PRIVATE EQUITYCOMPANYDUE DILIGENCE

How to achieve the best acquisition price and exitreturn

Edited by

Shahriyar Rahmati, The Gores Group

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Published in July 2012 byPEISecond FloorSycamore HouseSycamore StreetLondon EC1Y 0SGUnited Kingdom

Telephone: +44 (0)20 7566 5444www.peimedia.com

© 2012 PEI

ISBN 978-1-908-783-09-7

eISBN 978-1-908-783-59-2

This publication is not included in the CLA Licence so youmust not copy any portion of it without the permission of thepublisher.

All rights reserved. No parts of this publication may bereproduced, stored in a retrieval system or transmitted in anyform or by any means including electronic, mechanical,photocopy, recording or otherwise, without written permissionof the publisher.

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Although every reasonable effort has been made to ensurethe accuracy of this publication, the publisher accepts noresponsibility for any errors or omissions within this publicationor for any expense or other loss alleged to have arisen in anyway in connection with a reader’s use of this publication.

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PEI editor: Wanching LeongProduction editor: Julie Foster

Printed in the UK by: Hobbs the Printers (www.hobbs.uk.com)

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Contents

Figures and tables

Introduction

Section I: Pre-acquisition due diligence Chapter one

Chapter one

Setting the stage for success

By Christian Sinding and Anders Gaarud, EQT Partners

Introduction

It all starts with deal sourcing

Finding the angle

Developing the business case

Leveraging the experience of industrial advisers

Focusing the advisers on key strategic items

Conclusion

Chapter two

Business due diligence: forming and testing the hypothesis

By Gary Matthews, Morgan Stanley Global Private Equity,and David Hanfland and Jeff Sexstone, A.T. Kearney

Identifying the value hypotheses

Develop a deeper understanding of the target’s industry

Create a stronger understanding of competitors and how theywill evolve

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Find ways to leverage the unique capabilities of your privateequity firm

Conclusion

Chapter three

Operational due diligence

By Alex DeAraujo, Welsh, Carson, Anderson & Stowe

Introduction

Modes of operational due diligence

Information requirements

Functional/operational expertise

Approach to quantify the financial impact

Underwriting the deal model

Conclusion

Chapter four

Financial due diligence

By Erik Shipley and Mattias Gunnarsson,PricewaterhouseCoopers LLP

Introduction

Objectives of due diligence

Planning well to execute well

Data matters

Plotting the course

Conclusion

Chapter five

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Financial due diligence, an operator’s approach

By Shahriyar Rahmati, The Gores Group

Introduction

Income statement

Balance sheet

Conclusion

Chapter six

Tax due diligence

By Dawn Marie Krause and Jason Thomas,PricewaterhouseCoopers LLP

Introduction

Scoping to achieve maximum results

Interpreting a tax due diligence report

Vendor/sell-side due diligence

Conclusion

Chapter seven

Human resource due diligence

By Steve Rimmer and Aaron Sanandres,PricewaterhouseCoopers LLP

Introduction

Employee demographics

Employment terms/agreements

Understanding the target’s compensation structure

Understanding the target’s benefit plans

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Management talent assessment

Understanding human resource transition challenges

Conclusion

Chapter eight

Modelling how ESG factors can impact risk-adjusted returns

By Vincent Neate and Jonathan Martin, KPMG LLP

Introduction

Increased focus on ESG

Understanding the scope of ESG

Link between ESG factors and financial performance

Long-term benefit for private equity

Impact of time horizon on perceptions of risk

Exiting responsibly

What methods are appropriate to measure these benefits?

Conclusion

Chapter nine

Setting working-capital targets

By Nick Alvarez, Anthony Dios, Tim Keneally, MichaelMcKenna and Krista Servidio, Alvarez & Marsal

Introduction

Quality of working capital

Tax considerations

External factors

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Post-close improvements

Conclusion

Section II: Post-acquisition implications of the due diligenceprocess

Chapter ten

Getting off to the right start: the first 100 days post-acquisition

By Andrew Mullin, Alex Panas and Kevin Sachs,McKinsey & Company

Introduction

Putting in place the right management team

Overhauling the business plan

Communicating priorities throughout the company

Aligning incentives with priorities

Establishing a process to track progress and to react to gaps

Conclusion

Chapter eleven

Developing post-acquisition plans

By Jurgen Leijdekker and Josh Sullivan, Welsh, Carson,Anderson & Stowe, and David Buckley, General Atlantic

Introduction

Post-close discovery

Management ownership and engagement

Developing the plan ‘headlines’

Developing the implementation plan

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The role of outside advisors

Conclusion

Chapter twelve

Buy-and-build strategies

By Jason Caulfield and Peter Williams, Deloitte & ToucheUK, Parm Sandhu, Tamita Consulting (UK) LLP, andJeremy Thompson, Gorkana Group

Introduction

Market activity

Rationale for buy-and-build strategies

Challenges to buy-and-build strategies

Managing the integration

Conclusion

Chapter thirteen

Beyond the board pack: leveraging key performance metricsto drive results in private equity investments

By Seth Brody, Apax Partners

Introduction

The first 100 days

Building the foundations

From reporting to analytics

Truth to transactions

Conclusion

Chapter fourteen

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Exiting by design: building the best way out

By Shyam Gidumal, Ernst & Young LLP and Martin Hurst,Ernst & Young GmbH

Introduction

Current market conditions

Forging a response

Conclusion

About PEI

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Figures and tables

Figures

Figure 1.1: Value creation breakdown in EQT portfoliocompanies

Figure 1.2: Average annual growth in EQT portfoliocompanies

Figure 2.1: Assessing a company’s competitive position

Figure 2.2: Attributes of a ruthless competitor

Figure 2.3: Ruthless competitors capitalise on their corecompetence

Figure 4.1: Expectations of data reliability and availabilitydepending on private equity deal types

Figure 9.1: Cash/working cash operating cycle

Figure 10.1: Nine vital aspects that contribute toorganisational health

Figure 10.2: The private equity change story should cascadethrough the new portfolio company

Figure 10.3: Success is correlated with clear metrics to trackand monitor performance

Figure 11.1: The development process of a value-creationplan

Figure 12.1: Companies can find growth through newplatforms

Figure 12.2: European bolt-on activity compared with privateequity buyouts and mid-market M&A

Figure 12.3: Value creation at Unitymedia using abuy-and-build strategy

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Figure 13.1: Bringing multiple data sources into one singledata repository

Figure 13.2: Sample approach to data-driven onlineoptimisation

Figure 14.1: European private equity exits, 2005–2010

Figure 14.2: European IPO exits as a percentage of privateequity exits, 2005–2010

Figure 14.3: US private equity exits, 2006–2010

Figure 14.4: US IPO exits as a percentage of private equityexits, 2006–2010

Tables

Table 2.1: Sample questions for evaluating business duediligence hypotheses

Table 2.2: Unique private equity value-creation levers

Table 3.1: Example of a cost-reduction analysis forprocurement

Table 3.2: Example of a sales, general and administrative(SG&A) cost reduction plan

Table 3.3: Example of an operations due diligencesummary

Table 4.1: Financial due diligence risk considerations byfunctional areas

Table 5.1: Revenue diligence items

Table 5.2: Sales compensation plan diligence items

Table 5.3: New products/markets revenue diligence items

Table 5.4: Material cost diligence items

Table 5.5: Labour costs diligence items

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Table 5.6: Operating expenses diligence items

Table 5.7: Accounts receivable diligence items

Table 5.8: Inventory diligence items

Table 5.9: Accounts payable diligence items

Table 5.10: Capital expenditure diligence items

Table 7.1: Example of potential executive termination costsin a portfolio company

Table 8.1: Sample ESG checklist

Table 11.1: Post-close discovery

Table 11.2: Example of a value-creation plan headline

Table 11.3: Example of a one-page implementation-planninginitiative

Table 11.4: Example of a value-creation plan metrics tracker

Table 12.1: Turnaround of Iesy following the buyout byApollo Management

Table 13.1: Process objectives for achieving rapid results byleveraging key performance indicators

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Introduction

This book, Private Equity Company Due Diligence, focuses onthe frameworks and the strategies undertaken by privateequity firms and their advisers prior to closing an acquisitiontransaction.

When looking into a potential acquisition, we as private equityprofessionals must possess the ability to dive into a targetcompany’s operations and financials, both with a lens focusedon understanding how the business is run today andsimultaneously view it through a lens for what it can be underour firm’s ownership. During a time frame which may be asshort as two weeks or as long as several months, privateequity firms must identify and request the sources ofinformation which support their investment hypothesis andrapidly iterate on analyses focused on the drivers which havethe greatest impact on investment returns. The ability totarget, prioritise and rapidly process large amounts ofqualitative and quantitative information that either support orrefute an initial hypothesis underpins the key value propositionof those who excel at the task of private equity company duediligence.

The scope of due diligence activities a private equityprofessional must partake in includes those which areconducted before a target company has even been identified.For example, the time spent by a firm to develop deepexpertise and relationships both formal and informal withincertain industries or geographies can often lead to proprietarydeal-sourcing opportunities or the development of uniqueinsights which over time, if nurtured and regardedappropriately, may become sources of sustainable competitiveadvantage. In the opening chapter of this publication, EQTPartners, the investment adviser to the EQT funds, providesan excellent overview on the firm’s approach to developing

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competitive advantages through their relationships andnetworks in their core markets in Northern Europe.

The majority of the chapters in this book focus on whatprospective buyers must do between the time interval whichstarts when a potential target investment is identified or madeaware of, and ends when the firm has determined they will bidon that asset at some price that has been informed by theirdue diligence. These areas include operational and financialdue diligence, as well as an assessment of the strategicposition of the target company. Other chapters on humanresources, tax, environmental and working capital providetremendous insight into important areas of a company thatshould be rigorously diligenced before a binding bid has beensubmitted – areas all which can materially affect the outcomeof the investment.

As its name suggests, the nature of ‘private equity’ connotesinvestments into companies that generally do not have highlydisclosed financial or operating data. For a variety of reasons,companies which private equity firms invest in often haveparticularly complex, limited or rapidly changing financial andoperating characteristics. Whether due to opacity of data or tovolatility in business performance driven by forces inside oroutside of the target company’s control, the authors of thisbook agree that having organised information and analysisthat makes decision-making possible dramatically increasesthe value of frameworks within a private equity investmentcontext. This contrasts with diligence conducted in publicequity markets, where multiple internal and external partieshave certified and validated the company’s financial andoperational information.

The repeated emphasis on focus during the due diligencephase is expressed by several of the authors in this book. It isimportant to understand and to view due diligence as aprioritised effort that should not apply equal weighting to the

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pursuit of an exhaustive set of possible issues, but rather onethat relies on both probability and insight-adjusted expectedoutcomes so that the limited time available for diligence canbe used on areas which bear proportionately greater risk orreward.

One measure of private equity fund performance whichquantifies the intuitive concepts of risk and reward involves theconcept of an information ratio, which can be expressed as‘alpha’, or manager-specific returns net of passive benchmarkperformance divided by volatility, expressed as ‘sigma’, or thestandard deviation of fund returns. Those funds which performthe most thoughtfully focused due diligence positionthemselves to increase their ability to capitalise on the driversfor returns, thus increasing the ‘alpha’, while reducing the riskof large downside ‘fat tail’ outcomes which increase the riskand volatility – the ‘sigma’ of their investor’s returns.

Building on the notion of increasing the focus on insightswhich can drive investment returns coupled with efforts whichseek to uncover sources of potential risk, firms often employ awide variety of internal and external resources. While allefforts are ultimately driven by a private equity firm’s operatingand investment professionals, an extended set of ‘diligencepartners’ such as the ‘Big Four’ firms, management consultingfirms, and sector or industry specialists can provide surgecapacity or specialised expertise to improve both the qualityand the efficacy of the diligence effort.

The net result of a focused diligence effort serves to inform apost-acquisition plan and a corresponding set of financialprojections which are the basis of the firm’s bidding price or,more accurately, the range of prices that provide anacceptable return. The development of a post-acquisition planis one of the first opportunities for a private equity firm todifferentiate itself from other competing firms, to engage thetarget company management team and to develop a

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well-grounded (albeit often highly preliminary) set ofassumptions upon which to bid for the target. As access tomanagement may be limited, the pre-acquisition plan mayinvolve highly varied amounts of input from those teams.However, given there are often no more than a handful ofcritical insights that produce the majority of the investmentreturns, it is more important to have an approximate andrealistic view of what each initiative can produce than it is tobottom out the analysis down to the nth level of detail.Spending time with management in a way that shows themyour firm both understands their business and knows theirindustry and markets will increase seller confidence in yourbid, and in the case of carve-out transactions where the parentcompany has a vested interest in your abilities, could make aneven greater contribution towards the difference betweenwinning and losing.

This book contains many insightful chapters written by authorswho practice creating and executing post-acquisitions plans.While these plans often have many different names, such as100-day plans or value-creation plans, you will find that theyare all focused on two central issues: how quickly can wedevelop a view of the potential of the business over ourintended holding period and how do we transform thatperspective into a tangible set of initiatives which demonstrateimmediate and substantive progress towards that potentialwhen executed within a very short and aggressively pacedperiod that starts before or at latest immediately upon closing.There are discussions and debates at nearly every privateequity firm around how best to create and execute theseplans, and it is often because of these productive andconstructive debates that these plans are sufficiently thoughtout, resourced, time-bound and teed up for successfulexecution.

As you may already know, the process of due diligence iscomplex, time-compressed, fundamentally imprecise and

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nearly always relies on less than complete information. Thechapters within this book articulate the approaches thatvarious top firms and their skilled practitioners take towardssolving the challenges created by these circumstances andwill hopefully provide you with tools and frameworks which youcan leverage or modify in your own professional practice ofprivate equity company due diligence. By sharing theframeworks and due diligence lessons of various privateequity firms and their advisors, it is our hope that newer fundsor those shifting their scope or approach can spend less timereinventing the wheel, particularly when they can borrow orlearn from their industry colleagues who have already incurredgrowing or experimentation costs.

Shahriyar Rahmati

The Gores Group

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Section I:

Pre-acquisition due diligence

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Chapter one

Setting the stage for success

By Christian Sinding and Anders Gaarud, EQT Partners

Introduction

Whether a private equity investment will become successful ornot is difficult to determine up front. Conducting due diligenceon a target acquisition can reveal much about the health of thecompany, and help a potential buyer to determine if theinvestment is worth making. In a due diligence process, it isimportant to identify early on the potential value drivers of adeal, to understand how they can be maximised and thefactors that can either positively or negatively impact theoutcome of a deal.

This chapter provides insight into how EQT Partners, theexclusive investment adviser to the EQT funds, aims toidentify potential opportunities and how it conducts duediligence to understand the full potential of the target companyin order to maximise its value-creation opportunities.

It all starts with deal sourcing

A key factor in making successful private equity investments istaking a proactive and methodical approach to originating astrong and continuous pipeline of investment opportunities.This means identifying potential businesses early on andpositioning your firm so that, ideally, a deal can be struckbilaterally with the seller before a formal sales process starts.However, as most sellers want to maximise their proceedsfrom an exit, most opportunities end up in a structured salesprocess in some shape or form. Once a structured salesprocess starts, the chance to make the investment a successis most likely reduced, or at worst lost, unless preparations aremade early to identify a value-creation plan. The initial duediligence should therefore start before an auction process

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begins and should involve substantial preparatory work toreview the target company, the industry in which it operatesand its competitors.

Conducting preparatory work gives the buyer a chance to takea view on whether the target is an opportunity worth pursuingor not. The earlier such a decision can be made, the moretime there is for the buyer to prepare and conduct further duediligence to build both the deal hypothesis and the businesscase. Doing so can better position the buyer to win the dealwithout accepting a lower internal rate of return (IRR).

Therefore, it is important to stay close to the market to gleanintelligence about upcoming sales processes or, even better,to create bilateral processes. This is achieved by cultivatingrelationships with the stakeholders involved in the sale.

EQT Partners, as the investment advisor to the EQT funds,approaches our core markets with a philosophy of being ‘localwith locals’. In the core markets of Northern Europe, with focuson the Nordic and the German-speaking countries, as well asAsia and the US where some EQT funds have investmentmandates, EQT Partners has offices staffed by natives of thatparticular country.

