Co-authored with @StenningSchueppert.
Successful private equity (“PE”) firms generally execute well in the three commonly accepted phases of portfolio company value creation: 1) Buy right, 2) Grow EBITDA, and 3) Sell that EBITDA at highest multiple possible. In our experience, many PE firms are missing critical low-hanging fruit by not maximizing their exit multiples because they do not have a detailed understanding of all of the different “levers” they can pull – which ones and how hard – to achieve the greatest amount of value creation. These levers can influence EBITDA growth (both top-line sales and bottom-line efficiencies) and/or their applicable exit valuation multiple. For this discussion, we’ll focus on the latter.
Many PE firms concentrate on a handful of core industries – they will get better deal flow, diligence the opportunities more effectively, have a network of applicable personnel for operations, and generally help their companies more meaningfully. The firms believe the selected industries are those with attractive macro characteristics and where the principals have experience, knowledge, or other related insight. The overall investment criteria and deal- specific investment theses are driven by the principals’ perspective. The less acknowledged challenge, however, is that when a firm exits an investment, the various buyers’ perspectives on value will drive the market-bearing exit multiple: not the principals’ perspectives. When the firm first invested in the business, the critical valuation “levers” may have been A, B & C. When the firm (or the market) decides it is time to sell the business, buyers may see the critical valuation “levers” as B, D & E.
Maven Associates recently created value for a client by helping them focus on the levers to pull to optimize the value of their business at exit while giving them adequate time, e.g. early in the investment life, to actually pull the proper levels and see the impact. Diligence will see through ”window dressing”: value – real value – needs to be cemented over time. The client in this case was a contract manufacturer owned by a successful mid-market PE firm. They are early in the investment executing a classic “platform” strategy: In the 12 months prior to Maven’s engagement, the client had tucked in three acquisitions to the platform, adding scale, service lines, and new products. Their critical questions for Maven were:
- What are the significant valuation levers that will drive the exit multiple? Which ones matter most and how are we positioned to impact those?
- With that in mind, what should the business’ go-forward strategy be and how should we plan and optimize, now, for that strategy?
Our team was able to address the valuation “levers” question through confidential direct interviews with more than 40 PE funds, industry experts, bankers, brokers, and lenderswhile analyzing market data of recent deals and related multiples. We learned that a more detailed understanding of the valuation “levers” creates more alignment and focus between the management team and the Board (generally the PE Firm) and creates better insights for future strategic decisions. Not just “grow,” but “grow here by this much.”
Get Clarity on the Valuation Levers. We invested time early in the project to identify properly the six basic valuation levers. Many levers are standard, well known, and apply to most industries: Customer concentration (more is bad), EBITDA margin (more is good), level of integration (for platform strategies, more is generally good), proprietary data or processes, etc. (again, more is good). Through the one-on-one interviews and strategic analysis, we ultimately identified ten valuation levers of various importance, supplementing the most commonly accepted metrics with an additional four key levers not yet considered within their framework. The real insight and value, however, was getting true clarity on how a lever was defined and valued in the market. For example, our client believed it was fairly integrated since all of the businesses were managed (or at least consolidated) on the same finance platform. The broader market perspective was that the integration level was low because the client maintained separate brands, sales teams, and operations teams, and did not have a common GL across the businesses. Even something as simple as its Board package demonstrated this lack of integration, with sections by previously acquired business instead of operating chapters (Finance, Ops, Sales, Corp Dev, Safety, HR, etc.). With that knowledge, our client now has years to evolve the company toward greater integration and the multiple bump it will earn by demonstrating a truly integrated business.
Identify Inflection Points for Valuation Levers. For each identified lever, we discovered a rough correlation between lever performance and the expected exit multiple impact. For most key levers, companies at the low end of the metric were achieving ~4x exits, while those toward the high end were achieving ~8x exits. For example, customer concentration: having top customers that comprise >60% of revenue puts companies at the bottom of exit multiples. A company has inherent risk in the business and both debt and equity sources will price in that risk… or they will simply walk from the deal. Whereas having a less concentrated customer base (top customers with <20% of revenue) can keep a business near the top of the spectrum. Most interestingly, we uncovered that for a few of the levers there was a distinct inflection point on previously expected straight-line continuum. In this part of the market, EBITDA margin was viewed as a barometer on the value of the proprietary processes. Below a certain level, it simply doesn’t matter what the company story is: it will always be viewed as business stuck with commodity pricing and limited differentiation. If its services are more valued, or different, the thinking went, the company should see that in its margin and nothing the company says can effectively convince the market otherwise. Above that inflection point, however, companies are viewed as having something special. In this particular industry, the difference between being viewed as an “order taker” and having “special sauce” is only a 2-3% delta in EBITDA margin. This insight has a direct effect on how to assess different paths for growth: If the client is able to migrate their revenue mix or trim costs to generate slightly higher margins, it should yield an additional .5-1x boost to their exit multiple alone.
