Justify recently joined the elite group of Triple Crown winners. But, as anyone who’s ever bet the ponies knows, they can’t all be Justifys. Sometimes you get a winner and sometimes, for reasons that aren’t quite clear to anyone, you get an underperformer.
It’s a concept with which most fund sponsors may be intimately familiar. You bet on the investment because you foresee its potential and understand the path it needs to take in order to achieve it. Sometimes you get a mudder – an investment that thrives under institutional ownership, meeting, if not exceeding, expectations. And sometimes you get a stuck-in-the-mudder – a portfolio company whose progression has stalled or gone sideways.
But, don’t shoot the horse just yet. The first step is to acknowledge its existence in your portfolio. The second step is to understand the many parties that have a stake in its success: yes, the fund sponsor, but also the management team and the lenders. And, the third step is to diagnose the problem and rehabilitate the investment.
Recognizing the Problem
In its broadest definition, a ‘stuck-in-the-mudder’ is a portfolio company where there is significant underperformance relative to expectations (specifically cash or Ebitda) and there are enough performance surprises to suggest management is not fully in control of the business.
That said, every investment is unique and no catchall definition will ever be comprehensive enough to capture the complex tapestry of characteristics that, when combined, lead to underperformance. And so, aside from the most obvious indicators of trouble (negative Ebitda coupled with a lack of liquidity), there are subtler markers that can (and should) flag where an investment might be stuck in muddy terrain. They tend to come in three varieties:
1. The financial markers: Here we see a lack of financial predictability, coupled with frequent budgeting and forecasting errors or missed targets. Margins may lag behind expectations. Capital investments may not be producing the expected efficiencies. The biggest flag, of course, is that cash generated by the company is not meeting expectations, particularly as related to the debt structure. The company is not throwing off sufficient Ebitda or cash to satisfy its stakeholders, and is, potentially, running the risk of covenant default. Or, maybe the company hasn’t yet run out of cash, but liquidity trends are a concern with no clear line-of-sight solution available.
2. The management markers: Here we see issues with management’s closeness to the business, often in the form of a significant disconnect between what management said would happen and what the actual, tangible results are. As is often the case in this scenario, the team lacks an acute understanding of the drivers contributing to underperformance. Sometimes that lack of understanding can be traced back to plans that are not tracked and/or lack measurable KPIs. And sometimes, it’s not a lack of understanding as much as it is a lack of acknowledgement of underperformance. But, management markers can also manifest in important non-financial flags. Product quality concerns, customer service issues, and employee unrest are all signs of underperformance attributable to underperforming management.
3. The market standing markers: Here we speak of underperformance relative to industry or market competition. Market markers are particularly problematic when the investment is based on a platform purchase with subsequent add-ons. If the outcome of serial acquisition has not been greater than the sum of its parts, that could suggest a ‘stuck’ scenario in which capital was mis-deployed or integration plans were poorly executed.
Rehabbing the Problem
So, your horse is stuck. The question becomes: how do you correct to get in racing shape?
The easy answer is that you have to find and release the trapped cash and Ebitda potential in the company – unlock the promise first noted during diligence and initial investment. The more difficult part is finding an effective way to do that. Here we suggest six potential strategies:
1. Must be the money: Start with the cash flow. Where does it come from? Where does it go? Building a detailed liquidity forecast is critical for all businesses and particularly critical to getting to the root of underperformance. A 13-week cash flow can be useful even absent significant liquidity problems (and should be mandated where those liquidity issues exist). Once you understand where the money is coming from and where it’s going, you will have enhanced visibility into the economics of the business.
2. Know thy customer: Because, they’re not all created equal. It is critical to assess who the customers are and their relative importance to the business. Which customers are helping profitability, and are there some who are not? In tangible terms, implementing a detailed SKU profitability analysis of customers and products can illuminate quite a bit about where the business is making money and where the business may be trading dollars (or worse). With this enhanced visibility, higher value customers can then be catered to, while lower value customers may ultimately prove a hindrance to profitability. (And yes, you’re allowed to fire them in such cases). Target the ‘low-profit’ portion of the product portfolio for improvement. Linking this knowledge to the sales function can generate significant performance improvement quickly.
3. Let the sunshine In: Often hidden costs develop across an organization related to the creation and deployment of products and services. Product margins are meaningful measures but, in many companies, those margins do not account for the totality of product costs. Implementing a zero-based budgeting process can help uncover those hidden costs. Matching those costs to their related functions will then help establish the effectiveness of those costs on behalf of the customer.
4. The big spender scenario: Know it. Avoid it. Conduct a deep-dive spending analysis to determine how revenue is related to expenses. In too many companies, particularly in underperforming ones, the spend on SG&A activities is misaligned to revenues. Identify, analyze and track spending trends to find where resources are not being applied to quality revenue-producing activities. If needed, cut them out, scale them back, or redeploy to more value producing activity.
5. Who’s the boss? Too often, that answer is not clear. Companies undergoing change need well-communicated lines of organizational responsibility coupled with strategic leadership. When the model is either not clear, or simply not adhered to, it can create confusion that makes progress hard to measure and almost impossible to track. Establishing a proactive, timely communication process matched with visibility tools to identify priorities and review progress of action plans, can help achieve improved performance cadence.
6. Define success: What are we trying to do? What does the transition from ‘stuck’ to ‘success’ look like? Course corrections come complete with a huge list of ‘to dos.’ Businesses that successfully undergo change understand the difference between the want to dos and the need to dos. To effectively change the trajectory of an underperforming business, management should prioritize the need list and build tactical programs around it. For example, if the goal is Q1 profitability, how do we achieve that across organization and by department? How many new sales leads do we need to convert? How much inventory do we need to think about buying? How does the weekly invoicing plan compare to the operations plan? This requires a granular understanding of the business – the sum of the learnings from the list above. If, after all the aforementioned analysis, the root causes of underperformance are clearly understood, then implementing corrective initiatives will also require changes in measurement methods. Building and tracking the right KPI measurement tools to monitor those initiatives is critical.
Now, not every investment will return Triple Crown payoff. But, for the sake of all investment stakeholders, fund sponsors must quickly recognize and rehab an investment that’s gotten stuck in the mud. It can be done quite successfully. But doing so will take both an honest assessment of the situation and people, coupled with a willingness to take some of the meaningful steps (outlined above) required to change the trajectory of an underperforming business.
And off to the races we go…