An advantage of being ‘local with locals’ is having strong anddirect access to relevant stakeholders. It is much easier toorganise meetings on short notice, and where necessary inthe local language, which can provide for much betterdynamics. Additionally, nothing gets lost in translation.Business owners can also take comfort in our long-termcommitment to the local market – and potentially participate inthe deal post-closing as a minority owner in the businessesthey have built, together with an investment partner committedto continuing to support and grow the business. We personallybelieve that this local approach makes it easier for owners tosell their businesses to such a fund, either fully or partially.

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Finding the angle

Buying a company is probably one of the easiest things inprivate equity – just pay the highest price. However, buying agood company at the right price is far more challenging. Inorder to avoid the winners’ curse, it is important to identify anangle early to justify a premium over which other bidders willoffer without necessarily accepting a lower expected return. Ifall a buyer does in a structured sales process is to wait for it tostart, receive the information memorandum, do the standardanalysis and finally win the auction, it very often becomes amatter of how low can one go in terms of IRR requirement.Additionally, there may be crucial information that wasoverlooked, which other buyers did not.

‘Finding the angle’ could often be a cliché and thus needs tobe carefully thought through. Some angles are better thanothers and caution should be exercised in order to not get tooexcited about an angle and how unique it is.

Key questions to ask in any acquisition process are: first, whyshould the asset be acquired, and second, what is yourdifferentiating factor as owner of the business, compared toother potential buyers? The angle could arise in several ways:is there a consolidation game to be played? Is there acompetitive advantage to be gained, such as putting a newmanagement team in place? Are there other businesses in thefund’s portfolio that have a strong fit with the target company(thus taking an industrial buyer approach)? Does the buyerhave unique access to financing sources that can create abetter capital structure to support the company and deal?

At EQT Partners, we aim to start reviewing potential targets asearly as possible. This allows us to prepare for the duediligence process by identifying and recommending an anglefor the acquisition. It is important that information is identifiedto allow a decision to be taken whether or not to pursue anopportunity before the formal sales process starts. This

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approach allows for us to focus on interesting investmentopportunities where there may be a competitive advantage, aswell as to reap the benefits of investing time and effort in amore focused way.

Case study 1: XXL

In 2010, EQT V acquired Norwegian sports retailer XXL. EQT III hadpreviously owned Plantasjen, a leading Norwegian outdoor gardencentre chain of stores. Through this ownership, EQT gained strongretail sector investment expertise in Norway. During EQT III’s six-yearownership, Plantasjen grew the number of stores from 28 to 72 via anaggressive roll out in Norway, Sweden and Finland. Plantasjen’svalue-creation strategy could therefore, to a large extent, be seen as ablueprint for XXL’s business plan.

This industrial angle and experience gained from the Plantasjeninvestment positioned EQT V well in a highly competitive salesprocess for XXL and ultimately helped EQT V to win the deal. Severalmembers of the EQT Partners investment advisory team and theindependent industrial advisers who worked on the Plantasjeninvestment participated in the due diligence process, which meant thatEQT V was able to leverage the knowledge and experience gainedpreviously when assessing XXL.

The sellers and management of XXL recognised that EQT would be agood owner, and consequently gave EQT special access during thedue diligence process and in the important last stages of the saleprocess. Since the acquisition closed, XXL has successfullyestablished a strong presence in Sweden and is continuing to roll outstores in a similar manner as was achieved in Plantasjen.

Developing the business case

Building a strong investment case is one of the key workflowsin any due diligence. The management case presented in asales process can often be described as a hockey stick, as itsets out fairly ambitious growth targets in order to achieve thehighest price possible for the seller. A typical managementcase usually assumes a continuation of the existing businessmodel with continued and loosely documented sales growth

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and margin expansion assumptions. As a result of these fairlyoptimistic views, the typical management case often turns outto be an upside case for a potential buyer.

The easiest and probably the most common way of creatingthe business case for a buyer is to accept the directionalstrategy and the key drivers of the management case and tomake appropriate haircuts. This usually includes making moremodest assumptions on sales growth and margin expansionbased on a buyer’s own commercial and financial duediligence. In terms of sales growth assumptions, this typicallymeans taking a more cautious view on the outlook for marketdevelopment and/or a conservative view on a buyer’s ownmarket share development. The assumptions on margindevelopment are usually more conservative, as it is typicallydifficult to retain all the increased profit from more effectiveproduction or operational leverage.

An alternative approach to building an investment case is tostart from scratch. In practice, this approach ignores theoriginal management case. This is a more radical and boldstrategy – and one that could be successful if executedproperly. It challenges the status quo and focuses on the fullpotential of the business. The key to this approach is to find abuyer’s own theme to support value creation. It could result ina business plan that is even more aggressive on key driverssuch as sales and EBITDA development compared to theinitial management case, or in the target company pursuing adifferent or complementary strategic direction than assumed inthe original management plan. This type of so-called ‘industrialacceleration’ is an approach EQT aims to pursue for ourinvestments.

Taking the industrial-acceleration approach usually requiressignificant investments over the business plan period. Capitalexpenditure (capex) spend to achieve higher EBITDA is, froma valuation perspective in most cases, a highly compelling

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investment case. The reason is simple – capex spend has anet debt effect while an increase in EBITDA results in amultiplier effect. That said, the payback needs to work; acompany with a proven track record of growth should producea higher exit multiple and better exit alternatives. At EQT, thetrack record of the funds shows that most of the valuegenerated by portfolio investments has come from salesgrowth and margin expansion. In fact, more than half of valuehas historically come from sales growth (see Figure 1.1). Inseveral past investments, net debt at exit has often beenhigher than at entry as investment in growth has beensignificant. Further, top-line and earnings have grown in thedouble-digits on average, which has also resulted in similargrowth in the number of employees within portfolio companies(see Figure 1.2).

A key part of the discussion and interaction with managementteams during due diligence is to test the strategic ambitionsthey have for their companies. EQT likes to ask the CEO of apotential investment what he or she would do with unlimitedaccess to capital to fund the company’s profitable growth.Most management teams are used to working with capital as ascarce resource, so this is a good opportunity to test how‘hungry’ they are, how high their growth ambitions are andwhat strategic focus they have, as well as to what extent theyhave the mindset to deliver on a full potential business plan.

Figure 1.1: Value creation breakdown in EQT portfoliocompanies

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Source: EQT.

Figure 1.2: Average annual growth in EQT portfoliocompanies

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Source: EQT.

On the back of this mindset and approach, it is also importantto identify a capital structure that would provide enoughflexibility to support such a growth strategy as part of the duediligence process. Engaging banks providing financing andgiving them insights into the company’s potential growthstrategy early in the process can also make it easier to agreeto debt tranches such as capex facilities to aid growth.Moreover, the flexibility offered by a capital structure thatmatches the company’s growth strategy may have a highervalue than a capital structure where the leverage is maximisedup front. The latter may actually hamper growth, as cash flowgenerated potentially cannot be used for growth, but instead isused for debt amortisation and for interest payments.

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It is important that the management team participates in thedevelopment of the plan, supports it and is motivated todeliver on it. The interests of the management team should bealigned with the private equity investor so they not only deliverthe plan, but also strive to outperform it. The best way toensure that management fully commits to the plan is to havethem invest real money (that is, no options) in their owncompany. ‘How good is good’ is a valid question when itcomes to always challenging and aiming for outperformance.A good company can always do better!

Leveraging the experience of industrial advisers

In the deal sourcing and due diligence phase, EQT seeksadvice from a network of independent industrial advisers.These industrialists, also known to other industry participantsas senior advisers or operating partners, are seasoned andexperienced former CEOs or operational division heads thathave hands-on experience in large corporate companies.They have experienced upturns and downturns in theircareers, and executed various growth strategies such asinternational expansion, driven penetration and improvedmargins. These individuals are therefore a very goodcomplement to the advice provided by EQT Partners’investment advisory professionals. Simply put, the industrialadvisers have, as their title would imply, an industrial andoperational mindset that is highly valuable in assessing aninvestment opportunity.

Case study 2: Tognum

In 2005, EQT IV acquired Tognum, a leading German supplier ofdiesel and gas engines for off-highway applications, fromDaimlerChrysler. The investment decision, which was based on thecompany’s industrial potential and value-creation strategy, was wellreceived by local German trade unions and an important minorityfamily shareholder.

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Industrial advisers with experience from DaimlerChrysler, Atlas Copcoand ABB advised on the development of a growth-oriented businessplan for Tognum that met a number of important objectives of the tradeunions and minority family shareholders. The plan focused ondeveloping an after-sale business, geographical expansion and capexinvestments to expand the company’s production capacity.

During EQT IV’s ownership period, Tognum’s sales increased by 15percent and EBITDA increased by 46 percent on an annual basis(2005–07).

In the deal-sourcing phase, industrial advisers are involvedfrom the beginning for their insights and to identify keycommercial questions. Involving them in early stages of theprocess also has the effect of increasing their commitmentand motivation as the deal-sourcing phase turns into the duediligence phase.

Industrial advisers play an even greater role in the duediligence phase. They attend management presentations and,given their credentials and experience, are respected by themanagement teams who very often are used to meeting amore financially oriented audience. This allows for a differentdialogue as it is usually easier for management teams toconnect with industrial advisers, given their commonbackgrounds and experiences. As a result, the quality of thediscussions is improved – with more emphasis on strategy andupside potential, industrial advisers can challengemanagement more on what they see as the full potential oftheir businesses.

The industrial advisers also play an important role inidentifying the full potential of a target company and insupporting the development of the business case. Bydiscussing the key drivers of a deal, they engage in greaterdetail on the assumptions of a case, focusing on an anglerather than taking a top-down approach (the latter can addless value in such a critical phase of the due diligence

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process). By discussing the rationale for the key drivers andassumptions in the investment case, the industrial adviserscan also focus on the details of a potential acquisition in astructured way.

Industrial advisers may also be invited join the targetcompany’s board of directors, should the opportunity manifestitself in an actual investment. Rather than outsourcing the100-day plan preparations (the changes that will beimplemented during the first 100 days of ownership) to anexternal advisory firm, the industrial adviser who will beappointed as the chairman of the board of the target companywill lead the development of the plan. The first draft of the100-day plan needs to be completed when the due diligencephase is concluded and, as such, the plan is included in thepackage given to the investment committee. By focusing onthe 100-day plan in the pre-closing due diligence stage, itmakes it easier for the board, together with management, toaddress the key drivers immediately after the deal closes inorder to begin value creation as soon as possible.

Separately, industrial advisers may be offered an opportunityto co-invest in the deal. This aligns their interests with the fund(EQT), as well as the rest of the management team.

Case study 3: Broadnet

In December 2011, EQT VI acquired Broadnet (previously calledVentelo), a Norwegian telecom operator. This deal was a textbookcase of how industrial advisers provided key input in developing thebusiness plan. EQT V already owned InFiber, a Norwegian telecomcompany. Therefore, a well-defined angle for EQT existed. All of theindustrial advisers on the InFiber board of directors advised on theBroadnet transaction. Broadnet was also a company EQT hadfollowed closely for several years and several of the same industrialadvisers had advised on this opportunity for some time. Therefore,they were up to speed on both the company and the market from dayone.

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During the second round of the due diligence process, a considerableamount of time was spent with the industrial advisers and the EQTPartners investment advisory team to discuss and develop the fullpotential investment plan. This included options in terms of organicgrowth and M&A, cost-cutting initiatives and a capex programme. Theindustrial advisers added significant value with their in-depthknowledge of the sector and ensured that the investment plan waswell thought through, reflecting the opportunities as well as the risks.At the end of the process, the potential plan was very different fromwhat the management team itself had originally presented to potentialbuyers.

As the CEO of Broadnet prior to the acquisition had indicated that hewanted to step down at the time of a transaction, a new CEO neededto be identified. As an interim solution, one of the industrialists agreedto take on the role as CEO. He was immediately involved indeveloping the 100-day plan and at closing, the plan was ready to beexecuted. No time was lost. Within two months of closing, severalinitiatives had been completed and the health of the companysignificantly improved. This investment is still in its infancy; however,based on the actions taken by management so far, the company hasdeveloped in line with the ambitious targets set out in the businessplan.

Focusing the advisers on key strategic items

Preparing for the due diligence process often means thatspecialist advisers need to be engaged to support various duediligence workflows. In such a staging process, the bestadvisers available should be hired, whether it be M&Abankers, accountants or lawyers. As the advisory business isvery much a people business, it is important to engage a teamthat is trusted and can adapt to the required style of work.

The key emphases for EQT in finding the right team ofadvisers are past experience in the sector and pastexperience of having worked with EQT on previous projects.The benefit of working with the same set of consultants is apre-established understanding and a pre-existing relationship

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for reporting. This facilitates a smooth work process andimproves output.

EQT Partners’ investment advisory team is very often staffedwith one team focusing on the due diligence and businessplan, and another team focusing on the financing process.Both these teams work closely together as their advice is to alarge extent interlinked; potential financing banks requireupdates on due diligence findings, and potential financingneeds to be aligned with the business plan.

At the start of a due diligence process, it is often a good ideato have a kick-off meeting involving all parties to discuss boththe investment opportunity and the initial thesis. The meetingshould align and prepare all advisers for the task ahead. Sucha forum also facilitates better cooperation among the advisersas some due diligence items often overlap between theworkflows to the respective advisers.

Working with specialist advisers in the due diligence processcan take various approaches: some work streams are more ofa check-the-box exercise, while others can be instrumental inidentifying potential value if performed correctly.

Due diligence work streams such as legal and financial aremore about avoiding pitfalls, as well as understanding anyunderlying issues that should be incorporated into the saleand purchase agreement, net debt adjustments, or which maybe addressed as part of a 100-day plan to improve controlsand reporting.

Commercial due diligence, however, is quite different. Ifperformed appropriately, it can provide key inputs to thefoundation of a full potential business plan and thus form abasis for value creation by management. The remainder ofthis section will therefore focus on the commercial duediligence workflow.

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There are several ways of working with managementconsultants in a commercial due diligence process. The easyroute is to agree on a scope up front and allow them to dotheir work. In the extreme case, they do not come back for acouple of weeks and then have produced a rather large deckof slides with useful, but often generic, information on thecompany and market.

An alternative approach is to stay very close to the consultantsthroughout the process. The scope and focus of the analysisis constantly revisited and updated as key issues areaddressed, and follow-up questions and concerns that arisecan be assessed and verified when needed. These questionsor concerns can relate both to the market as well as to thetarget company. In such an approach, the quality of the workshould be high and the analysis resulting from the commercialdue diligence can then become a very good basis for thedevelopment of the value-creation plan, as it focuses ontesting and verifying key assumptions and drivers in themanagement business plan. Clearly, the more genericapproach as discussed above could also lead to the sameconclusion, but the same granular understanding of the keyissues may not be reached and opportunities may be missed.

Conclusion

As this chapter has demonstrated, it is important to evaluate apotential investment opportunity as early as possible. Beingcomplacent in preparations or in due diligence can meanbuying the wrong company in the right sector, buying the rightcompany in the wrong sector, or simply buying a company atthe wrong price. The challenge is to find the right company inthe right sector at the right price, which can be accomplishedby conducting a thorough due diligence process, finding theright angle and supporting the right value-creation plan.

Christian Sinding is a partner with EQT Partners, exclusiveinvestment adviser to all EQT funds, and is based in the Oslo

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office. He joined EQT Partners in 1998 from AEA Investors,Inc. Prior to AEA, he was a financial analyst with BowlesHollowell Conner & Co. in the US. Christian is the head of theEQT Partners equity investment advisory team. During hiscareer with EQT Partners, he has been involved in advising onseveral portfolio investments such as Plantasjen, XXL,Gambro, Findus and StjarnTV. During his tenure with EQTPartners, Christian has also been based in the firm’s Munich,Stockholm and Copenhagen offices. He holds a BS inCommerce from the University of Virginia, which he receivedwith Distinction, in 1994.

Anders Gaarud is a director with EQT Partners, exclusiveinvestment adviser to all EQT funds, and is based in the Oslooffice. He joined EQT Partners in 2006 from UBS InvestmentBank. During his career with EQT Partners, he has beeninvolved in advising on several portfolio investments such asPlantasjen, Gambro, Securitas Direct, Blizoo, InFiber andBroadnet. During his tenure with EQT Partners, he has alsobeen based in the firm’s Stockholm office. Anders graduatedwith a MBA from the Norwegian School of Economics in 2003.

