some value creation from leverage or other sources, but the biggest driver of building value is going to be through growth. In a low-growth economy, that's just harder to make happen, so it's all the more important to be good at picking the right niches and then developing the right plans to grow companies. It's achievable, but harder.
Durbin: We're all temporary owners of our businesses. We will eventually exit them. One of the big challenges is positioning the company-not with lipstick for exit, but truly position it-so that it has an enduring business model that the next owner will appropriately value.
Kelsall:When it comes to exits, every decision I made was always around how a potential buyer would look at a particular situation, strategy, customer, customer concentration, pricing decision, sourcing decision, etc. I was always thinking about when I wanted to sell. It's a challenge and it's important.
Also, acquisitions can be really positive to create short-term value, but they can be really detrimental on the takeout, because you may put businesses together that you think make sense but then they don't for potential buyers. You need to think about your exit strategy when deciding on acquisitions.
Logan: At the end of the day, the next investors have to see something that they're good at so they can add further value to the company that you built to a certain level. And knowing we've accomplished what we could and built the company to a certain level and know that it's someone else's turn is hard, but important. Being candid about that and find somebody who's a better fit at that point is very important.
Griswold: The biggest opportunity to create value today is through developing human capital, specifically building a management team that will be successful and continue to grow after our ownership. But that's also the biggest challenge. Employment surveys show that with every hire, there is only a 50/50 chance the employee will work out as expected. And with every management team change, there's a risk that the dynamics will change and the company will run off the tracks. So while there's huge opportunity in enhancing management teams, and that's what we get paid to do, recognizing the fact that human capital creates the biggest challenges is key. The equipment is going to run and the competitors are going to do what they are going to do. The only thing that differentiates one company from the next is how management teams react and respond.
Masto: It's a tricky exercise to find new hires that bring not only the right skills and experience, but also the right cultural fit, so that it gels together as you add people and make those changes.
Griswold: And that's an issue with acquisitions as well. It's easy to do an acquisition from a books and records perspective. It's a little more difficult from a cultural fit perspective.
Noonan: Merger integration is hard, about half of integrations fail to meet expectations. They still get integrated, but not successfully. Seventy to 80 percent of the problem is cultural and has little to do with good market position or the business model. It has to do with the blending of the management teams and their ability to execute together.
Roundtable Participants: Chris Durbin, managing director, Vestar Capital Partners; Danielle Fugazy, contributing editor, Mergers & Acquisitions (Moderator); Kirk Griswold, founding partner, Argosy Partners; Douglas Kelsall, operating partner, LLR Partners; David Logan, operating partner, The Riverside Co.; Chris Masto, co-founder, FFL Partners; Dave Noonan, national director for private equity consulting, McGladrey (Sponsor)