Private Equity - Deserving the Undeserved
As Adam Smith observed, 'in order for markets to set prices and
values, two conditions are necessary: willing buyers and
sellers, and those same participants' possessing perfect
knowledge.' Should one side possess more information than the
other, then that side has a tremendous advantage. Therefore, the
holder of the information can utilise this additional knowledge
to extract 'undeserved profits.' Although private equity
companies would protest that their profits are far from
underserved, the very nature of their operations depends on
making optimum use of all available information. As a result,
the logic follows that the most informed companies are those
that possess not necessarily the most information on target
acquisitions, but the most relevant.
However, anyone who has knowledge of market theory will
also be aware that as more companies look to join the party,
prices inevitably rise as a result of increased demand. With
potential profit margins being limited due to the sheer number
of active players in the sector, the boom time experienced in
private equity throughout 2005 is logically expected to be
followed by a sharp downturn in 2006 as private equity companies
shy away from paying over-inflated prices that do not justify
the return on risk. Too many private equity companies are now
seemingly possessing similar knowledge leading to no competitive
advantage. Deals of the magnitude of SunGard, Hertz, Cadbury
Schweppes and Wind, supposedly picked up because of the value
that lies behind them, could well become relics of a nostalgic
golden age. 2006 may be a more conservative year with fewer
bargains to be had.
Yet to write 2006 off already may be slightly myopic. There
still remains an opportunity for private equity firms when
looking at targets and running existing portfolios to optimise
or approach the common knowledge they have at their disposal in
a different way.
As with the opaque nature of the private equity world, the
potential for profit and acquisition optimism could
depend upon the equally (yet perhaps unfairly) enigmatic world
of working capital. Identifying the working capital strategies
and processes in place at certain target companies and comparing
these to what are conceivably 'best practice' in the field can
prove to be revealing and financially rewarding. With the boom
time expected to sharply fade away, private equity groups should
quite rightly make their portfolio companies work for every
penny to ensure value is delivered. This should be underpinned
by a sound knowledge of and in-depth attention to their current
working capital strategies and those being used by sector
competitors.
A recent evaluation of the top 1000 companies in Europe
points to the fact that over 20% of the working capital scope
(defined as the sum of receivables, inventories and payables) is
surplus to requirements; effectively, 20% of additional value is
to be found amongst European companies alone and therefore
'undeserved profits' are still out there to be harvested.
Despite this seeming allure of '20% extra free', working
capital remains regularly overlooked primarily and perhaps
ironically because its impact percolates into multiple strands
of a business. Far from being compartmental and easy to
approach, the nature of working capital management is frequently
polluted by a managerial mindset of being 'somebody else's
responsibility'- often a symptom of the inefficient incumbent
management and a source of prospect for private equity firms.
The extent, to which working capital management is disjointed,
for the private equity firm, should be seen as the extent for
significant improvement that can be teased out of the business.
Sector leading firms are regularly those that have optimum
working capital through taking a holistic rather than siloed
attitude. For them, they appreciate that aspects such as
inventory management, sales forecasting and supplier dealings
are not stand-alone areas. Rather, they are interdependent with
factors including current system functionality, corporate sales
forecasting and even areas such as what processes are in place
to deal with customer disputes.
Of course the leading companies in each sector are very rarely
under threat from private equity firms primarily because they
can't be bought 'on the cheap', yet what they should be looked
upon in relation to working capital are the best practice
benchmarks that can be achieved within specific industries; a
reference frame that the private equity world would be advised
to adopt as the competition increases, prices become inflated
and targets become more scarce.
Put into practice, an approach that appreciates the value of
working capital and places it alongside other considerations
by the private equity company can have considerable business
benefit both in the bidding stage and once in control of the
target. A sound awareness of the sector's optimum working
capital and an analysis of the room for improvement that
specific companies can act upon strongly aids the business case
during the pre-bid process- the knowledge the private equity
firm possesses enable bidding companies to create a strong
differentiator in a crowded market.
Once in control of the target company, the opportunity
for the new management team to realise the acquired firm's
potential revenue generation can be approached with much more
confidence. The knowledge of best practices in comparison to
what is in existence can act as a sound and regularly overlooked
guideline that not only enables a more effectively-ran business,
freeing up cash in a sustainable way, but it also helps to
mitigate the risk and reduce operational and holding
costs-ultimately delivering the returns demanded by investors.
With the private equity community naturally under pressure to
replicate the headline figures and deals of the past twelve
months throughout the next twelve, a stronger adherence to the
principles of total working capital management should be seen as
one of the best ways to realise 2006's undeserved profits.