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Chapter two

Business due diligence: forming and testing thehypothesis

By Gary Matthews, Morgan Stanley Global Private Equity,and David Hanfland and Jeff Sexstone, A.T. Kearney

Identifying the value hypotheses

When conducting strategic and commercial due diligence on apotential acquisition, a private equity investor needs to have acommercial strategy that lays out a well-defined plan forcreating value. This strategy will guide both the due diligenceand the post-close execution plan. In today’s competitivemarketplace, rarely does one private equity firm outsmart therest of the field or have a financial advantage unavailable tocompetitors; rather, the justification to pay more than otherbidders must be based on the ability to create more value.Value arises from a greater understanding of how to succeedand/or an increased probability of success, as articulated inthe value-creation strategy. The private equity firm with thestrongest value-creation strategies will win more deals, havelower execution risk and ultimately deliver greater returns to itsinvestors.

Setting aside macroeconomic beta – returns with highcorrelation to business cycles or the broader economy – thereare three significant alpha (manager- or investor-driven returncomponents) sources of differentiation that an investor shouldpursue to create a value-maximising investment strategy for apotential acquisition:

1. Develop a deeper understanding of the target company’sindustry. Having a more thorough understanding of theindustry, where it is headed and how value is created cangenerate an advantage over the competition.

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2. Create a stronger understanding of competitors and how theywill evolve. The marketplace is dynamic. The competitorsneed to be well understood for the target company to stayahead of the field.

3. Find ways to leverage the unique capabilities of your privateequity firm. The ability to increase the scale of the business orto improve supply chain performance through verticalintegration or customer/supplier relationships with existingportfolio companies are ways to give your private equity firman edge over other bidders.

A private equity buyer’s due diligence process should focus ondeveloping and testing the value-creation strategy based onthe above three sources of differentiation. Although quality ofearnings and other risk factors are important to evaluate, theydo not enable a bidder to separate itself from other privateequity firms. An effective strategic and commercial duediligence process can improve the accuracy of the forecastmodel and therefore sharpen the price and deal structure suchthat if the business achieves its objectives, the investment willmeet or exceed target returns. This goal is best accomplishedby developing and testing hypotheses for how the businesswill succeed.

This chapter discusses how private equity deal and operatingexecutives can conduct due diligence and validate theacquisition opportunity by evaluating value from each of thefollowing three sources: industry, company and private equityfirm. It addresses how to gain focus and depth in due diligencedespite limited time and budget. Finally, it examines some ofthe pitfalls common to strategic and commercial due diligenceefforts.

Develop a deeper understanding of the target’s industry

Industry analysis should assess the degree of attractivenessversus risk in the market. Some key questions to ask are:

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• Is the target company’s sector attractive? Will it continue to beattractive for the private equity holding period and the nextowner’s hold? Are the fundamental industry forces creatinghead-winds or tailwinds?

• Is the industry consolidating because scale yields acompetitive advantage? If so, will this consolidation createopportunities to be a buyer or a seller?

• Are there emerging technologies that could substantiallychange the competitive dynamic?

As the questions above suggest, a good industry analysistypically is driven by hypotheses. For example, a hypothesiscould be that value can be added by rolling up multiplecompanies in the sector. The due diligence process needs totest the hypothesis by coming to an understanding of markettrends, industry economics and growth drivers. In general,hypotheses can be generated and evaluated across fourdimensions: market definition, size and penetration; marketgrowth and profitability trends and outlook; competitivelandscape; and key segment performance. Table 2.1 outlinessample questions in each dimension.

Table 2.1: Sample questions for evaluating business due diligencehypothesesIndustrydimension Potential questions to generate hypotheses

Marketdefinition,size andpenetration

• Which markets does the company participate in todayand which industries should it participate in tomorrow?How are its capabilities and competitive dynamicssuited or unsuited for successful positioning within eachmarket?

• How quickly and profitably is the market growing(compared to GDP, S&P 500 or other companies inyour portfolio)?

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• Can the market be redefined by non-traditional means?(For example, as Apple famously did with the handsetmarket?)

Marketgrowth andprofitabilitytrends andoutlook

• What is driving the growth (or decline) in the market?Will these trends accelerate or moderate?

• Are real prices stable (or declining)? What is thecompany’s source of pricing power? What barriers toentry exist?

• Are adjacent markets (to the target company) exhibitingtrends that may ‘spillover’ into the target’s industry?

• Are the costs for key inputs increasing or decreasing?What about ingredients that are required by thesuppliers (for example, oil that goes into the chemicalsthat the target company buys)?

• What new trends are emerging? What risks or rewardsdo they pose for the industry?

• How are future changes in technology likely to affect theindustry?

• What is the potential for regulation to create or destroyvalue in the industry or provide benefits or risks toselect participants?

Competitivelandscape • Why do customers patronise the target company? What

is the company’s core service or purpose? What is itsunique value proposition?

• Are competitors entering (or leaving) the market, andwhy?

• Are competitors large and powerful (or fragmented)?

• Are customers large and powerful? Are theyconcentrated or dispersed?

• Are there alternative products that could compete withthe target company’s?

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• What does the supply chain look like? Does thecompany have supplier flexibility or is it obligated to asmall number of market-dominating suppliers?

• How does the target company compare to thecompetitors in pricing/offering and cost?

Keysegmentperformance

• Are any customer segments outperforming others?Why? Is there value in narrowing the company’s marketfocus?

• Are any product or service segments outperforming theothers? Is there a means to narrow the company’sproduct line?

• What adjacent markets are available now or will beavailable in the future? Are they attractive andaccessible? Does entry into these markets leverage ordilute the core business?

Another question to ask is whether private equity deals havepreviously succeeded in this industry. If not, why? Almostevery company in the mattress industry in the US, forexample, has served under private equity ownership.Therefore, within this industry there exists a clearunderstanding of the high expectations that come with suchownership. However, the fact that few private equity dealshave ever been done in the advertising industry, for instance,may suggest that this industry simply is not structured in amanner that supports the private equity investment model.This is an industry that has very cyclical cash flow, that isprone to customer switching, and whose core assets (theemployees) walk out the door every night!

Understanding industry risks is also critical when generatingand evaluating hypotheses. These risks include industrygrowth, price stability and ongoing cost structures or one-timerestructuring costs. Risks can be assessed as an input to

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company valuation or as an increased hurdle rate to penalisepotential higher risk.

A deep understanding of the industry and the opportunitiesand challenges that it may present is the first step in the duediligence process. After the industry perspective has beendeveloped, the next step in the process should focus onassessing the company and its competitive positioning andhow that could evolve over time.

Create a stronger understanding of competitors and how theywill evolve

Strategic and competitive due diligence needs to focus onwhether the company’s business model will sustain itssuccess against its competitors. Again, because all bidders inan auction sale will have the same grasp of the basics –market share, trends and leadership quality – a successfulassessment must dig more deeply into the company’s keycompetitive factors.

Fundamentally, there are two ways in which a company candifferentiate itself from the competition:

1. Premium pricingHaving a superior offering or brand position enables somecompanies to command higher prices. When customers gladlypay a higher price for a product, the returns are generally veryattractive. Relative price advantage is typically driven byeffective brand marketing and perception (perceived value),and/or by an inherently superior product/service (tangiblevalue).

2. Superior relative cost positionIf a company can create relatively equal products lessexpensively than competitors, it can generate higher returnswithout relying on premium pricing. Relative cost advantage isgenerally driven by more efficient manufacturing, by better

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buying processes or greater scale, and/or by lower sellingcosts.

Although such a position can be difficult to sustain, the bestcompanies have relative advantages in both price and cost(see Figure 2.1). Kimberly-Clark is one example of a businessthat has achieved both lower relative costs and the ability toprice its products at a premium. Scale gives the company theability to run large and very efficient manufacturing plants andto keep selling costs low. Its many iconic and well-marketedbrands, such as Kleenex, Huggies and Scott, enableKimberly-Clark to command a premium price in the market.

It is important to assess the company’s position relative to itscompetition. Management teams will usually sell the benefitsof the company’s products or services, but the due diligencehas to compare those features with what other players in themarket are offering. To begin the strategic and commercialdue diligence process, the following two questions need to beanswered, to obtain a perspective on how the target and itscompetitors are currently positioned: 1) is the company gettingpremium prices? 2) Does it have lower relative costs? Costanalysis can start with a high-level unit cost comparison basedon secondary research. As the due diligence processcontinues, the cost analysis can be further refined with moredetailed research, targeted customer and supplier interviews,and even interviews with competitors to get their estimates ofcomparative costs.

Figure 2.1: Assessing a company’s competitive position

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Source: A.T. Kearney.

Figure 2.2: Attributes of a ruthless competitor

* Property, plant and equipment.Source: A.T. Kearney.

Once the company’s current positioning has been understood,hypotheses should be developed to understand how itachieved that position. Can its cost position be sustained? Do

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further savings opportunities exist? Similarly, for distressedpotential acquisitions, analysis is needed on the ability toimprove internal processes and/or to upgrade core productsand services.

Whether a company is healthy or distressed, how easily couldcompetitors match the quality of its products and/or services?Likewise, why are costs lower? What could be done to furtherlower the company’s cost position? How long would this take?When answering these questions, it is important to recognisethat the competitive landscape is dynamic. Just as thepotential buyer is evaluating how a company can improve itsrelative cost position, other competitors are doing the same.

Hypotheses can be tested by evaluating market andcompetitive data. One of the authors’ favourite hypotheses isthe ‘ruthless competitor’ framework for thinking through therisks and rewards of a given strategy. This framework askswhat would happen if the world’s best competitor entered thismarket – a company with a business model unencumbered byconventional wisdom, legacy equipment, plant locations orsupport functions (see Figure 2.2). How could the targetcompany react to the ruthless competitor’s moves, and howlikely is it that those reactive moves would succeed?

This is not a theoretical exercise. Rather, the ruthlesscompetitor framework is a way of identifying how the targetcompany and its competitors rank in an assessment ofimportant capabilities (see Figure 2.3). How likely is it that oneof the other current competitors will become a ruthlesscompetitor? Conversely, how could the target company bemade into the ruthless competitor? Answers to thesequestions will drive the post-close operating plan.

Figure 2.3: Ruthless competitors capitalise on their corecompetence

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Source: A.T. Kearney.

Find ways to leverage the unique capabilities of your privateequity firm

The third source of value creation is the potential value yourprivate equity firm brings to the deal. Is your firm uniquelycapable of increasing the performance of the target companyand, therefore, justified in paying more than other bidders?

A private equity firm can bring four typical attributes to atransaction: (1) access to a unique management team; (2)experience in the industry; (3) one or more portfoliocompanies in the same/related industry; and (4) unique insightor skill for value creation. Strategic and commercial duediligence sets out to prove or disprove hypotheses aroundthese levers. Table 2.2 describes some of the key conceptsthat drive strategy for each lever.

The greatest value comes from pulling multiple levers. Forexample, having one or more strategically advantageouscompanies in your portfolio (point #3 in Table 2.2) implies thatyou have both experience in the industry (#2) and a uniqueinsight into creating value (#4). The key is not to becomefixated on which concept belongs to which lever, but rather tounderstand where the value comes from and how muchadvantage it gives your firm over other potential bidders. It is

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not enough to ‘have done a deal’ in this industry, to ‘know theplayers’ or to ‘have a guy’. Such knowledge and experiencemay be easily replicated or hired.

Conclusion

Strategic and commercial due diligence should codify thestrategy and its value for the portfolio company going forward.Due diligence should result in a written plan that identifieswhat is expected to change within the company once it isacquired, and when. Ideally, the plan should also describehow the change will take place, who is accountable and howmuch value it will provide.

Table 2.2: Unique private equity value-creation leversUnique valuelevers

Key concepts for drivingvalue-creation strategy

Ability forothers toreplicate

1. Access touniquemanagementteam

• Leadership to drive operations • Difficult –depends onuniqueness ofthe managementteam

2. Experiencein the industry• Existing industry profiles

• Understanding of key valuedrivers

• Proven experience in turnaround/improvements

• Easy – externaladvisors can beadded to theprivate equityteam

3. One ormorestrategicportfoliocompanies

• Ability to conduct industryconsolidation

• Ability to vertically integrate

• Difficult (typically)

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4. Uniqueinsight or skillfor valuecreation inthe industry

• Novel idea of how to define themarket; new product offering

• Vision for future (for example,insight into impending technologyor benefits from likelyconsolidation)

• Ability to add unique functionalskills (for example, suppliermanagement, sales forceeffectiveness, call centreeffectiveness)

• Medium –external advisorsmay be helpful

Avoiding common pitfalls

Due diligence is not always perfect and sometimes can lead toconclusions that are not fully thought through. Here are a few of themore common pitfalls:

1. Don’t get lost in the weeds. Time and resources are always limitingfactors in strategic and commercial due diligence. The window is short,and funds are scarce at this juncture of the process. That is why theauthors suggest producing hypotheses to ensure that the diligenceremains focused. Work hard to distinguish between information that isneeded to assess the value-creation strategy and research that can bedeferred until you have won the auction. If the information does notmaterially affect the hypotheses driving the value-creation strategy, itis not needed before the final bid.

2. Evaluate the wildcards. Don’t miss the effect on the company ofpotential regulatory changes or unexpected cost drivers such ascommodity spikes or environmental disasters. These factors can ruin aplan to compete on costs. For example, a deal involving memory foamfor bedding products in the US went awry after the hurricanes in theyear 2007 destroyed the chemical supplier factories, causing the costof goods to increase by 50 percent. Alternatives were not available,and passing along that spike in costs greatly reduced demand for thisdiscretionary consumer durable and ultimately sank the investment.

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3. Don’t define competition too narrowly. A plan to compete on price canstumble when competitors are misunderstood. Be careful not to definecompetition too narrowly by failing to account for competition fromlow-cost foreign countries or from substitute products. Additionally,don’t fail to recognise the impact of potentially disruptive technologies.For example, improved processes and technology are changing thegame in the pharmaceutical industry. Ten to 15 years ago, competitionwas among corner drugstores. Now, the corner drugstore is beingreplaced by mail-order and central-fill pharmacies that fill tens ofthousands of prescriptions a day at a fraction of the cost of traditionalcompetitors.

4. Understand customer requirements and what the customer will payfor. The future value of any company depends on its relationships withits customers. It will be a fatal error to underestimate the impact thatnon-product factors – such as service, selling capabilities and brand –will have on relative price. An effective value-creation strategy ensuresthat the key attributes that customers are willing to pay for aremaintained.

5. Involve target company leadership in the analysis and planning. Thevalue-creation strategy should be more than a theory. It needs to bestress-tested by the team that will implement the plan going forward –whether it is the existing management or a new team to be brought in.With either a formal approach during exclusivity or an informalapproach prior to closing, the private equity operating partner/executive should make sure that management ‘owns’ the strategy.

With such a plan, the private equity firm can better assessthese elements:

• Value of the target company and industry.

• Additional value the private equity firm can create from theacquisition.

• Costs to restructure or transform the company.

• Capital expenditure investments required.

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• Risks that could affect value, with key mitigation plansidentified in advance.

With these analyses in hand, the private equity firm can dotwo things. First, it can better define its valuation and sharpenits negotiation strategy.

By estimating how much more value it can create than otherbidders, the best private equity firms will pinpoint final bids justabove rival firms. Equally importantly, it can develop an actionplan to support post-close activities. Once the deal has closed,it will be time to start creating value; the value-creationstrategy will provide this roadmap.

Gary S. Matthews is a managing director and operatingpartner of Morgan Stanley Global Private Equity and is basedin New York. Gary joined Morgan Stanley in 2007 and has ledseveral private equity backed companies including, SimmonsBedding Company, Sleep Innovations, Inc. and Derby CycleCorporation. Gary also led several public company businessunits such as Worldwide Consumer Medicines forBristol-Myers Squibb, and served as managing director UK forDiageo/Guinness Limited and as president and CEO ofGuinness Import Company. He also held senior managementpositions at McKinsey & Company. Gary sits on the board ofdirectors for Van Wagner (outdoor advertising) and Learning

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Care Group and is chairman of Tops Markets, LLC andReachOut America HealthCare, Inc. Prior to joining MorganStanley, he sat on the boards of Molson Coors BrewingCompany, Canyon Ranch, and Lenox China (previouslyDepartment 56). Gary holds a BA, cum laude, from PrincetonUniversity and an MBA with distinction from Harvard BusinessSchool.

