Operational Engineering is the Key to Value Creation: Future Trends in Operational Engineering

By Anand Patel

The financial crisis of 2008 revitalized the way private equity firms create value. The credit crunch has significantly reduced the ability of firms to secure leverage.
Exhibit 3

Thus it has been difficult for firms to utilize leverage to implement consolidation and LBO strategies resulting increased deal competition, driving up prices for buyers. Consequently, operational engineering has proved to become the main strategy PE firms employ to generate high returns and create a competitive advantage.

In light of the Euro zone debt crisis, the importance of operational value-added strategies will continue to be the key in private equity. As more PE firms master operational improvement, new areas of value creation will have to be exploited to avoid an increase in bid prices resulting from increased competition.

In this paper, I discuss the importance of operational improvement in value creation and the strategies and frameworks top firms have employed to drive operational enhancement. Next, I explain the growing need for PE firms to innovate new approaches for value creation in order to differentiate themselves from competitors. I identify the under-utilized operational improvement strategy of top-line growth, compared with the numerous cost cutting strategies that dominated the 1990s. Included is a framework for driving organic growth capabilities across portfolio companies.

Lastly, I discuss the opportunity for value creation from business wide focus on sustainability improvements. Finally, I demonstrate the success of top-line growth

strategies and sustainability initiatives in value creation using real-world examples of firms that have implemented said strategies.

Historically, private equity firms had relied on financial engineering for value creation by applying leverage and multiple arbitrage strategies. The availability of cheap debt allowed for firms to implement multiple arbitrage strategies using leverage. An example of a successful industry consolidation strategy is exemplified by Blackstones roll-up strategy in The Merlin Entertainment Group Case. Firms realized increased ROE by taking on more debt.

In the 1990s, private equity firms discovered the benefits of operational enhancement for value creation in portfolio companies. Even during the boom of credit in the mid 1990s, top firms relied on operational improvements to create value. A 2005 McKinsey & Co. study of deals completed by 11 leading private equity firms revealed that company outperformance was the main driver of value in almost two-thirds of the transactions. 1 Company outperformance constituted 63% of value creation, compared with only 32% driven by financial leverage and market appreciation. Multiple arbitrage created only of 5% value.

The 2008 credit crunch solidified the importance of operational engineering as the key to value creation in private equity. Moreover, the inability of the euro zone to solve its debt crisis in the past few months foreshadows the continued lack of available cheap debt in the coming years. It will serve as an impetus for the continued importance

of operational improvement as a key competitive advantage for firms to create value in portfolio companies.

Although the idea of operational improvement has spread across the private equity industries, top firms maintain their competitive advantage with effective strategies and frameworks for maximizing operational value creation. Effective frameworks and strategies incorporate basic aspects of private in creating a strong value creation regiment. 2 & Exhibit 1 Most importantly, the goal of PE is to attract investment through financial engineering and increasingly through operational improvements that create value. Firms should focus on companies and projects that are core to the portfolio companys future value, utilize capabilities already available to the company, and have the building blocks to build financial performance in the future. As a result of highly leveraged acquisitions in private equity, these improvements should be focused on liberating and generating cash quickly. Strategies for improving cash flow reside in the broad value creation categories, increase profits and improve capital efficiency. To increase profits, firms can either grow revenues through pricing and volume or reduce operating costs in COGS and SG&A. To improve capital efficiency, firms work toward reducing working capital and improving fixed capital. To reduce working capital, firms can improve inventory management and improve receivables/payables terms and timing. Firms can improve fixed capital with long-term strategic project investments.

In operational improvement, the differentiating factor is the not finding potential opportunities, but in determining the right areas to invest. The reason is because private

equity firms have a short investment horizon in which to make improvements. Firms assess opportunities by comparing the level of difficulty, costs of implementation, and estimated time required to see the desired change to the operational improvement sweet spot to create value. Exhibit 4 The timing of enacting operational improvements is so critically important that many firms create 100 day plans that outline in detail the operational strategy the firm plans to implement. Ideally, the plan will detail two or three high value/high risk and difficult projects and many quick improvement strategies that are easy to achieve. PE managers also should religiously track certain metrics that drive success.

To sustain the ability a firm to improve performance, the firm must have permanent access to operations experts. As we learned in class, the Operating Partner Model is one of the most effective and widely used methods. The model has three variations of implementation strategy. The Elder Statesman variation involves maintaining long-term relationships with retired executives on industries on the investment horizon. The In-House Consulting variation obtains a full internal staff with deep industry expertise in specific functions. This model works for large PE firms that can absorb the overhead costs. Lastly, the Integrated Partner model is a hybrid that combines characteristics of the two previous models with the internalization of a group of former industry executives.1

Finally, in order to ensure that the senior management team in a portfolio company is aligned with the PE firms strategy, PE firms need to incentivize company

managers with performance based compensation based on aggressive performance targets. This strategy is known as getting Skin in the Game, because it matches managers financial compensation to the performance of the company.

