Today's economic conditions have curtailed the desire of private equity firms to exit their portfolio companies through initial public offerings or strategic sales, or to realize a return of capital through a dividend recapitalization. PE firms now hold their portfolio companies longer, and run them leaner.
Fortunately, many portfolio companies were able to take advantage of the unusually favorable capital markets in the recent past by negotiating covenant-lite terms and payment-in-kind toggle features that today enable them to better manage through the economic downturn. But while they may have some breathing room, PE firms are taking action both to cushion their portfolio companies through these rough economic times and prepare them for growth when a recovery begins.
The combination of leverage and a recessionary economy are creating even more of a laser focus on optimizing cash flow, performance efficiency and cost reduction. Here are a few of the steps they're taking:
Restructuring debt. Some portfolio companies have their debt trading at distressed levels in the secondary market. This is creating opportunities to repurchase debt at a discount or to do debt-for-debt exchanges that, even if the nominal interest rate increases, the outstanding principal amount of the debt as well as total cash outflows are reduced. These debt repurchases and modifications not only involve complex tax issues, such as cancellation of indebtedness income, but legal and business matters as well. On Feb. 17, President Obama signed the American Recovery and Reinvestment Act of 2009, which includes a provision for a significant tax deferral of COD income that could make debt transactions done in 2009 and 2010 even more attractive.
Fine-tuning treasury and cash management operations. Portfolio companies are finding ways to conserve cash and enhance working capital, such as improving collections and tightening payables management. For treasury and cash management operations, companies are putting in systems and procedures to better manage counterparty risk, rationalizing their banking relationships and implementing more sophisticated treasury technology to give their people better visibility into their cash management. They also are assessing global cash optimization opportunities, such as pursuing strategies that support cash repatriation in a tax-efficient manner.
Teaming with management. All companies need management teams that have the experience and know-how to operate for an extended period in a challenging environment. Some PE firms have assembled deep benches of talent in their operating partners who can support company management through difficult times they may not have encountered before.
Re-evaluating compensation and incentives. The C-suite occupants of many portfolio companies signed on in a much different economic environment. Now, instead of the optimistic growth scenarios of buyouts before the credit crisis, executives may find themselves and their companies with an uncertain future. Recognizing this, PE firms are working to keep key people motivated by re-evaluating stock options, performance bonuses and other rewards.
Improving efficiency and reducing costs. Tight times require a tight ship, and companies are looking at every possible means to rein in operating expenses. Simultaneously, they are carefully analyzing returns on capital deployment across the balance sheet and adjusting investment mix to maximize return. While difficult in today's market, some portfolio companies are divesting noncore assets to raise capital. Others are looking at smaller tuck-in acquisitions that might be more affordable and add to cash flows and synergies. Still others are employing shared services models with other portfolio companies of the same financial sponsor to enhance purchasing power and contain costs.
Building the brand, increasing revenue. Portfolio companies have to do more than just hang on to survive the downturn; they have to stay competitive by keeping their brands alive and laying the foundation for growth. To improve top-line performance, firms are considering different pricing strategies, creative customer retention programs, selective brand extensions and targeted new product introductions.
PE firms have to manage their portfolio companies more wisely than ever, paying close attention to their companies' finances, management and operations to help them survive the downturn and be ready for when better days inevitably return.
Chet Wood is managing partner, U.S. merger and acquisition services, at Deloitte Tax LLP. Barry Curtis is the national managing partner, private equity, at Deloitte & Touche LLP.