David Hanfland is a partner and vice president with A.T.Kearney in Chicago and leads the firm’s Transaction Servicesand Healthcare practices in the Americas. David joined A.T.Kearney in 1993 and has led a range of projects across theinvestment life cycle including due diligence, mergerintegration planning and management, carve-outs, supplychain and manufacturing network strategy, G&A efficiencyimprovement, and investment exit strategy. David received aBS from Indiana University Kelley School of Business and anMBA from the University of Chicago Booth School ofBusiness.

Jeff Sexstone is a principal with A.T. Kearney in Atlanta andmember of the firm’s Transaction Services and Transportationpractices in the Americas. Jeff joined A.T. Kearney in 2006and has led multiple projects in M&A strategy, due diligenceand negotiations, merger integration, and divestiture strategy.He has previously held positions at DHL and Accenture. Jeffreceived a BS from Virginia Tech and an MBA from theUniversity of Virginia Darden School of Business.

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Chapter three

Operational due diligence

By Alex DeAraujo, Welsh, Carson, Anderson & Stowe

Introduction

It is becoming increasingly well understood that operationalvalue creation is one of the most critical, and often the onlylargely controllable component of returns, for private equityfirms. Therefore, how can private equity deal and operatingpartners identify both the opportunities for operational valuecreation and their associated risks to drive superiorrisk-adjusted returns? Operational due diligence and itssubsequent execution hold the keys to driving desiredinvestment performance.

Operational due diligence is the process of validating theunderpinnings of the base investment case. It can also identifypotential risks and ways to mitigate them, as well as identifyupside opportunities in advance of submitting a final bid for acompany or a business unit. Operational due diligenceconsists of several components, including:

• Revenue enhancement. For example, improve pricing policies,processes and analytics, enter new geographies, improvemarketing effectiveness, introduce new products and sellthrough new channels.

• Cost additions. Identify baseline costs to achieve forecastedrevenue growth, such as additional resources, material andlabour inflation, and additional investment in sales andmarketing.

• Cost reduction. For example, improve procurement execution,manufacturing or service delivery performance, labourarbitrage, manufacturing consolidation, and sales, general andadministrative cost (SG&A) reduction.

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• Risk identification/mitigation. For example, upgrades andintegration, C-level resource upgrades that increase generaland administrative costs, understanding liabilities/exposuresand one-time costs required in order to capture operationalimprovements. Many of these risk mitigation efforts will resultin costs that need to be incorporated into the investmentmodel.

The type of deal – standalone or part of a merger with anexisting portfolio company – impacts the nature of thediligence to be conducted.

Standalone

When evaluating a potential standalone acquisition, the firststep is to validate both the operational underpinnings of thebase case forecast and the management team’s ability toachieve the forecast. This should take priority over evaluatingprofit-improvement opportunities.

Often, operational improvements already have been identifiedby the target company and incorporated into the managementpresentation and financial forecast shown in the company’soffering memorandum or CIM. These improvements andforecasted results should be viewed with scepticism; in manycases, these items have not yet been fully implemented, dueto timing, resource or capital constraints, and thus must bethoroughly vetted. It is not uncommon that the ‘upside’associated with near-flawless execution is included in thefinancials while the true costs, efforts and risks of executionmay not be fully reflected in the CIM.

On the other hand, the buyer may have access to proprietaryinsights drawn from direct access to former companymanagement, former board members, or a former CEO orsenior executive in the same industry. In these cases, therecould be a very specific insight into the nature, magnitude andtiming of potential operational improvements. Depending on

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the buyer’s level of confidence in the insights obtained and thecompany’s ability to implement operational improvements, thebuyer can incorporate certain improvements into the dealmodel and potentially bid more aggressively for the target. Inan auction, this insight could spell the difference betweenwinning or losing a bid.

Merger with an existing portfolio company

When the plan is to merge the potential target company orbusiness with an existing portfolio company, the focus ofoperational due diligence is to identify sources of value fromand risks for integrating the two businesses. When a privateequity buyer already owns a company similar to the potentialacquisition, the buyer already possesses a significant amountof proprietary information about the industry and possibly thetarget company, and therefore can often bid as a strategicbuyer. Additionally, the private equity buyer can leverage theback office, purchasing or go-to-market capabilities of itsexisting portfolio company to create outcomes that would notbe possible without the ability to combine both businesses.Interdependencies between initiatives, execution risks and thecapabilities of each organisation must also be understood.

For both merger and standalone operational due diligence, theappropriate level of resources should be engaged in the duediligence process. Ideally, the buyer will have on its teamindividuals who have worked in companies similar to the targetcompany and individuals who have led operationalimprovements. Ideally these individuals are the same oneswho will be responsible for doing the same in the new portfoliocompany.

Modes of operational due diligence

Value creation through operational improvement is asignificant component, and is often expected, of private equityfirms. An Ernst & Young study has shown that 57 percent of

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value creation comes from operational improvement, whilemultiple expansion or deleveraging of target balance sheetsthrough debt pay-down comprises the balance of investmentreturns1. Therefore, it is essential that buyers vigorouslyconduct due diligence on key areas of the target company’soperations in parallel with an equally rigorous commercial duediligence process. While operational due diligence can takeconsiderable effort and expense, it is well worth theinvestment especially if operational improvement is animportant element of the deal thesis.

Operational due diligence can be helpful in many situations,including validating the operational underpinnings of the basecase forecast, validating a proprietary value-creation insight orenabling the buyer to pre-plan merger integration. While theneed for operational due diligence is obvious in distressedinvesting or carve-out transactions, it also plays an importantrole in growth equity and in other investment styles.

Standalone

The first step in conducting an operational due diligenceexercise is to validate the soundness of the base casefinancial forecast. This includes revenue drivers, such as thenumber of units sold and price per unit; cost, such asheadcount, materials and labour cost inflation; and marginenhancement plans. While some of these elements aretypically covered in the commercial due diligence, the intenthere is to bring an operator’s lens to validate key assumptionsand to assess execution and implementation risks. Next, thediligence should focus on understanding additional sources ofprofit improvement and focus on identifying risks andadditional costs that need to be incorporated into the forecast.

As we know, management forecasts are typically created bybankers and management teams whose primary interest is tomaximise the valuation of the company at the point of sale.Because of this, it is important to identify the key levers that

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drive their forecasts and thoroughly investigate each one. Inmany cases, the forecasts often bake-in a significant amountof margin improvement; achieving a portion of the forecastedmargin expansion is often a threshold element of theinvestment thesis. To assess this properly, a two-way lens thatfocuses on both the downside/execution risks and the upside/operational improvement opportunities should be applied.

To narrow the focus of the due diligence effort, it is necessaryto run a variance analysis to understand the source ofpossible margin improvements. This author recommendsusing a historical/projected waterfall chart, lining up specificcomponents of growth side by side over the past three yearsand for next three years, organised based on an operationalversus a financial lens. Based on this variance, identify theone to three critical drivers that need to be validated. Is thismargin growth strictly due to operating leverage (defined asincreased profit margins resulting from the benefits of a coststructure that grows less quickly than forecasted revenues) orare there other drivers? Is there a material change in how thebusiness is going to be run? How does this compare with whatother participants in the same industry are experiencing? If themagnitude of margin improvement is material, andcounterintuitive relative to the performance demonstrated byother industry participants, then it must be thoroughly vetted.Analysis of margin improvement driven by new products, newchannels or new ways of doing business may be covered inthe commercial due diligence, but it is critical that an operatorbe brought in to ensure that the projected benefits are in factrealistic and achievable within the constraints of timing, costand ability to execute. Depending on the outcome of theabove diligence findings, this information can be used to justifya lower valuation for the target company.

The private equity buyer could also have highly relevantinsights into cost, such as procurement for direct or indirectspend items, health benefits or insurance. A proprietary

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procurement programme that has pre-negotiated deals withindirect or direct sourcing vendors can typically beimplemented in a new portfolio company quickly with little costand risk2. A repeatable approach to health benefits can alsobe a consistent source of profit improvement or costavoidance, by standardising benefits programmes, buying asa combined entity, and ensuring appropriate levels ofemployee contribution and risk sharing.

If the buyer has a similar company to the target company in itsportfolio, very specific and targeted cost benchmarking can beapplied to the target. Having proprietary insight could result infindings that the target company’s cost structure is out of linewith industry norms, and if so, that an opportunity to save oncosts exists.

The buyer may also have direct industry expertise that can beapplied to the target. For instance, one of the private equityfirm’s senior industry executives is the former CEO of a verysimilar target company. This can lead to very powerful insightswhich can be validated through benchmarking. As a note ofcaution, it is critical to understand any set of benchmarks wellenough to ensure applicability. Peeling the onion tounderstand the nuances of industry benchmarks will help toavoid judgment errors and to increase the credibility of theanalysis.

Merger

When the plan is for the potential target to be merged into anexisting portfolio company, and the two companies are similarin size, significant thought must be given both to how to mergethe two companies and how to operate them as a single entity.As cost and revenue synergies are often the primary reasonfor doing the deal in the first place, the operational workstream should be part of the due diligence process in nearlyevery one of such deals.

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Mergers, however, have many shortcomings. A book by DavidHarding and Sam Rovit of Bain & Company, Mastering theMerger, claims that 70 percent of mergers fail to meetexpectations because they run into a number of commonpitfalls. Two key elements of merger success are: 1) to have arobust deal thesis (which this author would add should includeoperational value creation), and 2) to integrate quickly when itmatters (which requires significant pre-close vetting andplanning). As such, it is critical both to understand how valuewill be created at a granular level and to start the mergerintegration planning well before the deal closes. A properanalysis should include as many ‘concrete’ elements, such ascost reduction and revenue growth, as ‘soft’ elements, such asunderstanding the organisations – their histories, capabilitiesand cultures.

During the operational due diligence process, the buyer maygain or validate a general sense that the target company isunder-managed in some way. These insights, when takentogether with the analysis of the company’s financial forecast,could lead to the identification of specific margin improvementopportunities and potentially to a higher valuation for thecompany.

Information requirements

Access to information, both qualitative and quantitative, isimportant for identifying areas where profitability can beimproved. The approach used to sell the company – auctionversus proprietary deal – has a significant impact on thequality of the information available for the purposes ofconducting operational due diligence. In an auction, typicallythe potential buyer has limited access both to managementand to detailed company operational data. The analysis ismore challenging, but can still be done. In a proprietary deal,where there are only one to two potential buyers, the buyercan typically ask for significantly more information and access

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to management. In this situation, make the best out of it – itdoes not mean asking for ‘everything under the sun’ but itopens up access to targeted, relevant information to validatethe operational thesis.

Key data request items

Management teams are often very strained during a salesprocess. In addition to maintaining base businessperformance, they are inundated by data requests frombankers, lawyers, accountants and potential buyers.Therefore, it is important that due diligence teams ask for veryspecific items. Asking for too many items, or for items thatappear irrelevant to the seller or the management team, canerode a potential buyer’s credibility. This is particularlyimportant in situations where sellers may give the ‘last look’opportunity to their preferred acquirer. Given these dynamics,it is important to apply a very tight filter to data requests and toask for as many ‘off-the-shelf’ reports as possible (instead ofcustom data).

In this context, the following are typical operational duediligence data request items:

1. Detailed profit and loss statementsIdeally at the trial balance level, where there is clearseparation between labour and non-labour cost, by geographyand by product line. This item should also include cost bydepartment/cost centre.

2. Detailed balance sheetAlso at the trial balance detail level. This data can be used tounderstand the composition of larger balance sheet accountsand to understand a business’s reserves, fixed assets andliabilities. Observations relating to inventory, working capital,accounts receivables reserves and accrued liabilities that mayreflect further risk or opportunity should be examined closely.

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3. Detailed payroll database and organisational chartsThis is a standard download of the payroll file by employee;compensation and bonus should be included. Employeenames, if sensitive, can be redacted if positions anddepartments are included. Reasonable assumptions can bemade for benefits, taxes and travel. This item is particularlyimportant if personnel reduction is contemplated.

4. FacilitiesLocation, size, purpose, whether owned or leased. Copies ofthe lease, including ongoing costs and potential exit costs.These items are necessary if footprint consolidation iscontemplated. Pay particular attention to the actual rent orterms versus ‘market’ and the cost or ability to terminateleases.

5. Operating metricsRequests should be customised based on which operatingimprovement opportunities are likely to apply. The absence ofthese reports can be a good indicator of how operations arerun and how costs are managed. Examples of such reports(these should largely be off the shelf) are listed below:

• Standard operating reports used to run the business: nearlyevery company has (or should have) a monthly or weeklyoperating packet that reports more than pure financial data toinclude the metrics that management believes are mosthelpful to run the business (for example, volume, price,backlog of orders, revenue per order, call centre utilisation andkey employee turnover).

• Manufacturing: labour productivity, direct materialcost-reduction programmes in place or the lack thereof, cycletime improvement opportunities, inventory turns, yieldpercentage and waste percentage (scrap, expedited freightand overtime labour).

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• Warehousing: cost per square foot of warehouse space,staffing, labour unit cost, permanent versus temporaryemployees, use of third-party logistics providers during peakseasons. These are indicators of efficiency and are commonlybenchmarked.

• Call centres: number and location of call centres (a rule ofthumb is the minimum efficient scale of call centres is around250 employees), labour costs, cost per minute, call centreefficiency metrics (for example, average handle time, averagehold time, drop rate, utilisation).

• Sales and marketing: have distinct conversations on pricing,winning new customers, retaining existing and share of wallet.Often, too much effort is spent on acquiring new customerswhen there is an upside to adjusting pricing, retaining andgaining wallet share from existing customers.

• Pricing: the individuals involved in the price-setting process,how and how often is price variance measured, pricerealisation versus market. How are discounts managed andwho has the authority to offer discounts to customers?

• New customers: sales pipeline tracking, examples ofproposals, win rates, root cause of losses, order backlogtrending/conversion analysis.

• Retention of existing customers: net promoter score (NPS)with active follow-up, how NPS compares with competitors,churn rates, root cause of lost customers.

• Share of wallet: account planning templates and reviews,mapping of key stakeholders and relationships, share of walletmetrics if available.

• Sales force effectiveness: sales team structure (huntersversus farmers, inside versus outside), new sales revenue per

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head, percent performance versus quota, sales compensationplan.

• Marketing: spend as a percentage of revenue, spendallocation (for example, direct mail, online, advertising),marketing plan/calendar, channel mix, marketing return oninvestment.

Table 3.1: Example of a cost-reduction analysis for procurementCostcategory $ spend %

reductionRationale forreduction

Parcelshipping(UPS, FedEx)

$1million

50percent

Target has two vendors,priced at 20 percent offlist; our buying grouprate is 60 percent off list

Car rentals $200,000 40percent

Private equity firmnegotiated rate

Officesupplies

$500,000 30percent

Each of ten locationsbuys on its own;centralise spend anduse negotiated rate withvendor

Manufacturingsupplies

$3million

20percent

Private equity firmrelationship with vendor

6. Procurement

This function is often a significant source of value, especiallyin product-based companies or companies with large indirectspend. Many mid-market companies do not have a centralisedand/or sophisticated procurement function. Some duediligence on a few key spend categories can identify potentialsources of savings with a fairly high degree of certainty. Keydata request items include:

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• Organisation/process: the individuals responsible forprocurement, is it viewed as a strategic function, is itcentralised or decentralised, are there goals in place for costreduction?

• Spend: accounts payable download, spend by supplier, annualcost-reduction goals and progress versus these goals, list ofcost-reduction projects.

• Contracts: selected contracts of important, high-spendsuppliers.

Table 3.1 is an example of a cost-reduction analysis forprocurement. If the spend amount and contract terms areunderstood properly, these can be counted on with a highdegree of certainty.

Access to key members of management

A central element of due diligence is to have focusedconversations with key members of the target’s managementteam. Who these individuals are depend on the specificcompany and the nature of the opportunities to be evaluated.For operational due diligence, interacting with middlemanagement directly responsible for a particular businesssegment or functional area nearly always yields higher qualityinsights. For instance, whenever possible it is preferable tointerview the call centre manager instead of the COO, thehead of procurement instead of the CFO and the head ofmarketing instead of the CEO. Although some of theseindividuals may not be involved with the due diligenceprocess, the buyer should push to speak with them as muchas possible, especially if their areas of responsibility comprisea significant portion of the margin forecast. The goal of theseconversations is to understand the data provided, to test theimprovement opportunities of the hypothesis, and toeventually produce an estimate of the dollar impact ofpotential improvement opportunities.