In the 1990s, the majority PE firms had become so adept in financial engineering that the benefit was going to sellers instead because of increased competition among buyers. This led to PE firms moving toward creating value through operational improvements. This involved process improvements, outsources, restructuring, or anything involved with cost cutting. As a result of the emphasis on operational improvements in the 1990s, PE firms have also mastered the art of driving operational enhancement in their portfolio companies.

The fact that the majority of PE firms are highly experienced and skilled in both financial and operational engineering coupled with the overall reduction in PE funding and available debt to PE firms has resulted in aggressive competitive bidding that has driven up the price of acquiring companies and making deals. Rather than paying huge price premiums to secure deals on bargain/distressed companies, PE firms need to look towards new approaches of value creation. I identified two growing trends for additional value creation: focus on organic top-line growth and the capitalization of ESG issues to create a competitive advantage.

In the advent of operational improvement, the majority of PE firms focused on bottom line improvements and overlooked the value of organic growth creation.

Revenue growth is an age-old strategy, but in response to current economic conditions top line growth can lead to increased returns for PE firms and attract investors. In order to engineer organic growth in portfolio companies, PE firms need to add new growth capabilities, restructure interaction with portfolio companies toward growth, and ensure growth is created net free.

Methods of creating organic growth capabilities depend on the specifics of the PE firm and the industries in which it invests. However, PE firms can apply two general growth capabilities across all portfolio companies, better pricing ability and improved sales force practices. Also, it is vital that PE firms make organic growth the main focus of value creation for portfolio companies, so growth initiatives are not undermined by cost-cutting measures. One concept PE firms use to refocus portfolio companies on organic growth is headroom. This framework involves assessing switchers, customers that could potentially switch companies, and what would it take to attract those customers to switch. Most importantly, PE firms must ensure that investments growth initiatives are net free. This means that cash invested in growth capabilities come from savings attained elsewhere in the portfolio company. Another positive aspect of organic growth enhancement is the positive impact on the fund raising and deal making process. GPs will be able to improve fundraising by selling a history of organic revenue growth in previous portfolio companies. Moreover, firms that master organic growth early on will be able to win more deals and provide rich returns for investors. A real life example of the effective use of organic revenue growth is KKRs management of Dollar General. From the beginning, KKR primarily worked on initiatives that were meant to

increase revenues, specifically by increasing volume. Before KKRs acquisition, Dollar General based store product selections and assortments on individual profit margins of SKUs. KKR implemented a strategy that looked at margin per linear foot, a measure that takes into account profit per dollar of sales, but also how quickly the product sells. KKR also improved store standards and sourcing of products, while expanding the private label business. KKR bought the company for $7.6 billion in 2007 and by the end of the 2010 fiscal year, revenue grew by 37% to $13 billion and adjusted EBITDA grew 126%. Dean Nelson, head of KKR Capstone said, And 80 percent of that was growth; it wasnt getting better terms from P&G or Kraft. 8

Since 1950, the global population has increased from 2.5 billion to 6 billion. Cumulative world GDP has increased 6 times over the same time period. This GDP growth has been accompanied by the growth of environmental degradation, including but not limited to deforestation, over-fishing, ozone layer depletion, global warming etc.5 Over the past 20 years, there has been a growing importance of environmental, social, and corporate governance (ESG) issues. The growth is rooted in the growing presence of ESG issues comes from the realization that the Earths resource are limited and will become more constrained in the future stemming from ESG megatrends including population growth, increasing resource consumption of developing markets, and climate changes. These megatrends present huge obstacles for society to overcome. ESG issues have resulted in the tightening of government regulation and changing consumer demand. 4

The recent global crisis pointed out the drawbacks of short-term profit maximization. Furthermore, the recent financial fraud has increased demand for transparency in corporate governance. In addition, increasing demand for transparency in corporate governance and operations have stemmed from consumers demanding for information on how production and consumption of goods affects the environment. The result of growing government regulation, resource scarcity, investor and consumer demand have put a growing premium on businesses that implement ESG initiates across all business operations. 4

During the late 1980s to mid 1990s, PE firms took a regulatory and compliance stance in response to ESG sustainability. Managers only considered only on sitespecific risks (e.g. safety or health conditions) to protect investors from regulatory, financial, and reputational risks relating to ESG. During the late 1990s to mid-2000s, PE firms began to use sustainability to generate revenue and reduce cost. Recently, a few top firms have been able to identify potential operational opportunities, by using sustainability as a source of continuous business innovation, risk reduction, and financial performance improvement. Exhibit 2 and Exhibit 5

Under sustainability efforts, companies can realize cost savings to drive value creation. The implementation of eco-efficiency in energy, water, packing, waste reduction, and resource use will increase operating efficiency and reduce those costs. In 2007, KKR partnered with Alliance Boots, an international pharmacy-led health and beauty group. Both companies believed corporate governance and sustainability can

create value. Before 2007, Alliance Boots already committed itself to achieving ESG initiatives. Alliance Boots sought to attain eco-efficiency savings in store design and transport. Presently, eco-efficiency initiatives in transportation reduced the road kilometers driven by 8.5 million and have reduced transport emissions by 4.78%, saving 1.6 million Euros in fuel cost. 3

PE firms that enforce sustainability management systems and sustainable practices can reduce operation costs across portfolio companies. Additionally, firms can reduce resource procurement costs through secure sourcing of energy, water, and raw materials. Sustainability training and development programs for employees can improve productivity.

