How you can use the private equity value creation model

Private equity has been extremely successful in growing businesses and create value. How private equity create value in their companies is what we will discuss in this article. The private equity value creation model consists of six areas:

1. Increasing the valuation multiples by changing the size, risk and growth traction leading to higher exit multiples than the initial acquisition multiples.
2. Revenue growth is the foundation for value growth and private equity is particular good at growing sales.
3. Margin expansion drives cashflow which leads to a much higher value.
4. Operational excellence leads to the ability to grow fast while retaining high quality and customer excellence.
5. Strong leadership is important to motivate, engage, direct and drive a growing organization.
6. Focus on cashflow is not only key because private equity are financial investors but because strong cashflow enables investments.

This article will explain each of the six areas and how the private equity value creation model work. The methods can be applied by ambitious entrepreneurs regardless of private equity investment. Gone is the time when financial engineering was the name of the game.

Mindset differences between entrepreneurs and private equity

Entrepreneurs and owners of private and public businesses can apply the same principles as private equity. The difference from operating a private or public business compared with a private equity owned business is often:

• Private equity’s superior sense of urgency, combined with:
• Private equity’s willingness to invest in business development and growth.
• The value creation focus.

Even those entrepreneurs that emphasize urgency is likely to be slower to action then private equity. Stepwise learning is part of the entrepreneurial roadmap whereas private equity makes multiple similar growth journeys. To a larger extent, private equity also uses industrial advisors and other consultants to speed things up. Many entrepreneurs are suspicious towards paying for advice which tend to make the growth trajectory slower and wobbly.

An alternative to hiring advisors would be to bring on venture capital investors. These types of investors have a very different value creation model than private equity, but they enforce a sense of urgency and clear milestone targets to aim for. The flip side would be a diluted ownership, a risk for conflicts should targets not be met and an emphasis on periodic fund raising rather than business development.

How is private equity value creation defined?

We need to understand what we mean with value creation before going into the six areas of value creation.

The private equity professionals that entrepreneurs most often meet are the partners and analysts that manage a private equity fund. They are the investment advisors to the fund. It means that these professionals identify, evaluate, acquire, own and develop and sell businesses. Their task is to make approximately 25% annual return on equity for the general partners who are the fund investors.

In below example, private equity can buy a company worth $250 million for every $100 million to be invested, with 60% debt financing. That is called leveraged acquisition financing. In approximate terms, the equity value of the $250 million company needs to increase 2.1x during 7 years of ownership. See below table.

This company will sell for $260 million per year assuming a 12x EBITDA valuation multiple and a 10% EBITDA margin. See below table. The private equity company needs to received $531 million when selling the shares in 7 years to repay the $150 million acquisition debt and get $381 million in equity that will be the 25% return on investment.

Targeted enterprise value to reach desired return on investment

Very few fast-growing companies are without debt. Relaying entirely on own generated cash flow will delay company growth unless the founders have invested large amounts of equity. Investments in sales and product development staffs require capital until revenues pick up. Working capital needs to be financed if growing fast are in themselves debt. To name a few.

Assuming our example company has a 50/50 proportion of equity and debt the enterprise value needs to reach $ 1.068 million in the 7 years example. Half of that is the debt and half of that is the targeted $531 million equity value that private equity will receive when selling their shares. They will use $150 million to repay their own acquisition debt. The remaining $381 million will make them the 25% return on investment.

Planning the value creation journey ahead of the acquisition is all about reaching the necessary Enterprise Value to make the math. With iterations we can conclude in our example company that revenues needs to growth 20% and the EBITDA margin needs to expand from 10% to 15%. See below table.

How private equity produce the revenue growth and expand the margin is what we will discuss next. Not too much of a surprise, revenue growth and margin expansion are the two most effective ways to increase the value of a business but there are also other ways.

We will now go through each of the six areas that forms every private equity value creation model. The first and the last of the six private equity value creation areas are financial. The other four areas are operational value creation areas.

Increasing the valuation multiple to be used to create value

To sell a company at a higher value than the company was acquired for is not only about revenue and margin growth. It’s also about transforming the company into a higher quality company. The extremes can be a young, growing startup earning $3 million compared with a proven fast-growing startup earning $300 million. A higher EBITDA-valuation multiple will be used for the larger startup that has learned to scale the organization and has proven that earnings is scalable on a continues basis.

Read more: Sales traction is important for value creation.

Similar businesses in the same industry can be very differently valued. In EBITDA-valuation multiple terms one business can be valued at 7x EBITDA, the other at 12x EBITDA and the third one at 15x EBITDA. Let’s take a traditional manufacturing industry as an example:

• The 7x EBITDA-valued manufacturing company is most likely a sub-contractor specialized in producing parts- or components for other companies.
• The 12x EBITDA-valued manufacturing company has their own inhouse engineering and product development teams and manufacture their own product. The have a larger part of the value chain and is in greater control of risks and seasonal effects. A 12x EBITDA-valuation multiple also suggest that sales growth has been strong for years.
• The 15x EBITDA-valued manufacturing company is similar to the 12x EBITDA company but has already sold substantial parts of the next years production. Predicted future sales growth is therefore of high quality.