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Functional/operational expertise

It is important that the due diligence team involveknowledgeable resources (industry experts, former membersof management, private equity operations team members and/or consultants) that have the functional, industry and/oroperational expertise to ask insightful questions and that canestimate the impact of potential improvement opportunities.Effort should be focused on identifying sources of risk orincremental value creation for the company.

Table 3.2: Example of a sales, general and administrative (SG&A)cost reduction plan

Consultants can be engaged to improve the quality of insights.If a generalist strategy firm is hired to conduct commercial duediligence, it could be asked to provide an industry or functionalexpert to attend the management meeting, and to vet themanagement forecast and the potential improvementopportunities for the company. A functional or operationalexpert who attends a management meeting and a few one- to

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two-hour consultations are usually provided as a courtesy ifthe private equity firm is already spending hundreds ofthousands of dollars on the commercial due diligence. Thistype of support is likely to help confirm high-level strategicthemes or assumptions, rather than to provide the privateequity buyer with detailed analysis or insights; expectationsshould be set accordingly. If substantial work is required, awork stream should be added to the commercial due diligenceto provide analytical support. Although expensive, this effortcan potentially validate proprietary insights that may enablethe private equity buyer to justify a higher valuation, or maypotentially identify operating and execution risks that wouldcause the buyer to re-think the acquisition. This could beparticularly helpful if the consulting firm is able to work with anindustry insider (for instance, the CEO/CFO of a similarportfolio company) that can help to guide their efforts.

Table 3.2 is an example of a SG&A cost reduction based on amerger of two companies in the same industry. A centralelement of the deal thesis is to reduce the SG&A by 70-pluspercent. In this example, payroll databases for each company,detailed trial balances and organisational charts wereavailable for this analysis, so it could be completed with a highdegree of confidence (and effort).

Approach to quantify the financial impact

For each area of opportunity (for example, procurement, callcentre or manufacturing), a five-step process can be used toestimate the financial impact of the improvement opportunity.

Step 1: Collect relevant data

The data request items outlined in the Operating metricssection above is a good starting point. Requests should beadjusted based on initial interactions with management andbankers to reflect what is easily available off the shelf. Asdiscussed above, given the time and resource pressure on

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management during the due diligence phase, it is veryimportant to get as much meaningful information from themwith as little effort as possible. When requesting data, ensurethe data is highly targeted to the intended analysis and thatthe data set is robust enough to support conclusions drawnfrom the data.

Step 2: Analyse data versus relevant benchmarks

The data should be synthesised in a way that makes itpossible to compare the target company – and combinedtarget and existing portfolio company – to similar companiesowned by the private equity fund, public companies and/orindustry benchmarks. Consulting firms that are hired to assistwith the commercial due diligence often have industrybenchmarks that can be used for this purpose. Analysingother public companies, industry reports, analyst reports andinformation from the Census Bureau and Bureau of LabourStatistics are additional useful sources of benchmark data.Expert networks, such as GLG and Guidepoint, can also besources of harder-to-obtain benchmark information. While thisbenchmarking exercise does not yield precise cost-reductiontargets, it can be a powerful way to focus the due diligenceeffort by collecting more in-depth information for the two orthree areas that have the highest likelihood of producingoperational improvements.

Examples of analytics include:

• Labour cost per hour versus similar companies (on-shore andoff-shore)

• SG&A as a percent of sales versus comparables

• Gross margin percent versus comparables

• Cost per square foot of warehouse space versus alternatives

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• Number of physical locations versus similar companies in theindustry (headquarters, manufacturing, distribution and sales)

• Bad debt as a percentage of sales versus competitors

• Number of employees per human resource staff

• Revenue and employees per finance staff

• Cost per minute of call centre time versus industrybenchmarks

• Sales commission percentage versus competitors

• IT costs as a percentage of revenue

• Manufacturing labour cost per hour versus benchmarks

• Expedited shipping (for example, UPS or FedEx) cost anddiscount off list price

• Inventory turns and waste versus similar production processes

It is very important to dig deeper to ensure that thebenchmarks used are relevant and are fundamentallycomparable. For example, a business that gets a highpercentage of its sales through distribution will have differentcost structure and headcount attributes than a similarcompany (size, activities, product offering) with a direct salesforce that sells to larger customers.

At this point, it is important to investigate areas that hold thehighest promise of gains from operational improvement. Forinstance, if IT is a very high percentage of the accountspayable spend, then ask for pricing of the five largestcontracts; if warehousing appears to have high labour costs,then ask for wage rates by position and staffing; if SG&Aappears high relative to peers, then a payroll database andorganisational charts are needed for further evaluation.

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Step 3: Review data and ask management targetedquestions

Once the analysis is complete, the findings should bediscussed with the company, especially in areas where thebenchmarks would suggest there is an opportunity foroperational efficiency. Questions should be asked todetermine if there is an issue with the data or the analysisitself, if there is a logical explanation for the discrepancy or ifthere exists a real operational improvement opportunity.Exhibits/schedules developed from the data analysis andshown to management can be very helpful so the answers arefact-based and concrete rather than conceptual and generic.

Step 4: Translate the analysis into estimated financialimpact

Quantifying the potential financial impact of any undertaking ismore art than science, and requires good business judgmentand a track record of quantifying and implementedimprovements. An industry insider can be particularly helpfulin this phase of the work.

As a rule of thumb, if the benchmarks and discussions withmanagement suggest that there is an opportunity to improvecosts by $1 million, it is advisable to take only 25 percent to 50percent of that opportunity as the cost savings estimate.These percentages are a judgment call and should beadjusted based on the level of certainty in the opportunity. Forinstance, in a situation where it is known that the targetreceives a 20 percent discount on UPS shipping, and theprivate equity firm has a group deal where 50 percent is thenorm, it is reasonable to bake-in 100 percent of theimprovement. On the other hand, if the target company’sSG&A cost is 5 percent higher than the benchmark, it wouldbe more prudent to estimate a 1 to 2 percent improvement,based on specific supporting evidence. Using this type of 80/20 approach will save time and help avoid excessive

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pessimistic or optimistic biases with respect to modellingoperational improvement. In addition to the above, it isimportant to properly reflect the timing of the savings impacts;everything cannot be done at once and portfolio companyexecutives need to plan, coordinate and mobilise resourcesbefore they can execute. It is not uncommon to take up tothree years to fully implement a transformational operationalimprovement programme.

Table 3.3 is a template to quantify and communicate thefinancial impact that could result from the measures identifiedfrom an operational due diligence exercise. It summarises thefollowing main outputs of this effort:

1. The EBITDA impact of operating improvements.

2. The EBITDA impact of cost increases.

3. The one-time costs needed to achieve the benefits.

Detailed supporting schedules and analysis should beincluded to support each of the rows in this exhibit. Of equalimportance, a judgment on the degree of confidence for eachof the improvements and costs should be made.

Step 5: Evaluate cost, effort and risks

There are two components of cost. The first is onetime costs(for example, lease termination cost, severance, recruiting/retention cost) and the second is recurring cost (for example,additional staff, IT upgrade costs and a larger warehouse toaccommodate growth). In some cases, they are directlyrelated to the areas identified in the operational due diligenceprocess. In other cases, they are identified in other areas ofdue diligence such as IT or legal; these need to be quantified.

It is prudent to be conservative in estimating the latter costs, touse a thorough checklist, and to estimate costs for additionalresources and external consultants. Then, add a safety marginfor unforeseen issues. Costs related to IT, severance/

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relocation and contract terminations can be high. Material andlabour inflation should be baked-in into the estimates. As ageneral rule of thumb, one-time costs should be no less than50 percent of the intended savings run-rate to be achieved.

Table 3.3: Example of an operations due diligence summary

In many cases, the operational improvement opportunitiesidentified through this process require significant effort fromthe target company, such as a major change in behaviour and/or cost-structure adjustment. In these instances, the risks,

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effort and cost to achieve the opportunity should be evaluatedand quantified accordingly.

Underwriting the deal model

An interesting question when conducting operational duediligence is whether the potential benefits identified should beincluded in the deal model.

On the one hand, including operational improvements requiresa high level of follow-through commitment from both the dealteam and the operating team and requires greater involvementof operating partners and consultants. Including thesepotential savings might also impact valuation in a way thatenables the private equity firm to bid more aggressively forattractive assets, which in some cases would be hard to justifystrictly on a ‘status quo’ valuation.

On the other hand, there are often many degrees ofuncertainty on the magnitude, timing and ability to achievemodelled operating improvements. By nature, due diligencetakes place in a highly compressed time frame, with limiteddata availability and access to management, and where thetarget company is trying to maximise its valuation. Therefore,the buyer needs to feel confident about the quality ofinformation received and the assumptions behind anyforecasted operating improvements. The other challenge isthat the estimation process may rely on benchmarks that mayor may not be directly applicable to the target company.

The net of the two arguments is that, in order to includeoperational due diligence findings in the target company’svaluation, the analysis must pass a fairly high standard on thefollowing points: availability of relevant data, access tomanagement, relevance of benchmarks, quality of analysis,and ultimately, the ability to achieve the identified operatingimprovements. The financial benefit needs to be materialenough and be high enough of a probability that it would move

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the needle on the valuation of the company. To estimate thisaccurately, it is advisable to contemplate a range of outcomes,probabilistically weigh them, and only incorporate into thebase case the improvements that pass a high standard ofcertainty. Ideally, obtain some level of management input intothe improvements in advance of the final bid.

Operating expertise within the private equity firm should bebrought to bear at the earliest appropriate time. Firms shouldbe thoughtful about not involving the operations team inpreliminary due diligence before an opportunity has beeninitially vetted, nor so far down the path of diligence that thereis little time left for work to be performed or for hypotheses tobe thoroughly tested and incorporated into the deal model. Agood rule of thumb is for the deal or operating partner to beinvolved as soon as an advisor for the commercial duediligence work stream is hired. Spending significant money onthird-party due diligence usually signals that the deal team issufficiently confident that the deal is attractive and has areasonable probability of success.

Ownership and value-creation plans

An important element in ensuring good outcomes fromoperational due diligence is to have very strong follow-throughto bridge the operational due diligence through at least sixmonths post-close. There are two key elements to this:ownership and value-creation plans.

Te ensure a high degree of ownership, the deal team, board ofdirectors, operating executive (where applicable) and themanagement team (to some degree) needs to be bought intoany plan that involves significant operational improvements. Ifthe private equity firm has an operating executive, the saidexecutive should be involved at the appropriate time in thedeal process and should approve the improvements. Ideally,the management team should be involved in the vettingprocess for any important operational improvements,

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especially those that involve significant changes in behaviour,structure or compensation for the management team. Forinstance, is not advisable to spring an aggressive off-shoringprogramme on a management team immediately post-closewithout some prior discussion.

A very effective method to ensure follow-through is toimplement a value-creation plan (VCP). This is discussed inChapter 11, Developing post-acquisition plans, in this guide.VCPs are particularly relevant in instances where operationalimprovement is an important driver of the valuation.

A VCP can help:

• Align expectations between management and investors upfront.

• Further vet the operating improvements with ‘full access’ tointernal data and cooperation from management.

• Prioritise opportunities based on their financial impact.

• Allocate sufficient internal and external resources to eachopportunity.

• Define and track clear key performance indicators (KPIs).

• Review progress in conjunction with the monthly financialresults.

Conclusion

Operational due diligence is a powerful tool that can identifyoperational improvements before a deal closes and possiblyinform the valuation of the business. It is particularly relevantin situations where substantial operational improvements areexpected on a standalone basis, or where a merger betweentwo companies is to take place. Operational due diligencerequires higher than usual access to data and management,especially when the sale process is an auction. It also requires

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relevant expertise to interpret the information about the targetand to quantify the benefits from operational improvement.The findings and analysis stemming from the effort can beincorporated into the deal model, especially in situationswhere there is a high degree of confidence that theoperational improvements are achievable. However,commitment from the investment team is needed to underwritethese changes and the target company will need to takesignificant actions.

Operational due diligence is an important tool to avoidbecoming part of the 70 percent of mergers that do notachieve their expected results. It is also a key enabler ofdriving the 57 percent of returns that are expected fromoperational improvements.

Alex DeAraujo is an operating executive with Welsh, Carson,Anderson & Stowe (WCAS). Since joining the firm in 2010,Alex is responsible for helping portfolio companies identify andimplement initiatives focused on growth and operationalimprovement. Alex also supports commercial and operationaldue diligence efforts. Before joining WCAS, he was a seniormanager at Bain & Company, where he worked for sevenyears with private equity clients on commercial andoperational diligence, and often on implementation of theseefforts post-close. Prior to Bain, Alex also worked at GeneralElectric in business development, corporate audit andoperations management. Alex earned a BS in MechanicalEngineering from Michigan State University and an MBA fromHarvard Business School.1 Ernst & Young, Return to warmer waters: How do privateequity investors create value? A study of 2010 North Americanexits, available at http://www.ey.com/Publication/vwLUAssets/A_study_of_2010_North_American_exits/$FILE/How_do_PE_investors_ create_ value_N_America.pdf.

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2 For a more detailed discussion on procurement programmes,see Jeff Gallant, Developing a private equity procurementprogramme, in The Operating Partner in Private Equity, PEI(2011).

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Chapter four

Financial due diligence

By Erik Shipley and Mattias Gunnarsson,PricewaterhouseCoopers LLP

Introduction

Well-executed financial due diligence can provide privateequity firms with many opportunities, the nature and extent ofwhich depend on how the due diligence process proceeds.The task, however, is a challenging one – the executiveconducting the due diligence, whether a deal professional oroperating partner, must tread the fine line of gaining a deepunderstanding of the target company’s finances whilesimultaneously helping the target’s management team to viewthe transaction and outcome as a mutual goal.

Conducting due diligence is like running an obstacle course:the goal is clear, but how one gets there may be less certain.While uncertainties may lead some to decide that having aloose plan, or none at all, is best suited to deal with difficultiesor surprises, a risk-focused and process-oriented approachwill always lead to a more successful outcome.

For any deal, in the absence of the mythical crystal ball,expectations of future performance are couched in historicaloutcomes. This is especially true of reported financial resultsthat inherently relate the story of all functional areas in anorganisation. Therefore, the financial due diligence objective isto elucidate those outcomes and to help develop a plan thatbegins as early as the initial negotiations and stretchesthrough to the exit.

Objectives of due diligence

The core objectives of the due diligence planning process are:

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• Managing risk.

• Validating value drivers.

• Supporting negotiations.

• Paving the way to capture value.

The first step in any successful due diligence is thinkingthrough the approach underlying each of the objectives.Consulting advisors with specific and deep technicalknowledge of the functional areas is a recommended practiceto ensure that the due diligence objectives align with thespecifics of the deal. In financial due diligence, mapping thecore financial due diligence analyses (such as quality ofearnings, debt and debt-like obligations, and working-capitaltrending/normalisation) to the key deal finance objectives willallow a proper framing of the overall process. This framingexercise can also help to determine how resources, bothinternal and external, should be directed so maximum time isspent on high-value items.

Managing risk

While the definition of risk varies both theoretically andpractically, a clear understanding of the risks by functionalarea is the best place to begin (see examples in Table 4.1).Placing bounds on the risk analysis is best done by cullingnonoperational and nonrecurring items from the ongoingresults. This can be done by identifying transactions and otheritems that may not be apparent from the reported financialdata, ideally from a bottoms-up transactional and trendanalysis. This analysis, coupled with detailed discussions withthe target’s management team, can provide insights into bothavailable opportunities and risks. Further, this exercise laysthe foundation for achieving the remainder of the due diligenceobjectives.

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Table 4.1: Financial due diligence risk considerations by functionalareas

Source: PricewaterhouseCoopers.

Validating value drivers

After cleaning up the financial data, understanding the trendsand relationships implied by the financial information is next.While management generally has a high-level understandingof the company’s underlying business drivers, they are oftenmyopic; typically, only the CEO and CFO see the wholepicture but they are not necessarily able to bridge the details.

Regular management reporting typically does not evolve instep with the business. This often leads to disconnectionamong the management team’s articulated vision, theallocation of resources, and the alignment betweenmanagement reporting and key business initiatives. Abottoms-up validation of the key drivers including input fromother functional areas (for example, human resources, tax, ITand legal) will aid in refining the underlying assumptions and

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help to bring reporting, strategy and overall focus intoalignment.

