Due diligence and execution capability
Ask a random list of Wall Street analysts what in the new world of private equity will separate the winners from the pack, and they are likely to fall back on a familiar list: creative deal sourcing, structuring, use of leverage, reputation and so on. Yet, what is increasingly apparent is that what will really make a difference in the brainy strategies of PE is old-fashioned execution. What former Honeywell International Inc. CEO Larry Bossidy called "the art of getting things done" is driving portfolio company profit growth, increasing revenues, cutting costs and proving to be the best formula for using working capital more efficiently. Execution, not financial engineering, is the alchemy portfolio managers are seeking.
Most PE firms have no idea if the company they are about to acquire knows how to execute. Many still rely on a traditional due diligence process that fails to measure a company's ability to execute core business activities like acquiring and keeping customers, producing and delivering a service or product that customers value, or getting paid and paying suppliers.
All too often, the PE due diligence process focuses on risk mitigation issues such as accounting, treasury or IT -- all of which are critical but do not provide insight into a company's ability to achieve its growth strategy. Another common problem is the tendency to look at operational elements, such as talent quality, in isolation, which yields an incomplete and possibly misleading sense of capability.
As a result, PE due diligence is failing to gauge the critical question: How can we effectively grow earnings by developing stronger, more effective operations? While most firms use great care and precision to develop a robust investment thesis, often they forget to match that level of rigor in understanding a target's ability to execute that thesis in a disciplined way. When the history of the most recent boom and bust cycle of private equity is written, the shocking lack of intelligent due diligence will surely emerge as a leading culprit of the problems so many firms encountered over the past two years.
By evaluating a target company's execution capability, it becomes possible to understand how well the company is implementing its strategy. It also provides a framework to determine the type of operations a company needs to reach its desired future state. Every deal has detailed projections for the size, margins and cash flow of prospective investments at exit. However, few have an outline of what operations will be needed (footprint, products, capabilities) to support that future business or a road map for building those operations efficiently over time.
Getting a true sense of operations can be tough. For starters, most companies' accounting systems aren't set up to look across activities. Those that are (for example, activity-based accounting systems) typically look at specific product costs, not at higher-level operations metrics across value streams. While product-specific costing allows an understanding of unit economics, it doesn't provide a more strategic view of capability -- how long and how much it costs to do what makes a business unique.
Also, more often than not, operating performance is measured strictly through averages. While averages are useful guides to understanding how well a business is operating, looking at distributions around the mean provides an invaluable sense of where opportunity (or risk) exists.
One PE firm, for example, was taking a hard look at a retail company for acquisition. The company's finance team reported that it had average inventory variances of less than 1%. But when the PE team looked deeper at inventory, at an item-by-item level, it found significant variances among the SKUs.
These variances suggested a very different execution story at work: (1) a weakness in the company's forecasting and inventory management systems; and (2) the need for a different view of a specific product/customer group. These discoveries didn't spoil the sale. But they prompted the PE firm to refine its growth strategy and identify the need to invest in better forecasting tools.
Understanding execution early will also prove essential to mapping out what operational capability will be essential to meet future investment goals. Rarely is profit growth linear -- "we'll just do more of the same and make more money." Rather, it requires doing things differently: serving different customers, producing different products, operating faster or cheaper. Stretching operational capabilities in these new ways poses a variety of challenges in terms of people, processes, information technology and infrastructure.
People. Do we have the right skills, the right customer relationships and the right understanding of strategy to get to our desired future state?
Processes. Are the underlying metrics that will get us to our future state moving in the right direction? Do we measure or have an understanding of the root drivers of our current results? What will we need to do to improve them?
Information technology. What kind of information forecasting and results reporting will we need to run our business in three to five years?
Infrastructure. Do we have the right footprint and the right cost/service levels to support our growth?
By planning for these future needs up-front, private equity firms can drive changes more quickly and effectively.
For example, one private equity firm target had deep expertise in long-cycle manufacturing of highly engineered products for a relatively small number of sophisticated big buyers. Its growth strategy called for serving new types of customers. As the diligence team looked at those new customers' specific expectations, it found that the company would need to adopt a different sales/service model and a shorter cycle with a more flexible production model. Anticipating these changes up-front allowed the company to plan, budget and track development of the right capabilities from the day the deal closed. Mapping out a company's core execution capabilities across key activities can provide PE firms with a comprehensive view that they can work toward with management. This allows investment firms to evaluate the growth potential of the target's business much deeper, helping firms budget more accurately for the type of growth capital needed, and to drive a much richer conversation with management about the "how" of their strategy, helping position investments for success.
To date, firms that have recognized the new imperative around profit enhancement have added operations talent to their team in the form of former CEOs or management consultants. This is a good start, however, the execution capability needed to truly differentiate an investment firm goes much deeper than what just one or two portfolio board members or some tactical advisory work can provide. This capability must be at the heart of the investment process, from due diligence to growth planning to ultimate execution.
In the long run, private equity firms must make execution capability a core competency, much like General Electric Co. did with Six Sigma or Toyota Motor Corp. did with lean operations. Using operational excellence to separate oneself from the pack is a strategy that works -- and it's high time for private equity firms to take these decade-old lessons to heart.
Richard Crowell is managing partner of Vance Street Capital LLC, a private equity firm. David Niles is president of SSA & Co., an operations consulting firm.