Get an External Perspective on Valuation Levers. As noted earlier, our market research revealed additional key levers our clients should be balancing across their strategic plans. Our client prioritized the levers differently than the broader market. By seeking well-rounded external perspective, our client enjoyed greater market clarity to employ over the investment life and tailor its experience as it plans for an exit. Firms invest in companies when the principals are confident in their deal thesis. After purchase, PE firms should be cautious about confirmation bias. Value can be created if the deal thesis is correct. Value can also be created if the deal thesis is wrong. Once a company is purchased, firms should mentally start with a go-forward strategy blank slate. Within the first 6-12 months of ownership, firms should know what they have with their new company: the team, the capabilities, the underlying asset value, and the company’s true core competency and core value. It is important to be objective about what the go-forward strategy should be versus trying to prove a potentially false deal thesis. An element of being objective is to not assume that the firm’s framework for what will determine the exit multiple is accurate. Getting an external perspective supported by comprehensive market testing on the critical drivers for the exit multiple will give the firm and the management team confidence that they are making the right strategic decisions.
Get an Early View on the Exit Environment. Getting an external perspective on valuation multiples has two benefits: First, it increases Board and management confidence in go-forward decisions. Second, the firm gets an early view on the likely buyers, lenders and potential investment bankers. This creates opportunities to build relationships (that in turn will create ‘buzz’ for your deal) in the years that precede the exit.
A More Valuable Go-Forward Strategy. Our engagement involved two phases. The first phase addressed the questions on levers and their corresponding impact on exit valuation multiplies. The second phase was to build a go-forward strategy with the management team. The insights from the valuation analysis fed directly into the strategy. When we build a strategy we are making decisions in three areas: (1) Where are we going to play (products/services, customer segments & geographies)? (2) What is our competitive value proposition? and (3) What capabilities must be in place to execute the strategy? Understanding what drives the exit valuation multiple enabled Maven to make valuable – and far more concrete – strategy recommendations that should maximize our client’s exit valuation. For example, some end markets are more valued than others while some end markets yield higher EBITDA margins. We incorporated both elements into our market prioritization. In another example, the insight on the importance of integration led to recommendations on the organizational structure, brand strategy, and the roadmap for IT. For PE firms that work with their portfolio companies to build 100-Day Plans or Value Creation Plans, the insights from the valuation multiple analysis can significantly improve those plans.
Generate More Deal Flow. If your PE firm is executing a “platform” strategy, increasing your deal flow can be a priority. One of the natural byproducts of the extensive outreach and interviews with PE funds, bankers, brokers, and lenders is raising awareness of your platform. Maven’s direct interviews generated new opportunities – and many new deal flow relationships – for our client. Some deals were already in market and the bankers did not have our client on their list as a potential acquirer despite the obvious strategic fit. Other deals were not yet in market and we were able to get our client a first look and involvement in the upcoming processes.
Maximizing Your Exit Multiple is a Smart Investment. For mid-market businesses with EBITDA >$10M, the time and capital to develop a detailed understanding of the different levers that will drive their exit multiples may be the best investment a firm makes. For example, if a business has a $30M EBITDA at exit, achieving just an extra half turn on your exit multiple will deliver $15M in incremental equity value. That alone is a 50-100x return on the investment required to build the proper roadmap to achieve this bump.
Why You Should Use a Third Party. Most PE firms have internal staff capable of doing the exit multiple research and some larger firms may even have their staff doing some form of this research as part of the due diligence on deals. However, there are several limitations for a PE firm doing this research and analysis in-house: (1) The breadth – and depth – of people a third party can access. In our experience, more people are willing to be available and transparent with an intermediary, especially one they have a relationship with like Maven, than they would with a potential seller. (2) It is critical to get a neutral interpretation of the information from the players in the market. Try as they might, teams that have worked long and hard getting a deal done will have a harder time interpreting the information without bias. Maybe the deal thesis is off a bit. Will that be as easily surfaced with an in-house team? (3) A third party, particularly strategy consultants and independent PE-experienced professionals, will be able to blend a strategic perspective on the business with an owner/investor perspective. We look to build a solid strategy that will maximize both exit EBITDA and corresponding valuation multiple for a powerful one-two punch.