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— Judgment Call —
A little more than 18 months ago, at the height of the hottest deal market in recent history, private equity firms were generally too busy to consider leveraged procurement for their portfolio of investments. Other macro-strategic initiatives trumped the perceived "low effort-minimal value" proposition. But as markets changed, so did the minds of portfolio managers under massive pressure to generate quick, yet sustainable, cash flows, which can no longer be accomplished easily through acquisition, divestiture or organic growth. Enter one of the oldest cost-savings strategies in business: buying in bulk. Leveraging the buying power of a portfolio can save a lot of money. That's why large conglomerates historically have migrated to a centralized purchasing strategy, often called "strategic sourcing" -- one that leverages the combined purchases of disaggregated business units. PE firms have adopted a piece of the Wal-Mart Stores Inc. business model, using their power in the marketplace to gain pricing advantages.
PE firms are negotiating with suppliers for discounts that can benefit their entire portfolio of companies. These purchasing synergies become especially attractive with the recent downturn in deal activity, coupled with deflated multiples and longer investment-hold times. The result: Some of the largest PE firms and many in the middle market are generating millions of dollars in cash and tens of millions of dollars in exit value. One clear advantage of cross-portfolio purchasing agreements is that the savings flow directly to the bottom line, to be used to pay down debt or finance other investments. The added cash flow also may raise the company's purchase price. Generally, cash savings will bolster Ebitda, where it will usually benefit from a multiple in the purchase price calculation when a company is sold. This kind of value can very well exceed the investment in a centralized purchase program. It also benefits the supplier. Vendors representing supply categories -- such as small-package and parcel-delivery organizations, temporary labor providers, computer and office supply houses, telecommunications companies and others -- are welcoming the opportunity to work with PE firms and appreciate the PE value proposition. For instance, this type of arrangement allows a vendor to create a relationship with both the PE parent and its portfolio companies, and may offer an opportunity to add the PE firm's future investments as new customers, all with relatively low acquisition costs. Of course, there are several real and perceived potential challenges when developing cross-portfolio discount programs. A successful PE investment is one that is eventually sold or spun off as an initial public offering; therefore, there is always a question for both the supplier and the PE firm about whether the discount will be able to move with the portfolio company without creating burdensome complications or carve-out issues. The increasing prevalence of these types of arrangements has made it easier for PE firms to include contractual provisions that allow the portfolio company to maintain the discount post-divestiture. In other words, these discounts have become portable. Many of the indirect and general and administrative suppliers have embraced the value proposition of PE customers and consider their business an "annuity." They keep all of the current investments as clients after a deal closes and add the new investments as well. Other potential concerns include disruption to the business, loss of purchasing control, introduction of mutual responsibility across the companies and development costs. PE firms have been able to avoid these issues, for the most part, by instituting these programs using a proven methodology. In addition, some PE managers are initially put off by the perception that these purchasing programs may not be worth the payback. They ask: "How much can you really save by consolidating the purchase of paper clips?" However, PE firms that have analyzed such programs and adopted the approach have found that the cost savings can be significant over time. Many have achieved in excess of 300% of their investment/development costs -- and this is typically achieved in the first 12 months of a program's inception. Private equity firms that are interested in establishing cross-portfolio purchasing programs should be prepared to undertake a multistep analysis of their purchasing decisions. The analysis should look across the portfolio at the needs of each company to identify which purchased services or supplies they have in common. In addition, the analysis may offer other opportunities for savings, from streamlining IT systems or implementing regulatory compliance requirements more efficiently to functional improvements in business-performance strategy and even internal audit needs. The analysis could even touch upon such strategic requirements as how to approach the U.S. market's potential move to international financial reporting standards. One fund manager said her team first tackled noncontroversial areas, such as office supplies, information technology, small-parcel shipping and telecom services. After successfully implementing the initial purchasing programs, the fund decided to tackle healthcare, which has more emotional ties for employees but which also was the largest percentage of indirect spending at its portfolio companies. In total, the fund saves about 15% a year in supplier costs through the various purchasing programs. It also achieves better participation and buy-in by setting up steering committees of key personnel from portfolio companies that are heavy users of the particular goods or services being purchased. Meanwhile, a midmarket PE firm that spans the education, healthcare, technology and direct-marketing industries had a similar experience. A focus on key general and administrative categories allowed nearly all of its investments to achieve better pricing and terms than they had been getting, even if the companies individually had "best-in-class" purchasing. The fact that the portfolio companies spanned numerous, varied industries was not a deterrent. With financing issues and reduced multiples continuing to affect private equity, it is likely that more firms will turn to executing operational improvements within their portfolio to drive returns. Leveraging a portfolio's procurement strength is just one of these operational improvements, and PE firms should be on the lookout for other opportunities beyond financial restructuring as a way to generate added value. Jeff Schlosser is a principal with KPMG LLP's transaction services practice and is a member of its U.S. private equity group team. |
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