Finger on the pulse

Amid challenging economic conditions, slower dealflow and a dismal fundraising environment, private equity investors across the board have retrenched and continue to focus their attention and resources on managing their portfolio companies. The troubled banking industry and pressure on limited partners to rebalance their investment portfolios, specifically their allocations to private equity, have made it critical that private equity firms be more proactive about keeping these parties informed on how portfolio companies are faring. Many firms have even added senior operating personnel and functional specialists at the fund level to more closely monitor performance and provide on-call support for portfolio company executive teams -- with an overriding objective of preserving value.

Preservation of value often hinges on fundamental activities that rely on having steadfast confidence in financial and operational information being reported and a deep understanding of changes in revenue and gross profit drivers, cost structure and cash flows. This information must be grounded in actual accounting system and operational data, as credibility and reliability depend on developing direct linkages between historical financial information and management's analysis, forecasts and reporting of metrics used to monitor the business. There are certain things that both private equity investors and their management teams should keep in mind if they want to effectively keep "a finger on the pulse" and maintain the support and commitment from their lenders and limited partners.

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Identify your core competencies and profitability drivers. Evaluate which customers, products and services are driving gross margin by appropriately considering all components of cost and corporate allocations. Use this data to identify losers that are dragging the business and threatening liquidity. Frequently companies do not fully understand profitability metrics due to incomplete cost data.

Analysis and forecasts need to be based on actual data rather than management's wishful thinking. It is important that an understanding of the business is validated beyond management. This helps avoid paranoia and reinforces that the private equity firm and management know what is happening at the company.

Good management reporting should be actionable and informative. Take the time to identify the right key performance indicators, or KPIs, that gauge the health of the business and make sure that data is being compiled accurately and presented in a way that makes analytical sense. Use management reporting and dashboards as tools to identify problems and performance improvement opportunities early.

More commonly, operating partners and functional specialists are being hired to handle a variety of issues across a number of portfolio companies, including strategic matters, enhancing operating efficiencies and monitoring financial performance. Although this trend represents a positive direction across the private equity landscape, the effectiveness of these individuals is often reduced by the depth and breadth of their charge. To get the most out of these important roles, the focus should be on project management with the appropriate mix of external consultants and advisers to assist operating partners with executing plans.

Implement review and monitor processes at each of your portfolio companies to ensure financial information is subject to a system of internal controls that supports accurate financial reporting. Scrutinize all financial information provided by management to ensure important issues aren't being missed. Consider periodic quality of earnings analysis by a third party to validate management's reporting of results to provide to lenders and limited partners.

Developing a plan to appropriately monitor and measure performance becomes even more difficult when you are overseeing a portfolio comprising several distinct businesses across multiple sectors with varying levels of talent among financial management teams. However, an unrelenting focus on existing investments is mandatory to (i) effectively communicate actual performance and expectations to lenders and limited partners; (ii) decide on whether to invest follow-on dollars; and (iii) react to early-warning signs of marketplace changes and trouble in the core business. Sound portfolio management decisions and meaningful communication with stakeholders is heavily dependent on the quality and integrity of underlying accounting information and analysis.

Mark A. Coleman is a partner with Laurus Transaction Advisors, a boutique firm focusing on financial and accounting due diligence and private equity consulting.

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