What Private Equity Numbers People Miss When They Evaluate Operations

By A.J. Murphy

We were highly interested in a recent Forbes contribution from a group of Bain & Company private equity folks, which highlighted the rising prominence of operational due diligence in private equity deals.

The authors cite “margin assessment” as the only factor that appears on both their “liability” and “winning factors” lists — and discuss ways that a parallel march through a target entity’s books and ops will ensure better use of investment money. We certainly wouldn’t dispute that.

But even the very bright numbers folks who incorporate a disciplined view of operations in private equity deals can hamstring themselves in terms of valuation and post-investment ROI — creating unnecessary risks and missing big opportunities.

It is telling that the case study offered in the article cites the success Apollo had in 2011 when acquiring a majority stake in an aluminum products company, Constellium. Success was driven in part by focusing on not only procurement process savings, but reworking the culture of the procurement department.

Moving Beyond “Squeeze and Slash” to Find Better Acquisition Prices and Better ROI

This is the standard drill when a private equity group takes over operations: The PE folks may or may not know what they’ve really got in terms of operations, but they know enough to grill every group in the company and find out what they’re spending. Armed with benchmark spending data, they often approach line-of-business leaders post-acquisition and simply start demanding cost cuts. (“Synergy” is often just another word for “give me more money.”)

While the Apollo outcome referenced in the Forbes article is wonderful, most PE firms simply don’t have the deep operational perspective to achieve outcomes like this. The default vision of ops becomes “squeeze and slash.” (During the conclusion of the article, this mindset re-manifests: “During uncertain economic times, the best way to reduce the risk of a deal is to attack baseline costs from year one.” Not untrue, but perhaps myopic.)

Here are a few blind spots we typically see:

Corporate culture and the intent of the deal: Intention is a massive organizational driver. Unexamined, it’s a liability. You’d be surprised how many times M&As are driven by the simple fact that there’s money to spend. This is not a rationale for investing in or acquiring a new company.

Take the massive Exxon/Mobil deal: The financials worked and, ostensibly, it was to be a merger, when in fact it was simply a big fish (Exxon) eating the smaller fish (Mobil). They advertised one intent and enacted another, seeing 10 years of headaches and delayed ROI when Exxon’s military, data-driven culture clashed with Mobil’s supportive, mentor-oriented organization. Hundreds of millions that never showed up on a balance sheet were burned trying to overcome this disconnect.

Intention is a massive organizational driver. Unexamined, it’s a liability.

Underestimating risk: Few PE numbers-crunchers are able to examine operations and regulatory landscapes that can severely jeopardize realization of value. They are rarely equipped to turn over enough rocks to assess the top 10 reasons why a major plant might go down for a year or what happens when there is a spill in a region where a high concentration of lawyers are practically waiting in their driveways, engines running, to go file massive class-action suits at the courthouse.

Simply paying too much: When due diligence encompasses deep operational perspective (that in turn includes culture, systems and technology), PE firms can make the most important cut of all: the purchase price.

A multibillion-dollar petrochemical manufacturer once engaged us for an urgent due diligence project in advance of acquiring a North American polypropylene manufacturer.

Our analysis of operational assets; forecast of potential for operational, maintenance and reliability improvements; technology portfolio, innovation pipeline and effectiveness of processes; cultural/management opportunities and threats revealed, among other things, $15 million in deferred capital issues that gave our client massive leverage when discussing terms.

Ignoring productivity’s rapid impact on margins: Cost-cutting is a valid avenue, but what happens when we take a slightly longer term view about how to quickly assimilate disparate processes and cultures? In manufacturing or similar sectors, the ability to eliminate redundant processes, align people and “make more stuff” can solve production bottlenecks and rapidly add margin to the bottom line. But a strict cost-cutting view from the balance sheet will not reveal these opportunities.

When we deepen our perspective on all the factors that will impact ROI, we see a universe of attainable options for identifying the right targets, finding the right acquisition or investment price and delivering ROI beyond cost-cutting. In examining all the factors from a deeper ops perspective, private equity firms will build bigger value in their portfolios in both the short and long term.

About The Sinclair Group

Business leaders and advisors in heavy asset industries (energy, manufacturing, construction, chemical/petrochemicals) turn to us when they have an urgent mandate to achieve greater performance, profitability, production, asset protection or predictability — even in the face of persistent problems that resist every known incremental fix.

We typically deliver 10X ROI on our engagements because our principals’ deep industry expertise and InsightIQ™ model help you radically challenge entrenched assumptions about your business. You can’t solve differently until you see differently. We find amazing outcomes that are currently hidden at the intersection of company, culture, industry and operations. Find out more about how Sinclair Group can help you create dramatic results from a new view of what’s possible.

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