Buying cheap and selling expensive is not only about the size of cashflow to be valued. It’s about transforming the business to a higher quality business as above examples has shown.

So which are the valuation multiple expansion drivers?

There are four levers that determine the quality of a business from a valuation point of view:

1. Size is important for value creation. A larger business has more room for cost reductions and synergies with addon acquisitions. A larger business can become an industry leader and secure important customer relationships and pricing power.
2. Global potential is key for private equity value creation. Only the US and the Chinese markets are strong enough to foster very large businesses. There is a natural growth cap in most other geographical markets unless the business has globally scalable potential and ambitions.
3. Growth prospect is not as certain as many like to believe. Remember that many businesses have local or at best regional potential. Companies with products and organization set up for a global market has a higher value than those that do not. These companies fit the private equity value creation model.
4. Quality management and processes are key to expand fast. An experienced leadership team is so much more valuable than two founders that in effect is the bottleneck for expansion. This point is on of the most important to private equity seeking to use their value creation model. Documented and used processes and a well-functioning organization is also key for a smooth scaling of a business. Building company organization and scalable processes in conjunction with revenue growth is often overlooked by early-stage or inexperienced entrepreneurs.

Bottlenecks, too much key person dependencies and not truly scalable offerings all leads to a bit more challenging valuation. These are soft valuation areas that are frequent reasons why entrepreneurs and investors often not agree on valuation.

Read more: The 10 soft factors that affect the valuation of a business

Revenue growth is key to value creation

Revenue pays for expenses and investments and generates the cashflow needed to grow. It’s only so long that one can rely on equity to finance a startup.

The faster one can prove that the products is saleable the better. Starting with a Minimum Viable Product that sell has three advantages over a long product development phase. The revenue generates cashflow to fund the business. The business proves that someone is ready to pay for the product and customer feedback makes for improvements of the product.

A mature business with stagnant revenue can be an interesting business to apply the private equity value creation model.  Typically, one would identify the strongest offerings and list the top 15 ways to improve sales and margins. Investments in sales is obvious but most likely also branding to build employee engagement and sending the message that there is a new kid in town.

Revenue comes in different forms and has different value

There are different kinds of revenue from a value creation point of view. Here are some examples:

• Recurring revenue is more attractive than one-on-one sales since the risks of sales fluctuation is lower. The return on sales investments can also be high with the outcome being recurring revenues. Recurring sales is also a great platform for upsales, i.e. sell additional higher valued services. To software-based service or entertainment businesses, recurring revenues can be the annual services fees. To industrial companies it can be multi-year serial delivery orders, aftermarket services or software updates. Built correctly, recurring sales can be a safe way to annual accumulative sales growth.
• Predictability revenue is obviously more attractive than un unpredictable revenue forecast. Large customers are often deemed more predictable than very small customers, unless they come in large volumes. Serial orders or multi-delivery sales is a form of predictable revenue for manufacturing and software-based businesses respectively.
• Diversified sales are generally deemed to generate a higher quality revenue than those in businesses with high dependency on a single customer.
• Sales traction, i.e. a sustainable sales growth, is a particular high-quality factor. All strengths and attractiveness summarizes in a sustainable sales growth.

Read more: Sales traction is important for value creation.

The nature and quality of the revenue sets the basis for future revenue planning and forecasting. With high quality revenues it is easier to plan and execute for revenue growth, which is really the key driver behind value creation.

Businesses that can show strong and sustainable revenue growth obviously has an attractive offering. Private equity value creation models aim to reach such revenue growth. The attractive cashflow is usually strong or the revenue growth would not have been sustainable.

Margin expansion to drive cashflow

Margin expansion is key to the private equity value creation model, second only to revenue growth. Companies are valued not only revenues but on cashflow. Using EBITDA-valuation as an example show the leverage one will have if being able to improve the margins with a few percentage points. See below table.

To entrepreneurs there are two margin expansion areas to deliver if wanting to copy the private equity value creation model:

1. Gross margin improvements have the strongest impact on cashflow margins and operating profit margins. The gross numbers are much larger than then net numbers. That is why also small improvements will have big impacts on the net and hence the margins. Prices may not be that easy to improve but actual prices versus pre-calculated prices is an area to keep an eye on. Design, sourcing, purchasing, operations and production and distribution and logistics are areas that is often overlooked from a margin perspective. Small improvements makes big numbers on the operating margin.
2. Operating margin is the area that is most often analyzed. It is the margin that is key to cashflow covering all expenses except tax and financial items in some jurisdictions. Tightly connected administration expenses are also easier to understand than than core operational areas included within the gross margin. Although the private equity value creation model focus primarily on improving the more important gross margin, one or two percentage points of margin improvements can often be squeezed also from the operating margin level. Included in the operating margin and not already covered by the gross margin are sales, organizational set up and general expenses.