Not only can sustainability initiatives improve operating margins, but can also create significant top-line growth with product differentiation, product development, and increased market access. Companies can advertise its sustainability efforts to increase consumer awareness. Through the development of new products, companies can fill the demand for unmet ESG needs. In addition to new products, companies can command a price premium with added sustainability features to current products. Also, companies can create new revenue streams by recycling waste. Lastly, sustainability efforts can improve the reputation of a company with consumers, supplies, and regulators to open up access to previously closed off markets.

Finally, sustainability initiatives can protect companies from value erosion by reducing legal, financial, and reputational risks. Green initiatives improve brand image and reduce possibility of bad publicity, regulatory risks, and pressures from investors. Firms achieve lower financial risk rating reducing the costs of capital. Most importantly, sustainability programs help mitigate risks from changes in the environment, regulation and stakeholder sentiment. The most recent example of value erosion from the lack of risk management is BPs loss of $90 billion dollars in market capitalization after the 2010 Deepwater Horizon oil spill. 9 & Exhibit 6/7

There are still challenges with the growth of value from sustainability improvement initiatives. First, PE firms traditionally have a short-term financial focus, but to reap the full benefits of sustainability improvement measures usually requires a longer investment horizon. Secondly, businesses also have to create ways of quantifying ESG initiative impacts to show to investors. No standard metric exists for valuating social and environmental improvements on the bottom-line. Exhibit 8 Implementation of sustainability initiatives requires a new set of human talent and resources. Lastly, because the business of sustainability for value creation is new, the talent pool for human talent is limited. This may limit short-term growth in the implementation of sustainability initiatives.

Doughty Hanson has been a long-time proponent of sustainable business practices. Therefore, his sustainability initiatives have already shown results. Hanson was the first to appoint an in-house head of sustainability. In February 2007, Hanson acquired

Avanza, the largest bus operator in Spain. Avanzas business model is related to many ESG issues, because public transport can combat air pollution. The company has ESG issues regarding the use of alternative fuels and engines to meet regulatory standards. Qualitatively, Hanson worked with management to find specialist in advanced fuel management outside the firm. The enhancement of environmental and social issues resulted in being certified to international standards of good practice. Quantitatively, Hanson established fuel reduction targets and arranged driver training. Initiatives are expected to reduce fuel consumption by 2.5$ to 5% over two years or .7 million to 1.4 million Euros a year. Even more so, Hanson is investigating the potential for solar power that is estimated to generate 150k Euros a year. Last but not least, health and safety initiatives in streamlining systems have resulted in savings of 200k Euros a year. 3

Private equity is a highly dynamic investment strategy that actively creates value for investors. The ability of a PE firm to be innovative in its value creation strategies is the key to sustain competitive advantage and create attractive returns. The advent of financial engineering in the 1980s and operational improvement in the 1990s were innovative solutions to create value in a maturing industry. Ample opportunities for potential value creation still exist through operational improvement in portfolio companies. Value generation requires expertise, experience, and process. The Operating Partner model incorporates the experience and expertise required; however, a few successful firms have developed the framework for consistently determining the right operational improvement opportunities to pursue.

As the industry moves toward complete maturity, PE firms are searching for new innovative approaches in operational enhancement for future value creation. This trend will continue to grow as the return of LBO in unlikely due to the current European debt crisis and as many PE firms are focusing on strategies that have become commoditized. Recently, A few top firms have implemented organic growth enhancement strategies and EGS initiatives that have positively effected value creation. These firms are gaining competitive advantage by leading the way in toward the future of value creation. As they create a benchmark for other private equity firms to duplicate. Finally, the ability to consistently innovate new methods of value creation will determine the performance of private equity firms over the next few decades.

Appendix: Exhibits

Exhibit 1: Basic Principles of Private Equity

Exhibit 2: Three waves of sustainability

Exhibit 3: Decline the use of Leverage in the 2008 credit crunch

Exhibit 4: Risk/Return Tradeoff of Potential Operational Improvements

Exhibit 5: Graph showing Changing Business Response to Sustainability

Exhibit 6: Potential Areas of Sustainability to Create Business Value

Exhibit 7: Model of How Sustainability Drives Business Value

Exhibit 8: Reporting of Sustainability Initiatives

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