Looking up from the down cycle

It's no secret that the economic turmoil and slowdown in the broader economy has been much worse than most had anticipated, and its effects have been felt across the private equity industry. While the consensus seems to be that investment activity will gradually pick up again, currently a great deal of committed capital remains on the sidelines as PE funds focus on preserving the value of their existing portfolios.

For the smaller companies that comprise middle-market PE portfolios, the increased emphasis on cutting costs and maximizing efficiency that typically accompanies an economic downturn presents some unique challenges that are less prevalent for larger-cap portfolios. This is especially evident when it comes to lower middle-market portfolio companies, valued between $25 million and $125 million. Individually, these smaller companies often lack the scale and resources to effectively navigate difficult economic conditions. As a result, it is critical that middle-market PE firms focused on the lower middle market adhere to a few key practices in order to successfully manage the portfolio through the downturn and position portfolio companies to grow when the market recovers.

PE firms need to be hands-on when it comes to teaming up with middle-market portfolio companies. Passivity, even toward a portfolio company with a phenomenal management team, presents a number of unappealing and unnecessary risks, particularly in this economic environment. PE portfolio managers should be prepared to roll up their sleeves and get their hands dirty where it makes sense, being careful to maintain the balance between maintaining a constructive relationship with management while still driving results.

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Take a metrics-driven approach to managing the portfolio. Have a deep understanding of the variables that are driving the portfolio's performance and use it to shape the management planning and strategy. Keep a close eye on performance as the plan rolls out to ensure things are moving in the right direction. Set early goals so that management will gain acceptance within the organization.

In a down market, cost savings is obviously a priority, but it's also important to maintain a long-term focus. Strategic planning to build the business in a down market -- for example, expanding to Asia, or building a stronger sales and distribution system -- can help a company accelerate its momentum coming out of the down cycle. Look to reinvest savings into market share opportunities to take advantage of weaker management teams at competitors. Identify costs, inefficiencies and other opportunities within the portfolio and develop strategies to address them. The good news is the environment is perhaps never better for negotiating with third-party vendors than in an economic downturn. In the middle market, aggregating purchase power creates the scale needed to cut costs on commodities like healthcare, insurance and freight, and also on indirect spend like IT, telecom and office supplies.

For example, Baird Private Equity has had tremendous success aggregating costs for health and welfare benefits, one of the largest areas of common spending across all companies. Individually, smaller companies have limited leverage for price negotiations and gaining access to higher-quality service and data to manage claims and wellness. By leveraging the size of the portfolio and working with brokers and providers, Baird Private Equity identified potential savings of 10% to 15% at each participating company. These savings are significant, considering the cost of healthcare for most companies is increasing by double-digit rates.

Successful middle-market PE firms can add tremendous value to their portfolio companies by providing management with tools and resources to which the portfolio companies otherwise likely wouldn't have access. When portfolio companies need help with items like strategic planning, supply chain management, top-grading talent, and sales training and process, it's important for a PE firm to be able to leverage its network to help determine a path forward.

For example, with smaller companies there is always an opportunity to top-grade management, and it's not difficult to find great talent in a down market. While smaller companies may have one or two strong senior leaders, typically they have weaker infrastructures and systems where PE firms can help. For example, a PE firm might connect a portfolio company with a seasoned executive for counsel on how to most effectively build a sales force. In another instance, a PE firm might host a workshop to help a portfolio company identify and structure sourcing strategies in China and India. Overall, having a "tool kit" of resources to address these needs can be a very effective way to help drive value throughout the portfolio.

Facilitate opportunities for portfolio company executives to tap each other for feedback and share best practices. On a quarterly basis, Baird Private Equity convenes executive roundtables to facilitate knowledge sharing among executives across the portfolio. The roundtables cover a wide variety of management topics from cost savings opportunities to best practices for protecting cash when the liquidity crisis was taking hold. The most recent roundtable brought together portfolio company CFOs to discuss how their companies were faring through this challenging lending environment.

When it comes to developing strategies to address the needs of portfolio companies, sometimes one size fits all, sometimes that's not the case. Flexibility is perhaps the singularly most important key to successful portfolio management in the middle market. While some of the portfolio companies' needs are quite similar, others may require more customized individual solutions, and a portfolio management team needs to be nimble enough to accommodate those instances.

Ultimately, the goal should be to position the portfolio to meet or exceed investment objectives and generate meaningful returns for investors. Baird Private Equity's portfolio management program has generated more than $10 million in savings across the portfolio in the past two years alone, and for $5 million to $15 million Ebitda companies these are real savings. PE firms that have a focused portfolio management team to drive these initiatives, analyze the risks of the portfolio and use the portfolio size and resources to its advantage will be the most successful in today's environment.

Rob Ospalik, principal, and Fred Niemeier, vice president, lead the portfolio management program at Chicago-based Baird Private Equity, the global private equity group affiliated with Robert W. Baird & Co.

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