Supporting negotiations

A proper due diligence approach will provide a strongfoundation for all phases of the negotiation between theprivate equity buyer and target. By organising the key pointscaptured in the risk analysis and in the determination of thedeal’s key value drivers, a prospective buyer can reinforce oradapt its negotiation strategy to achieve the most beneficialoutcome. Developing a negotiation action plan based on themost material risk and reward drivers will help to ensure thatthe buyer focuses on what matters and potentially bolster itsposition with ‘throwaway’ points in order to capture the itemsthat are truly important to the buyer. The aforementionedapproach is applicable to the analysis of nearly any incomestatement balance sheet or cash flow-related item.

Paving the way to capture value

Successfully unlocking value begins by leveraging knowledgegained in the due diligence process to outline a roadmap forthe target post-close. A well-executed financial due diligenceeffort will not only dive deep into the financial details of thetarget company, but also understand how those detailstranslate functionally and operationally into the expectedsynergy areas and into one-time costs. Further, the impact onfuture run-rate earnings can be discerned.

The due diligence findings can help to lay the foundation ofthe target’s 100-day plan, and to identify potentialimpediments that can be proactively anticipated pre-closerather than reactively avoided post-close. Proper planning tocapture value will, at best, lay the foundation for rapidexecution of various initiatives, and, at worst, minimise thepost-close stress on both the management and the deal team

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by having a methodical plan that has been agreed on by allparties.

Planning well to execute well

The transaction basis and ownership structure of the targetshould be used as guideposts for key considerations of thedeal. Targets generally fall into the following broad categories:the transaction basis is either a standalone or a carve-out, andthe ownership structure is either public or private. Thesecategories will be discussed in-depth in the section Plottingthe course below.

Data matters

Financial due diligence is, by its nature, data-driven.Therefore, the most obvious and pervasive issue faced in anyfinancial due diligence exercise is the quality and availability ofdata. Both of these factors typically scale up or downdepending on the basis of the deal and the ownershipstructure, as well as the recent performance of a financialstatement audit.

With a sufficient understanding of the target’s structure andbackground, the first step of financial due diligence is datagathering. While this can take many forms, two areas inparticular can significantly impact the deal timeline: 1) the datarequest list and 2) audit working paper access. While neitherof these should take precedence over the other, the seconditem is often helpful to gain a deeper understanding of theorganisation and to refine the due diligence scope andapproach.

Data requests are often the biggest stumbling blockencountered in financial due diligence because of a variety offactors. These factors include the limited bandwidth of theindividuals ‘under the tent’, finding/creating data or reports notused in recurring management reporting, and misprioritisationof requests. The data request list should be aligned with the

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priorities of the due diligence effort. When constructing thedue diligence timeline, it is necessary to consider datagathering, analysis and hypothesis-testing. While the extentand nature of the data requests will be determined by thetransaction basis and ownership structure, deep industryexpertise of the preparer both in the deal space and specificindustry are important to avoid timeline-killing multiple ‘bites ofthe apple’. In the absence of this expertise on the part of thetarget management, additional support will be necessary toensure that the output aligns with the objective.

Audit working papers essentially are the details behind theone-page audit opinion. These papers should provide insightinto why the auditor feels that the financial statements presentfairly, in all material respects, the financial position of thetarget. Although the audit opinion provides comfort that thecompany’s finances has been looked at and tested by a thirdparty, limitations remain, such as the approach (typicallytop-down), the precision (materiality is a judgment call), andthe knowledge and experience of the audit team.

The second level of comfort relates to the proper application ofaccounting principles. Regardless of the comfort gained, theaudit working papers may provide early indicators of potentialdeal issues which should be considered in the due diligenceprocess. As with any data review or request, a review of auditworking papers is most effective when a list of focus areas isprepared prior to the review.

An audit is only as good as the people who performed it. Anexample once occurred during a visit to a mid-tier accountingfirm that audited the financials of a standalone softwarecompany. The audit partner was asked to point to the VSOEanalysis (vendor-specific objective evidence – the keystone ofsoftware accounting under US generally accepted accountingprinciples or GAAP), to which he replied that they had notperformed a ‘formal analysis’. The audit partner’s response

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indicated that he did not understand the accounting rules.Therefore, the revenue recognition was probably wrong andthe data was not likely to be readily available (since nobodyhad looked at it). Both turned out to be true. This case shouldserve as a reminder that restatements are not uncommon andthat while an auditor may dismiss something as immaterial forpurposes of their opinion, it may not be for the transaction.

Access to audit working papers involves several administrativesteps which could impact the deal timeline. Ideally, the requestfor access to the working papers should be made early in thedue diligence process. While accessing the working papers isan important step, some exercises will be less fruitful thanothers and the deal timeline needs to allow sufficient time forexecutives to dig into matters absent from the audit workingpapers.

Plotting the course

Beyond data, other matters that affect the risks and processescan prove problematic without proper planning. Figure 4.1illustrates the typical expectations regarding data reliabilityand availability for the different types of deals and ownershipstructures. Although a deal may not fall neatly into these broadcategories or even deviate from the norm, consideration of theitems discussed below will result in a better planned andexecuted due diligence process.

Standalone

A target is typically considered standalone when it has adiscrete legal organisation, separate operational and financialcontrols, distinct processes and reporting that do not dependsignificantly on any upstream or related entities. To use acomputing acronym, it follows the WYSIWYG (what you see iswhat you get) principle.

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Figure 4.1: Expectations of data reliability and availabilitydepending on private equity deal types

Source: PricewaterhouseCoopers.

Generally, a standalone entity will have more abundant datathan a carve-out as all financial statement accounts will besupported by detailed sub-ledgers. Further, the financialstatements of standalone entities should not be clouded withjudgmental allocations of revenues, costs, assets or liabilities.Finally, management generally has full visibility into all aspectsof the target’s financial and operational results; although thatknowledge may not be centralised, answers can generally befound in the underlying data and supporting documentation.

Because standalone entities run autonomously, the post-closetransition is straightforward as it involves tailoring the financialreporting to the needs of the sponsors and the transactionlenders. Further, strategic enhancements can be implementedimmediately as the management team should not bedistracted with other matters resulting from the transaction.

Exceptions to the standalone simplicity arise when the entityhas a decentralised organisational structure and weak centraloversight. This symptom is typically found when prioracquisitions have occurred and minimal integration has been

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attempted. In such instances, performing discrete duediligence exercises of the primary sites or geographies will bemost efficient as it avoids the bottleneck that is usually createdwhen all questions and data are sourced through centralmanagement.

Issues can also arise when contracts or business units withinan entity are set up as autonomous units and thencross-charge each other for services provided. Onemultibillion-dollar standalone transaction resulted in theinability to reconcile the underlying data to the financialstatements after three weeks of due diligence because ofallocations and cross-charges. It was discovered that whatstarted as $1 of costs may show up as $0.50 in one place and$2.50 in another – and management had no ability to detanglethe expenses as each dollar could be allocated andreallocated several times and the intercompany eliminationwas a systematic mystery to the finance team. The auditorsrelied on computer controls to get comfortable with theelimination. In such a scenario, it is best to approach the duediligence process as a carve-out.

Carve-out

A carve-out transaction may take many forms. Generically, it isa product line/group/category that represents a subset ofincome-producing assets pulled out of a broader organisation.While these transactions are typically asset deals and it is thuseasier to avoid successor liability issues, certain jurisdictionsmay require stock purchases and certain liabilities may attachto the assets rather than to the legal entity.

Understanding the carve-out process from the identificationand segregation ‘what’s in and what’s out’ stage to thecollection and aggregation of financial data stage is essentialto focus the due diligence approach on the areas with thegreatest risks. The cleanest carve-out processes involvededicated and experienced internal resources or external

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advisors who pore through the details of the asset and helpthe parent surgically excise the target. The messiest carve-outprocesses rely on internal resources that are inexperiencedand temporarily reassigned. In the former situation, the selleris more aware of value and may be less willing to concede onprice. The latter scenario presents many additional risks, aswell as opportunities.

In addition to the financial statements of the carve-out, aseparate standalone analysis should be performed to createdeal-basis financial statements. Additionally, there may beincremental costs not reflected in the carve-out financialstatements but which would be necessary on a standalonebasis. Regardless of the approach taken, the financial duediligence process should involve a detailed deconstruction ofthe operations linked to the financial data presented, andaugmented with robust discussions of allocations. The sellerwill often use the difference between the reported financialstatements and its deal financial statements as a black hole tohide costs or issues (whether intentional or not).

While the deconstruction of operations should be a relativelyquick exercise, some deal teams have foregone this effort onlyto later deal with tens of millions of dollars of additional costs‘showing up’ post-close. Peeling back the layers of the costallocation risks can reveal additional value to the seller, butultimately will provide the banks with more comfort overfinanceable EBITDA and result in fewer surprises post-close.Further, this exercise will directly support pricing negotiationsrelated to the transition services agreement (TSA) and help toexpedite weaning the target from the parent.

Another difficulty with carve-outs can be the targetmanagement who are unable to respond to detailed questionsunless the scope of their regular reporting has prompted themto focus on those areas. As divestitures typically involvenon-core (that is, neglected) product lines, little attention is

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paid to anything other than relatively high-level financialresults. While a proper financial due diligence exercise willidentify unusual trends or transactions, the resultingexplanations are often underwhelming. Relying on theunderstanding of the carve-out methodology, the standaloneanalysis, and the transaction-level build-up and analysis canhelp to fence-in risks.

The complexities of a carve-out require significantly moreup-front planning than standalone entities. These complexitiesare related to standing up the back office and operationalinfrastructure (that is, weaning from the TSA), and financialplanning related to ongoing cash costs. Ideally, this planningwill be integrated into the due diligence exercise of leveragingdata and insights from the process.

Other key areas of focus include employees, operating assetsand post-close adjustments. Employee matters to beaddressed include right-sizing or realigning the employeepool; assessing compensation and benefit levels (includingreplacement or supplanting non-cash components); andassessing the hire versus outsourcing model for servicesprovided under the TSA. The data gathered during duediligence should serve to test key assumptions underlyingfuture-state employee costs.

Operating assets are often assessed in terms ofcapital-expenditure trends (especially growth versusmaintenance). In a carve-out, the reality is that while thecapital spend may appear sufficient to sustain the business,the methodology underlying the calculation and thepresentation of those values are often overlooked, eventhough the values themselves are highly subjective. A simpleadditional procedure performed during financial due diligencesuch as analysing the in-service dates and asset values fromthe detailed fixed asset listing, and aligning the same with the

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reported capital spend, should highlight potential problemsthat may require additional cash post-close.

Most carve-out scenarios result in a post-close adjustmentfocused on one or a few key balance sheet categories thatcan be specifically tracked for the business. Front-loadingdiscussions about which assets will be included in thepost-close adjustment will allow for a greater focus on thesame during due diligence, and the related trend discussionsshould help set the stage for final negotiations and furthersupport any asset-backed lending facility contemplated for thedeal.

Public company

The internal controls, regulatory reporting and regular financialstatement audits of a public company typically result in higherquality data. However, those same drivers may limit what thecompany is willing or able to disclose. Confidentiality orcompetitive concerns often curb data disclosure and eitherrequire heavy reliance on audit working papers or the use of a‘clean room’.

A clean room is typically a segregated data set to which only aselect number of individuals (often consisting primarily orsolely of external advisors) is granted access; the individualsinvolved are called the ‘clean team’. Derived data and detailedfindings can only be shared within the clean team, but asanitised and summarised version of resulting deal points isgenerally shared with the broader deal team. The use of aclean room takes more time on the front-end to negotiate bothrelated agreements and data scope, and more effort on theback-end to communicate key findings without breaching theclean-room protocol. In private equity, clean rooms areprevalent when the private equity buyer has an existingportfolio company in the same industry as the target.

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Assuming that public company data access challenges areovercome, the expected higher quality of the data allows thefocus to turn from process to practical matters such asintegration and operational planning.

The primary employee matter to resolve for public companyacquisitions is replacing or supplanting non-cash ordeferred-compensation arrangements. Decisions on sucharrangements should be grounded in the historical data (whatdid they get?), and combined with a realistic understanding ofthe model impact (what can we give?). Management of apublic company is likely to be more optimistic than pragmaticregarding public company costs. For example, a popular moveis to add back to EBITDA all costs related to Sarbanes-OxleyAct compliance. The assessment of these potential costsavings should be approached in a manner similar to othermanagement adjustments during financial due diligence – byunderstanding the logic and validating the data. This costassessment should also be conducted with a view of the exit,whether through a public or private sale.

The final consideration of conducting financial due diligenceon a public company is the limited protection offered byrepresentations or warranties and no post-closingmechanisms. These factors inherently pose risks to the duediligence process which cannot be completely abated,although ensuring that the process is scoped to dive intosufficient detail in key areas should reduce the risk to anacceptable level.

Private company

Management teams of private companies are often not asseeped in regulatory compliance concerns as their publiccompany counterparts. Therefore, access to data is often nota problem, although quality may be.

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Private company management tends to be less focused onaccounting and more focused on cash. This may lead tounderinvestment in the internal accounting and financefunction and heavier reliance on external support. Further,there are few internal controls or formal policies. These factorscan lead to inconsistent recording and presentation of data,which will be exacerbated by any attempts to move from acash to accrual basis of accounting. Instead of relying solelyon management reports and explanations, building a freshunderstanding of the data from the bottom-up can yield betterresults.

Focusing on applying macro-level GAAP or accrual-basisfilters to the transaction-level data during due diligence can atleast provide a sanity check on the reported results and furtherhighlight anomalies.

Highly utilised finance resources and/or heavy reliance onexternal support can also lead to an inability of managementto quickly respond to detailed questions. In this case, usingtransaction-level data can expedite the due diligence processas unusual trends can be discussed in terms of specifictransactions. Doing so can limit the scope of answers to beobtained from management.

Similar to public company costs, private company or personalowner costs are a favoured area of management to takeartistic license. Both a standard inquiry and sourcedocumentation will reveal any obvious discrepancies, butwhether the reported costs are truly non-operational is moredifficult to ascertain. Detailed discussions and reliance onmanagement representations is sufficient to resolve anydiscrepancies in most instances; however, deal teams shouldprotect themselves contractually for more questionable itemsand amounts.

The final area that should be considered for private companiesis related-party transactions. Private company owners are

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often advised to undertake a myriad of strategies to savecosts, protect assets, transfer assets or reduce taxes.Regardless of the purpose behind the various related-partyarrangements and structures, financial due diligence shouldprovide a good understanding of the transactions themselvesand how they are reported in the financial statements.Separately, the arms-length nature of the transaction shouldbe assessed in order to properly model any incremental costspost-close (including any one-time moving/transition costs ifproblematic arrangements cannot be remedied through thepurchase contract).

Note that the above discussion broadly assumes that privatecompanies are smaller and less sophisticated than publiclytraded companies. A large complex private company,however, has much in common with public companies andshould be assessed accordingly.

Conclusion

Each deal is unique, but the challenges of conductingthorough financial due diligence are universal. Regardless ofthe deal specifics, anticipating the challenges and plotting aresponse will better align views and set expectations acrossthe deal team and with target management. Focusing on thebackground as well as the tactical and practical matters of thedeal while scoping the financial due diligence exercise willresult in a more efficient and meaningful exercise.

Erik Shipley is a director in PricewaterhouseCoopers LLP’sTransaction Services Group, based in San Francisco. Headvises both private equity and corporate clients on dealsfrom buy-side due diligence and deal structuring, includingcross-border acquisitions and public company takeovers, tocomplex carve-outs, initial public offerings, and divestitures.Prior to joining the Transaction Services Group, he spentseveral years auditing public and private companies. Erik

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holds degrees from the University of La Verne and BrighamYoung University, and is a Certified Public Accountant.

Mattias Gunnarsson is a partner in the Los Angeles office ofPricewaterhouseCoopers LLP’s Transaction Services Group.He specialises in providing acquisition and divestiture-relatedadvice to private equity and strategic clients. He has extensiveexperience leading large complex US and multinational duediligence engagements and regularly advises his clientsthroughout the deal process from initial valuation support,performance of due diligence, negotiation of purchaseagreements, development of transition service agreementsand processes, as well as resolution of purchase priceadjustment disputes. Mattias started his career in PwC’s auditpractice. He is a graduate of Gothenburg University and is aCalifornia Certified Public Accountant.