Operational Excellence

Having covered the important revenue growth and margin expansion, operational excellence is also key in any private equity value creation model. With operational excellence with mean how we operate our businesses and processes on a daily basis. Being inefficient can rapidly eat on margins or, worse, deliver poor quality, delays and bad customer experiences.

To grow fast one needs to also develop the company’s operational excellence, not only sales and product innovation. This must be done in tandem with sales growth. Most successful entrepreneurs are either sales wizards or product development nerds. Few are particularly good at operational excellence, meaning organization and processes. This is an area that is targeted by all private equity value creation models. Outside advisors and consultants are commonly hired to help which is often a win-win situation for the entrepreneurs that can stay focused on sales and products while still growing the business in harmony. Gradually as the business grow outside advisors and consultants are replaced by hired staffs and operational leaderships.

The two main reasons why operational excellence is important to private equity value creation models:

1. Quality delivery and customer experience. Every business need processes and roles and responsibilities as soon as sales starts to scale. Having the founding team involved in part of the operations in not efficient and not the best use of competence. Quality and customer experience will start to deteriorate with increased spending as a result.
2. Financial performance will quickly fall apart if operational excellence starts to fail. Pre-calculation and pricing will become wishful thinking and cashflow will be harmed.

Operational excellence is key to private equity value creation models. To much focus on organization and processes will harm the business. With sales and products focused entrepreneurs that is seldom the case, however.

Strong leadership is private equity value creation critical

Leadership is an area that is super critical to all private equity value creation models. It is also an area where conflicts amongst entrepreneurs and investors is likely to occur. Which entrepreneur would like to admit lacking leadership skills?

The single most common reason why small businesses do not grow is the entrepreneur himself. With small businesses we mean businesses with sales up to circa $100 million. The company is evolving as the business is growing and revenue and operations picks up. Entrepreneurs that cannot change themselves to the same extent as the business is changing will find themselves redundant. Alternatively, the business reaches a plateau and stop growing with the entrepreneur blaming the market or something else.

Let go to grow is great advice to aspiring entrepreneurs.

Entrepreneurs are likely to become the bottleneck for additional growth sooner or later. That is the key reason why many investors prefer to invest in businesses with a founding team rather than a single entrepreneur. Being a single entrepreneur, it is therefore important to build a truly senior management team to support the growth. A challenge to many self-made entrepreneurs and an area where private equity value creation models often excel. Advisors and brought in to help built an area and then gradually exchanged for hired manager.

Private equity deals often fail already between the indicative offer stage and the final offer due to lack of leadership within the target company. Non-ended owners such as investment holding companies are even more careful about investing in the right team

4 types of entrepreneurial leadership

Our typical entrepreneur goes through four stages of personal development. Each perfectly fine to stay within if recruiting complementary leaders to the company. It is very common that the original entrepreneurs are traded for a more seasoned CEO as leader of the business once private equity steps in as the owner of a business:

• The expert entrepreneur: Often a product nerd who’s main contribution is, and possibly should remain, the customer solution provider.
• The innovator type is either a serial entrepreneur rather than a unicorn founder or steps back as Chief Innovator Officer hiring a professional CEO to lead to day to day business.
• A manager is something everyone can become but some don’t like. Being more found of sales or product development than managing the office and the employees is a common treat amongst successful entrepreneurs. At some point however, staff needs to be managed. Also senior staff.
• Leadership is different from being a manager. Some people inspire and engage their co-workers naturally. They have the gift. To them and to those that gradually learn to become a leader people are exciting and co-workers are important. Truly successful entrepreneurs excel in leadership in combination with a skill for sales or product development. Most entrepreneurs however would benefit from hiring a professional CEO to lead the company, or at least a leadership coach to help them try become a true leader.

How private equity assess leadership

The private equity value creation model is very precise with regards to desired leadership. Much more than understood by many entrepreneurs.

Great leadership can turn a mediocre idea into success. A great idea will never fly without leadership [beyond small business revenues].

A particular important part of the due diligence when acquiring or investing into a business is the management presentation. Not only is management presenting the business plan, it’s also an opportunity for private equity to judge the management team.

A powerful leader doing the elevator pitch introduction and later engage in detailed discussions with other senior managers presenting the company gives a great impression. Founders selling the business and doing most of the presentations gives a poor leadership verdict. They are leaving the company once sold but presented themselves as key to the company. A contradiction of importance to most founders.

It varies but many private equity investors shift leadership in the middle of their ownership period. Specialized leadership depending on the phase of business development has become the norm for many investors.

