Over the past few decades, private equity (PE) firms have mastered value creation for portfolio companies and clients through PE outsourcing, cost reduction, financial engineering and automation. In addition, PE firms are experienced in recognising patterns that enable them to identify and invest in the most rewarding portfolio targets. On the contrary, PE owners generally don’t have this expertise in commercial productivity.
Commercial improvements, such as a better customer-product mix, competitive company pricing and growth in sales volumes, support significant value creation for both PE owners and portfolio companies. When PE firms take on pricing in their portfolio companies, clients notice margin growth between 3% and 7% in a year. A potential improvement in pricing allows PE firms to gain more confidence in their growth potential and set themselves apart in competitive deals. This rapid margin expansion from pricing transformation results in greater value creation for both investors and portfolio companies during the fixed holding period. Additionally, a track record of successful improvements in pricing, digitisation, outsourcing and environmental, social and governance (ESG) objectives could result in higher exit valuations. The best opportunities for value creation lie in these areas.
Strategic PE outsourcing
Historically, PE-owned companies in the mid-cap range have opted out of using PE outsourcing, owing to their fear that service quality would decline. They are also of the opinion that outsourcing is better suited for larger companies. However, PE-owned companies could explore outsourcing as a way to access innovations, new technologies and advanced capabilities, which would likely result in revenue growth and increased profitability. PE outsourcing is no longer limited to just large companies, as more and more outsourcing service providers have now started targeting mid-sized firms.
For maximum value generation, firms of all sizes should consistently analyse and identify areas where PE outsourcing would generate value for each stakeholder. This includes non-core competencies of the firm, such as technological innovations or cost-efficiency strategies (which could be lagging). Outsourcing these activities would help a PE firm accelerate its growth by helping it focus on its core offerings, accessing advanced capabilities and technologies, and reducing operations costs.
Automation and digitisation
Enterprises have accelerated their digital transformation journeys exponentially since the global pandemic set in. PE-owned companies have to move faster today as they digitise models and automate their business processes.
To accelerate digitisation, both large- and mid-sized companies have to invest in value-creating activities. Multiple processes, such as product reconciliation processing among companies, invoice payments through multiple systems, payroll processing, utility bills, tax exemptions, reporting tasks and general accounting, could be interconnected once automated. Data from the 2021 EY Private Equity Divestment Study shows that 51% of all PE firms view artificial intelligence (AI) as a critical value-creating domain for portfolio companies within the next 24 months. Besides increasing process and control automation, AI supports decision-making and forecasting that have a direct impact on cash conversion and margin enhancement.
Activities that generate value can see outsized investments in capital, focus and time where business-critical activities can be streamlined, automated or outsourced.
ESG in PE
PE professionals are currently facing growing pressure from limited partners (LPs) to add ESG goals to their businesses and strategies. PE firm executives place ESG initiatives among their top three strategic priorities (at the enterprise level), along with talent management and strategy and product expansion. With ESG becoming a leading driver of disruption and change, business and client expectations have shifted to value generation from risk management. According to leading PE investors, an ESG profile is critical in determining whether a deal will close or not.
Due diligence for enterprise-level ESG allows PE firms to identify value in target organisations by analysing services and products from start to finish, including source materials, multi-tier supplies, waste and recycling. For existing PE portfolio companies, an operator can mitigate their ESG risks or choose to capitalise on opportunities for value addition. A proven method of doing this is conducting an ESG materiality analysis of existing assets to identify companies with intensive emissions and find ways to reduce their carbon footprint. Other methods include training teams in ESG skills and investing directly in ESG initiatives at portfolio companies.