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Chapter five

Financial due diligence, an operator’s approach

By Shahriyar Rahmati, The Gores Group

Introduction

Well-executed financial due diligence is one of the mosteffective means by which a private equity firm, and especiallyits operating partners, can mitigate risk and drive returns in aninvestment. The information gathered and analysis performedduring the due diligence process will inform the decision as towhether or not to pursue the deal. Complicating matters,however, is that a significant portion of due diligence occurswhen a buyer has incomplete information and periodic access,if any, to management. The ability to draw and supportimportant deal assumptions despite ambiguity can distinguishfirms from one another and determine success or failure in abidding process.

Financial due diligence typically comprises three components:1) validating historical financial statements using a quality ofearnings (QoE) report; 2) understanding historical financialstatements to assess management’s projections (includingproforma adjustments); and 3) analysing historical andongoing operations that will be used to eventually underwrite adeal. This chapter will focus on the third point and provide apractical framework for private equity executives by linkingbusiness operations, financial analysis and data requests.This chapter will assume that the first two stages of financialdue diligence have been satisfactorily completed and that thebuyer has a basic understanding of the company’s incomestatement, balance sheet and cash flow dynamics.

The initial investment thesis should frame the direction andgoals of due diligence. The thesis should consist of an initialhypothesis and a set of focused analyses designed to prove or

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disprove the hypothesis. The investment thesis is particularlyimportant for financial due diligence as it will typically highlightthe key areas of focus and analyses required.

Income statementRevenue

Developing a view on the revenue landscape of a company isfirst in order of importance when conducting financial duediligence. It will form the basis for due diligence and typicallyprovides key insights which can be used to assess thecompany’ capabilities and activities against the functions mostvalued by customers.

As early as possible, segment sales by geography, channel,product line and end-customer type. These items should beclearly described in the initial data request list (see Table 5.1).It is also vital to understand average selling price trends,rebates, returns and discounts, as well as the salesorganisation topology, which supports total company revenue.

All requests should encompass sufficient data to showhistorical trends. This data request will vary by business typeand should answer questions about abnormal increases ordeclines, or new product or channel strategy deployment.Early in the due diligence process, sellers may be reluctant toshare specific customer or product-line data, but pursue thisdata so potential issues can be flagged and further analysed.

The analysis performed should produce the following outputs:profit margins, average selling price trends, geographic andcurrency considerations, and sales force structure. Theseoutputs should be reflected in the deal model as appropriate.

Table 5.1: Revenue diligence itemsData request description Purpose

Revenue by customer Customer concentration/trends

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Revenue by product Growth/decline rate by productand mix shift

Revenue by geography Growth/decline CAGR bygeography

Revenue by channel Profitability/CAGR by channel,channel concentration

Revenue in units soldNew products (to be defined)

Average selling price trendanalysis and growth in terms ofunits

Rebates, discounts, returnsDetermine gross versus netrevenue items and risk intrends

Sales compensation plans

Sales compensation plans can be powerful tools to directsales resources to focus on particular attributes of thebusiness. The structure of plans also provides an explicitframework for salespeople to optimise their owncompensation. A salesperson with a compensation planfocused exclusively on revenue dollars who also has theability to affect price may sell products at a lower margintowards the end of a particular month quarter or year in orderto meet compensation plan targets. A purelygross-margin-driven plan will result in high gross margins onpotentially low sales dollars.

Analyse the degree to which sales compensation plans arefixed or variable in order to correctly model the relationshipbetween sales and selling costs over the intended holdingperiod. Changes in revenue, average selling pricecompression, gross margin increases and employee attritionare all potential effects of changes made to salescompensation plans. As such, it is important that datarequests provide the information required to highlight

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significant changes to compensation plans made over the lastseveral years and the impacts, if any, which resulted (seeTable 5.2).

Table 5.2: Sales compensation plan diligence itemsData request description Purpose

Most recent and previous salescompensation plans

Review of key components/terms of plan

Quota/sales target-settingprocess documents

Test current accruals andexpected payouts

Fixed versus variablecompensation and supportingdetail

Model cost structure versussales levels attained

Number of plans and structureof plans (if >1)

Understand compensationdrivers and variability of plans

Sales organisation charts Understand reporting structure

Tenure by sales representativeand sales representativeturnover

Understand forced attrition

Revenues from new products or new markets

Often, a seller’s case for an increased future value of itsbusiness is predicated on its successful entry into newmarkets. New markets may be defined as geographicdiversification using additional sales channels or previouslyunexplored go-to-market methodologies. The company mayalso enter new markets through product development effortsto access the markets it previously could not serve.

Geographic diversification brings with it its own set ofchallenges and the items below should be considered whenreviewing management’s assumptions for revenue growth asa result of geographic expansion:

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• Payment terms may be longer or shorter than in the rest of thebusiness.

• Credit risk must be assessed and it may not be normalpractice for customers to provide detailed financialinformation.

• Local partners and the company may have to share risk andrewards in ways previously not done.

• Regulations may require customs compliance and can carrysignificant penalties for non-compliance.

• Foreign currency risk may exist if currencies other than thecompany’s primary currency are used.

The company may access new markets through partners suchas distributors and value-added resellers, or throughe-commerce. Analysing the following items will provide insightinto the implications of entering new markets:

• Marketing cost to establish a presence in new markets, ifrequired.

• Time required for new channel partners to become productiverelative to targets set.

• Fixed and variable components of compensation of channelpartners.

• Credit risk and credit-level management, where applicable.

• Cannibalisation of revenues previously served by company’sdirect sales force.

• Alignment of sales force cost structure if alternative channelsare used instead of direct sales in certain geographies or forcertain product lines.

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The cost of educating new value-added resellers, distributorsor sales representatives not employed directly by the companyis easily understated. The amount of time required for thosesales representatives and distributors to become productiveneeds to be factored into projections. Many models presentedby sellers carry optimistic assumptions around sales forceproductivity and the amount of cost required to continue toservice and support those distributors until are they able to sellproducts on behalf of the company.

Table 5.3: New products/markets revenue diligence itemsData request description Purpose

Revenue over forecast horizonfrom new markets

Isolate revenues from newmarkets

Revenue breakdown (newversus existing products)

Isolate revenues from newversus existing products

Revenue by sales channel Breakdown of sales by channel

Cost assumptions for marketentry or product development

Management assumptions forcost to develop or maintainchannels or launch newproducts/markets

Another key consideration when attempting to project revenuegrowth is to understand both customer and product profitabilitytrends. During the due diligence process, request data that willenable a view on the profitability (at gross margin level) of thecompany’s top and highest volume product lines to bedeveloped (see Table 5.3). Doing so allows various revenuecases to be properly reflected in the deal model.

Information required to perform this type of analysis may notalways be readily available. The seller may only be able toextract and provide detailed transactional data which must beorganised before it is useful in allowing trends to be observed.Projecting these trends into the future requires a solid

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understanding of both the current state of profitability and theexpected changes that come with management’s growthplans.

Product complexity

The profitability of future revenue forecasts can be affected byincreases or decreases in the actual number of products orproduct varieties sold. When analysing the products sold bythe company both today and those expected to be launched(and contribute significant revenue to future periods), note thatmaintaining a certain number of product lines carries with it itsown costs.

A large variety of distinct products or services (also otherwiseknown as stock-keeping units or SKUs), particularly inenvironments that demonstrate volatile or rapidly changingforecasts or have short product life cycles, can lead to excessand obsolete inventory. There are also costs, such as salesand marketing and R&D, in continuing to sell and update awide and deep product portfolio. While it is important to offer adiverse product portfolio to meet customer demands, it ishealthy to question the number of products required and thedegree to which selling unprofitable or highly complexproducts truly add value. The costs of supporting newproducts should be understood and, if significant, factored intothe deal model.

Material cost sensitivity and price/cost pass-throughcapability

With the exception of most software and some servicescompanies, most potential acquisition targets will have asubstantial portion of their costs associated with raw materialpurchases. Materials may be purchased for resale in the caseof distributors, or for conversion to finished goods in the caseof manufacturers. Some companies may have relatively

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concentrated exposure to underlying commodities such ascrude oil or metals.

Early in the due diligence effort, develop a view of the cost/price dynamics faced by the target company. To perform thisanalysis, the impacts of price changes, product mix shifts,material costs and even currencies must be largely isolated.

Due diligence will provide a sense of the periods when costincreases were more or less able to be passed to thecustomer through higher prices. Obtaining data by product linewill reduce errors in the analysis regarding product-level mixover time (see Table 5.4). An analysis that shows averageselling price (ASP) trends, product-level mix and margins andgeographic trends will help isolate the impacts of material costincreases to profitability. Where a business uses multiplecurrencies, understand these items on a comparable (that is,foreign exchange neutral) basis.

While selling price trends and underlying cost dynamics mustbe understood individually, it is also critical to understand theirrelationship to one another. Historical data, particularly overtime periods where significant raw material cost, labour cost orpricing changes occurred, is important in determining thecompany’s ability to avoid absorbing price increases from itssupply base and the extent to which it can pass through thosecosts to its customers. Requesting contracts with keycustomers which specify the ability to pass through priceincreases should be included in a standard due diligencechecklist provided to the seller as far in advance as possible.Some companies may not have contractual protection againstinput cost increases, which only makes an empirical analysiseven more important.

Table 5.4: Material cost diligence itemsData request description Purpose

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Rebates, returns and salesdiscounts

Understand historical andpossible future impacts

Rebate plans (both customerand supplier rebates)

Determine required rebates(recurring)

Detailed cost of goods sold orcost of sales data

Isolate labour, materials andoverhead data

Supplier spending profile(spending by supplier) with unitand spending data

Determine cost trends, supplierconcentration, key suppliersand types of items purchased

Product-level profitability dataincluding units so averageselling price data can becalculated

Understand sources ofprofitability and trends in cost,selling price and product mixover time

Impact of foreign currency dataon sales and purchases

Isolate foreign exchangeimpact and aid risk assessment

Contract terms with keycustomers and suppliersrelating to price and costincrease or decrease terms

Awareness of contractualexposures or protectionsrelated to cost or priceincreases

Timing is a key consideration when evaluating the short- tomedium-term impacts of cost increase or decrease passthrough via price. The ability to hold on to temporaryadvantages can result in substantial benefits over time, just asthe inability to do so can be detrimental. Additionally, it isimportant to understand how much time elapsed between costincreases and price increases, or cost decreases and pricedecreases.

It may be helpful to examine periods when costs exceeded thecompany’s expectations by reviewing the purchase pricevariance (PPV) line of the cost of goods sold (COGS) detail.PPV variances occur when costs are greater, or less, than thestandard costs set by companies in their cost accounting

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plans. High PPVs will indicate periods where costs increased,and vice versa.

Finally, items such as scrap and inbound freight should beisolated when performing price/mix/cost analysis.

Labour costs

Modelling labour cost requires understanding whereemployees are located, the functions performed and thecategories of cost included in total labour cost (see Table 5.5).Hourly employees, salaried employees, contract workers,temporary labour and terminated employees with ongoingcosts should all be considered. Pay attention to benefits suchas pensions.

Consider employee hires and tenure when modelling annualsalary increases and note the fixed versus variablecompensation portion of cash remuneration across allcategories of employees. Many labour cost analyses haveinsufficiently included the cost of rising benefits, only to modelthem as a percentage of wages when in fact they often growat a faster rate than employee salaries.

An early goal of due diligence should be to map detailedindividual employee compensation, by function, by thefinancial statement sections in which they reside or in thedivisions or geographies in which they work. Having abottoms-up view of the labour costs of a business and linkingthat detail to the company’s financials will provide a solidstarting point for modelling anticipated changes such asincreases or decreases in headcount.

Table 5.5: Labour costs diligence itemsData request description Purpose

Full employee list with basecompensation, target bonus,

Validate labour cost

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benefits, date of hire andemployment status

Overtime labour spending byindividual (if possible)

Determine level of spendingand purpose/use

Contract labour spending,types of contract labour used

Determine level of spendingand purpose/use

Severance policies byemployee type, category andgeographic location

Assess potential costs ofseverance by applying policiesand statutory requirements

Benefits detail, includingmedical, dental and otherbenefits provided to employees(including executive plans, ifany)

Understand current baselinecosts and potential futurebenefits cost CAGR to buildinto the model

Operating expenses

It is important to understand the potential sources of costincrease (see Table 5.6). In this section, the discussion willfocus on the nonlabour component of operating expenses.Lease obligations are often held flat over model time frames.However, a review of key lease provisions will provide theinformation required to correctly model increases over theremaining life of the lease. IT support costs for older softwaresystems may increase over time, and support costs forrecently implemented systems may have been bundled intothe purchase price and thus not reflected in the last one to twoyears of income statement data. Telecom costs are typicallycontract-based for data and land lines but variable for mobilecosts. While general insurance costs are fixed over anyparticular year due to the amortisation of prepaid assets, thecompany may be exposed to volatile insurance markets suchas wind, flood or earthquakes.

Table 5.6: Operating expenses diligence items

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Data request description Purpose

Lease documents for all leasedlocations, inclusive of operatingcosts and taxes

Validate leased real estatecosts

IT costs, including serviceagreements, softwaremaintenance, system upgradesand outside contractors/consultants

Validate and forecast IT costsand potential future risks andreplacement requirements

Telecom costs, including fixedline, mobile and data line

Validate cost base anddetermine contract terms inplace

Outbound freight expense, ifpossible by category (smallparcel and long haul)

Validate cost base andunderstand shipping modesused by the company

Professional services detail,including list of providers andtype of services rendered

Analyse types of serviceproviders engaged over time,scope of work and frequency(one time versus recurring)

Other discretionary spendingcategories, including travel andentertainment

Validate cost base andunderstand remainder ofoperating expense costs

Professional service provider costs should be viewed insufficient detail to understand which items are likely to berecurring, such as audit and some legal, and which wereone-time in nature and are to be excluded from future periodforecasts.

Other discretionary items such as travel and entertainmentshould be reviewed and understood within the context of thefrequency of contact made with customers or suppliers, or ifthe costs were related to individual projects such as enterpriseresource planning (ERP) system implementation or the

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opening of a new location which may have driven somecomponent of non-recurring expense.

Balance sheetAccounts receivable

An analysis of risk and velocity of cash flows must include anunderstanding of accounts receivable (see Table 5.7). Thisanalysis will provide an understanding of customers whichhave driven bad debts, customers which the companybelieves represent significant risk with respect to collection ofreceivables, concentration of customers with accountbalances and payment terms or discounts available to thecompany’s customers.

Before analysing the overall accounts receivable profile of acompany, understand the credit policies in place. Thethresholds of credit extension and the actual process followedin order to establish credit should be documented. Actual data,particularly for accounts with write-offs, should be testedagainst the policies in place to determine if policies werecomplied with or not.

Table 5.7: Accounts receivable diligence itemsData request description Purpose

Accounts receivable aging Identify health of accountsreceivable

Accounts receivable bygeography

Understand geographicdistribution/risk in accountsreceivable

Allowance for doubtfulaccounts: calculation andmethodology for specificreserves, if any

Calculate and understandbasis for company’s riskassessment methodology

Bad debt expense history, bycustomer

Identify risky customers

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Accounts receivableroll-forward from most recentaudited year-end periodthrough recent closed monthlystatements

Validate account balance as aresult of sales and cashreceipts

Customer payment terms fortop customers

Analyse actual payment andcollection performance versuscontractual requirements

Credit policy: mechanics ofapproval process andpermission thresholds

Understand internalprocedures for granting creditto customers and approval tiersin place

Discounts taken by customersin exchange for early payment

Identify opportunities availableand taken by customers to payearly in exchange for discounts

Table 5.8: Inventory diligence itemsData request description Purpose

Inventory aging Identify health of inventory andreasons for aging of materials

Inventory composition Obtain raw/work in progress/finished goods inventory (FGI)breakdown to understandquantities of each type andperform further analysis

Reserve calculation andmethodology

Calculate and understandbasis for company’s riskassessment methodology

Historical write-offs Identify risky customers,suppliers, materials orproduction elements

Consignment (either bysuppliers or for customers)

Assess opportunity fordecreased company-owned

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inventory and ‘hubbed’ FGIheld for customers

Channel inventory risk, ifapplicable

Understand risk of forwardsupply chain inventory risk if‘put’ back to the company

Inventory

Inventory analysis requires a fundamental understanding ofthe products produced or sold. It is helpful to have a solidunderstanding of the material flows, supply base andgeographic locations served by the company prior tobeginning an analysis of its inventories. In addition to overallinventory velocity, understand the level of risk inherent in thecurrent on-hand amounts. A complete picture of the inventoryrisk may require that channel inventories (forward through thesupply chain) and in-transit inventories (from suppliers) aretaken into account (see Table 5.8).