Focus on cashflow enables strong growth

It sounds obvious that investors focus on cashflow, and it is. Cashflow is the blood that fuel growth which fuels value creation. Lack of strong cashflow either means lack of growth abilities or the need for more capital from investors.

We have already discussed sales growth, i.e. the foundation for cashflow growth. We have also discussed margin expansion which has huge leverage on value creation. Beyond that, the private equity value creation model also focuses on capital attached to the business. Working capital is one of the most challenging areas in growing a business fast. Yet many entrepreneurs feel uncomfortable leading working capital initiatives.

Cashflow in manufacturing industries

Working capital is the capital tied to operation, the capital that is used to produce something. Some large multinationals manage a positive working capital squeezing their supplier payment terms while exercising their market position in sales. To most businesses however, you spend money first and receive revenues later. Money spent and invested is your marketing and sales, staff, rents, licenses, materials, components and distribution. Most traditional businesses like manufacturing or retail struggle with increasing working capital needs when growing fast. New sales requiring new purchases is growing before previous products are paid by the customers.

Stock needed for purchasing reasons, safety buffer or delivery quality reasons is another working capital trap. The private equity value creation model put a lot of emphasis on supplier and customer payment terms, smaller batch sourcing and other working capital initiatives. Combined, substantial working capital reductions can often be found freeing capital for growth investments in sales and product development.

Cashflow in SaaS businesses

Software based online services, often referred to as System As A Service, SaaS, can reach a point when recurring revenues exceed rapidly growing running expenses related to sales growth. The Monthly Recurring Revenue, MRR, is an important metric to track the building of accumulated sales revenue. With a large portion of fixed costs for staff and systems marginal sales can rapidly increase their cashflow once cost coverage is reached. Having said that, many aspiring SaaS businesses tend to underestimate the necessary marketing, sales and customer success support costs.

Successful SaaS companies that scale revenues beyond their fixed costs rapidly reaches a positive working capital and hence positive cashflow. That is why SaaS businesses with a globally scalable offering is so attractive to investors. The early stage venture capital value creation model focus on productizing, launching, building the infrastructure and initiate scaling. After those initial steps, the private equity value creation model steps in. Focus would be on scaling sales investing heavily in marketing, the sales force, customer retention, product up-sales and geographical expansion.

Infrastructure businesses cashflow and value creation

There are also some very capital intense businesses with infrastructure characteristics that attract specialized infrastructure focused private equity funds. Asset classes included private highways in the 1990’s, power stations in the 1990 – 2000’s, harbors and electricity grids in the 2000 – 2010’s.  Very much in focus looking ahead is electric vehicle charging networks while fiber optic networks remain attractive. Commonly amongst infrastructure investments are stable revenues, relative low risk and relative predictable growth opportunities. The private equity value creation model really heavily in the opportunity to invest capital to grow the asset base.

Can entrepreneurs use the private equity value creation model?

Absolutely so. Gone are the 1980 – 1990’s when financial engineering and leveraged financed structures combined with high interest rates created value. Competition from additional capital invested in private equity and low interest rates has forced investors to focus on business development. Steps that any entrepreneur can do themselves.

The advantage that private equity may have over entrepreneurs are:

• Number of businesses developed building experience on.
• Strong focus on the value growth path with limited distraction and sequential learnings.
• Strong investment appetite in sales, product development and operation.
• A structural and methodical approach securing traction, consistency and endurance.
• Network of advisors to tap for advice, temporally services and building positive pressure on management.

How entrepreneurs can copy the private equity value creation model

Still, ambitious entrepreneurs can take the best part of the private equity value creation model to gain their own growth. Implemented wisely with endurance will lead to gradual growth and value creation:

• Invest consistently over at least 3-5 years in sales strategy, productizing, marketing and sales resources to create revenue growth traction.
• Focus on gross margin initiatives like product design, sourcing, operation and production to expand margins and cash flow.
• Invest in experienced management team members and specialists to leverage leadership, innovation and operation to eliminate founder bottlenecks hampering growth. Create operational excellence by not holding back too much on recruitments but invest wisely in experienced key resources.
• Step aside to an Executive Chairman, CTO or CMO position and recruit experienced day to day leadership if managing people is not top of mined.
• Engage several specialized external advisors to bridge competence gap, gain temporary resources and a positive pressure on the team.
• Build financial control, predictability and analysis competence through milestoned business and financial planning to identify and manage cashflow proactively.

The private equity value creation model is powerful but not rocket science. The trick is to know how to leverage on the model, the tools and people to use, the processes, steps and timing for implementation.

Ambitious entrepreneurs with a truly scalable offering that adopt the private equity value creation model consistently will almost certainly build a growing market position and sales traction. Keeping an eye on all the details described in this article and engage experienced people to complement the founding team finalize the trick. Good luck.