Analysing inventory risk should be based on historicaldemand, future forecasts and other factors such as risk ofdamage due to age or environmental factors. Product lifecycles, absolute levels of customer demand, changes incustomer taste and long lead times throughout the supplychain all can impact inventory risk. Therefore, understand thevolatility of customer forecasts as well as the unique versuscommon aspects of inventories held.

It is also beneficial to understand at what stage in theproduction process the inventory is customised. Inventory thatis customised early in the production process is much riskier tochanges in forecasted demand than items which arecustomised much closer to the point of shipment.

Accounts payable

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An often overlooked area of analysis is the review of companyaccounts payable. Vendor-level accounts payable aging mayprovide information not otherwise found in other areas of duediligence, such as approximating spend levels, concentrationof the spend profile (direct versus indirect purchases) and thedegree to which the company is dual- or multi-sourcing.Sourcing professionals may use this data to arrive atconclusions regarding post-acquisition savings or for thepurposes of drawing other conclusions relating to the overallsupplier-facing strategy of the company (see Table 5.9).

Be careful to consider both the balance sheet and incomestatement impacts of accounts payable from the perspectiveof discounts and rebates. Suppliers may provide rebates ordiscounts on the condition that certain payment terms areadhered to. Efforts should, therefore, be taken to understandwhich suppliers may have such terms before makingassumptions about the ability to extend payment terms tolower working-capital requirements.

Table 5.9: Accounts payable diligence itemsData request description Purpose

Accounts payable aging Understand speed of accountspayable payments

Payment terms by vendor Understand contractualpayment terms versus actualpayment speed

Early payment discounts inprofit and loss statements(P&L)

Quantify discounts embeddedin P&L or possible throughearly payment

Rebate income contingent onearly or timely payment

Determine if company is at riskof losing rebate income ifpayment terms are stretched,either contractually orfunctionally

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Table 5.10: Capital expenditure diligence itemsData request description Purpose

Historical capital expenditure(capex) data by category and ifpossible by line item

Validate leased real estatecosts

Management commentary ofexisting or near-term capitalcommitments

Validate and forecast IT costsand potential future risks andreplacement requirements

Capex forecast formaintenance, new projectsdeveloping capabilities andcapacity expansion

Validate cost base anddetermine contract terms inplace

Capex approval structure andforms/overall processdocumentation

Understand approval tiers forvarious sizes of capex projects

Capital expenditures

A careful analysis of both historical and projected capitalexpenditures will provide insight into the level of investmentrequired to support ongoing operations of the business (seeTable 5.10). Additionally, care must be taken to note thecapitalisation of items which may otherwise be expensed,such as R&D activities and certain implementation ormodification costs related to IT systems.

Conclusion

The aim of this chapter was to provide a field-ready toolkit forprivate equity executives involved in financial due diligence,particularly those who focus on due diligence from anoperator’s vantage point. By determining the right areas offocus and the key analyses that need to be conducted, duediligence experts can zero in on the high impact items thatmust be completed in typically compressed time frames.

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The due diligence list examples shown should provide ahelpful starting point for understanding how financial data andoperational performance are linked to one another and helpcreate a framework useful for grounding the assumptionsbehind projected results.

Shahriyar Rahmati is a vice president of finance in theOperations group at The Gores Group in Los Angeles,California. At Gores, Shahriyar is responsible for portfoliocompany financial oversight and controls as well as leadingfinancial due diligence activities. Before joining Gores, he wasa financial operating partner at Graham Partners, amiddle-market buyout firm focused on control investments inmanufacturing and manufacturing services-related companies.Prior to his work at Graham Partners, Shahriyar held severalsenior executive roles at companies owned by private equityfirms including TPG Capital and Hellman & Friedman.Shahriyar has held senior executive positions in finance,corporate strategy and operations at companies such asSolectron, Isola Group, Bright Now Dental and ActivantSolutions. Shahriyar attended New York University as anEconomics and International Business major, completed theExecutive Supply Chain programme at Stanford Universityand earned his MBA from the MIT Sloan School ofManagement.

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Chapter six

Tax due diligence

By Dawn Marie Krause and Jason Thomas,PricewaterhouseCoopers LLP

Introduction

Private equity tax due diligence is not limited to theidentification and quantification of historic tax risks associatedwith a transaction or period of operation. Tax due diligence isinstead an analytical process which includes theunderstanding of tax benefits that may be utilisedpost-acquisition, estimating prospective tax costs of operatingthe target business, and providing structuring inputs,modelling review and contract recommendations. Although thetax due diligence process is typically thought of as a buy-sideexercise, it can also include sell-side/vendor due diligence.

In tax due diligence, a private equity buyer emphasises thecash aspects of the transaction, including the ability toamortise goodwill, the identification of cash sources needed tosatisfy debt obligations and the tax deductibility of interestpayments. Tax modelling in private equity transactions alsotakes into account the shorter-term investment horizon andgenerally values tax benefits received during the investmentperiod (generally, five to seven years, or the debt maturityperiod). With private equity buyers, the tax structuring work isoften focused on the partial rollover of existing shareholdersand management, interim equity monetisation and tax-efficientexit strategies.

As more companies expand their operations abroad, dealingwith unique issues that arise in a foreign (non-US) tax duediligence process becomes increasingly important. Culturaldifferences can play a significant role in defining the overalldue diligence approach. For example, local attitudes toward

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risk may differ from those in the US and risk assessment inother jurisdictions may take into account ‘detection risk’ (thatis, risk of audit by foreign taxing authorities). Whenundertaking foreign due diligence, it is especially important forthe operating partner to understand whether the tax exposureidentified is actual or theoretical and whether there are anypractical solutions that can limit historic or post-acquisition taxrisks.

This chapter will focus on areas in the due diligence life cyclewhere efficiencies and a deeper understanding of the tax duediligence methodology can add value and increaseeffectiveness. Further, the value of sell-side, preparatory duediligence and opportunities for operating partners to integratethat process into a sale transaction will be addressed.

Scoping to achieve maximum results

The scope provides the initial roadmap for the diligenceprocess, although this plan can (and often does) changeduring the course of the process. While a formal, revisedscope of work is generally not prepared, changes in objectivesor relevance of the work need to be clearly communicatedthroughout the entire process.

There are a myriad of factors which influence the scope ofwork, including the following:

• Structure of the transaction (that is, asset versus stockacquisition).

• Value of the investment and proposed capital structure.

• Ownership percentage/level of control.

• Significance of potential tax benefits to be realised from thetransaction.

• Identity of seller.

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• Availability of contractual protection (for example, earn-outs,indemnification, escrow and warranties).

• Timing.

• Industry.

• Availability of information.

• Buyer risk tolerance.

• Country of operation and geographic dispersion of business.

• Sale process, including whether the due diligence is phased orinvolves multiple buyers.

In order for the diligence process to be efficient, the scopemust take into consideration these factors and be tailored tothe specific characteristics of the transaction and the buyer’sobjectives.

Impact of sale type on scope

The type of sale process can dictate the timing and amount oftax due diligence. Where the buyer has the advantage of anegotiated sale, the time to complete the diligence can belonger and the use of a phased approach may be possible (ofcourse, a shorter exclusivity arrangement could have theopposite result). In the initial phase, the scope of work may belimited to work designed to identify only the most materialexposures (or ‘deal-breakers’). For example, the due diligenceteam could limit its review to the target’s tax reserves, prioryear tax return, public information and an overview call withmanagement. If, based on the initial work, the buyer decidesto move forward with the transaction, a more comprehensivesecond phase could follow-up on the initial issues identified.As a result, a phased due diligence can be cost-effective,especially in ‘no go’ scenarios.

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Similar to a phased approach is a ‘confirmatory’ due diligence.Here, the buyer completes the majority of the due diligence,but subsequently follows up on certain points to confirm itsunderstanding or to complete the diligence of less significantissues. A buyer may confirm certain tax points between thesigning and closing of a transaction, particularly where it hasrelied on estimates in completing its initial work (for example,where tax returns have not yet been filed). If the buyeranticipates the need for confirmatory due diligence, this shouldbe reflected in the scope.

A phased approach may also be used with an auction saleprocess, although the phased approach may be dictated bythe amount of information the seller provides as opposed tothe amount requested by the buyer. Less information isprovided in the initial phase to limit access to sensitiveinformation. This is especially true with privately held targetswhere public information is limited; more information isprovided in the later rounds of the diligence process whenthere are fewer buyers. As the auction sale process is typicallyconducted using a phased approach, the scope of the auctionengagement may be restricted initially, with the expectation ofscope amendments as, or if, the project progresses.

Full-scope tax due diligence arguably plays the most crucialrole in an ‘unconditional’ sale process where the buyer doesnot obtain an indemnification or escrow. There is therefore norecourse to recoup lost value if tax exposures are recognisedpost-acquisition. This sale process is most common withpublic company targets or private equity sellers. As the buyeris not able to secure an indemnity or escrow and the solerecourse for identified exposures is a purchase priceadjustment, greater importance is placed on the due diligenceprocess. The buyer should thus negotiate for a broader scopeand a longer time period to complete a full-scope tax duediligence process to achieve comfort that there are no latenttax exposures.

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Key questions for scoping:

1. Does the scope cover all appropriate tax exposure types (forexample, non-income, foreign and transfer taxes)?

2. Should certain areas (for example, state or foreign taxes) beexcluded or limited?

3. Are there specific industry (for example, telecommunicationsor oil and gas) taxes that should be included?

4. Can a phased or confirmatory approach be used?

5. Is indemnity likely and, if so, is the seller creditworthy?

Interpreting a tax due diligence report

Standard due diligence report information Receipt of a tax duediligence report of the target company is not the end of the taxdue diligence process, but a signal for more activeinvolvement by the operating partner. While no two duediligence reports are exactly alike, there are standard itemsincluded in most reports. Private equity executives conductingdue diligence, whether deal professionals or operatingpartners, should pay specific attention to the following itemsbelow.

Corporate structure

The report should explain the corporate structure from a taxpoint of view and, where appropriate, should include adiagram of companies, including the jurisdiction of each entityand its US tax treatment (that is, corporation, partnership ordisregarded entity). The corporate structure can provide asnapshot of the target’s tax profile and is important becausetax due diligence focuses on the legal entity’s activities asopposed to financial due diligence which focuses on operatingor business units. It can also provide an indication of historictax planning. For example, hybrid entities or entities in taxhaven jurisdictions generally attract attention during the tax

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due diligence process because of an abundance of anti-abuserules that govern them.

Tax return summary and statute of limitations

This section should provide certain information on tax returnswhich have been filed, taxable income reported and taxreturns which remain open to tax audit. This information ishelpful in understanding the scope of review. For example, thetarget’s failure to file tax returns may require an expansion ofthe anticipated scope of review.

Alternatively, it may not be necessary to review prior year taxreturns where the expiration of the statute of limitationprevents a tax audit. Further, a history of tax losses couldindicate that net operating loss follow-on issues should beaddressed in the due diligence. Lastly, historic tax losses canabsorb increases to the target’s taxable income that mayresult from a tax audit adjustment, whereas incomeadjustments to the target with positive earnings generallyresults in increased cash taxes.

• Tax audits. Information regarding recently completed andin-process tax audits can assist in qualifying the target’s riskexposure. For example, specific issues reviewed in prior yearscould lend insight into their future treatment. In addition,closing an audit without changes to a filing position couldprovide some comfort with respect to the methodology used,although it does not determine the tax treatment.

• Tax reserves. The amount of income and non-income taxreserves, if any, are derived from the target’s tax analysis andare a component of its balance sheet tax liability. The target’stax reserve information is a valuable resource in identifying taxexposures because it represents amounts for tax positionsthat may not be sustainable as reviewed by the target’sauditor. However, due to the relatively low standard of

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reporting for income and non-taxes, tax reserves should notbe interpreted to comprise all of the target’s tax exposures.

• Tax attributes. This section should identify available taxattributes (for example, net operating losses, capital losscarry-forwards and tax credits), analyse historic limitations andobserve potential limitations generated by the proposedtransaction. As tax attributes could impact cash flows and thevalue of the transaction, understand the amount and timing ofavailable attributes (including depreciation and amortisationroll-forwards). For non-US acquisitions, this section shouldalso include available tax holidays and tax amnestyprogrammes.

• Tax exposures. Timing item exposures (such as depreciationand interest) should be evaluated to determine the ‘true’ costof the exposure. For example, if the amount can be deductedin another tax period, the true cost of the exposure may beonly an interest and penalty charge. Further, determinewhether available net operating losses could offset anyexposure items. The structure of the target (corporation orpartnership), the type of acquisition (asset or stock) and thetarget’s business dictate the common exposure items for thetransaction. Common items identified during due diligenceinclude improper use or adoption of accounting methods,improper interest deductions and issues connected to relatedparty transactions. In the international context, tax exposureitems typically relate to transfer pricing, withholding tax andforeign tax credits.

• State taxes. As states have become increasingly aggressive incollecting tax revenues, state and local tax (SALT) issueshave become more important in the tax due diligence process.Typical SALT exposures may include underreporting ofincome in various states due to improper apportionment orfailure to properly analyse nexus issues. In some cases, SALTliabilities can be more significant than federal income tax

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liabilities. This is especially true with non-income taxes, suchas sales tax, which can be a material tax exposure evenwhere the target is in a loss position and/or the transaction isan asset acquisition. Other non-income SALT items includeemployment, property and transfer taxes.

• Assessment of the tax department and tax service providers.An assessment is usually provided only in situations where thetax department/advisers are particularly strong or weak. Thequality of the department/advisers is useful in determining thelevel of reliance which can be placed on the target’sinformation. The more sophisticated the target’s tax function,the easier it may be to reach a level of comfort with respect tothe target’s tax positions. Sophisticated tax departmentstypically have more effective controls in place and sufficientdocumentation to sustain positions taken on prior tax returns.This assessment also provides useful information fordetermining staffing needs post-acquisition.

Appreciating explicit and inherent limitations

In reviewing the due diligence report, recognise that the reportis subject to explicit and inherent limitations. Agreedlimitations, such as scope limitations, are generally specifiedin the report or in the relevant engagement contract. Inherentlimitations (and those in the engagement letter), however, maynot be discussed and, in fact, may not be apparent on the faceof the report. In order to fully understand the target’s taxexposures, discuss report limitations with the tax due diligenceteam.

The report may include a copy of the agreed scope and maystate any limitations encountered in its completion. The mostcommon impediments to completing the agreed on scope arelack of sufficient information or cooperation by seller or targetmanagement. The target company’s failure to provide theneeded information may provide insight into its tax function.Alternatively, the target’s records may simply be incomplete or

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the seller may choose not to provide access to certaininformation for strategic or legal reasons. Poor qualityinformation may be indicative of larger concerns, such as poordocumentation policies or hidden tax liabilities. Alternatively,limited access to information may be attributable to seller timeconstraints, confidentiality concerns or negotiation leverage.Start a review by discussing the agreed on scope with the duediligence team to ensure that the intended areas of work werecompleted or understand why any work was not completed.This information is helpful in determining whether additionaldue diligence should (or can) be performed.

As inherent limitations (or their magnitude) may not bespecifically identified, be aware of these limitations whenconducting their review. Initially, a due diligence process isoften a high-level review rather than a comprehensive analysisof the identified tax exposures reported. The due diligenceteam does not confirm the authenticity of documents (such aswork papers, legal agreements or tax elections) or investigatethe truthfulness of statements provided. Unless there is areason to believe otherwise, the tax due diligence teamgenerally assumes that facts provided are accurate,documents are authentic and that statements made aretrustworthy. For example, if a target’s management representsthat an election was made to treat a subsidiary as adisregarded entity for federal income tax purposes, but doesnot supply documentation supporting its representation (suchas the Internal Revenue Service acceptance of the election),the tax due diligence team will assume that the election isvalid.

Recognise also the inherent limitations in exposurequantification, which is typically based on imposed limitations,assumptions and estimated information. For example, whilegenerally not specifically discussed, there is an inherentmateriality level built into the due diligence review andreporting process. This materiality level is usually not an exact

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measure and is based on the size of the transaction, thebuyer’s risk tolerance and scope limitations. While potentiallynot part of the report, tax modelling assistance conductedduring due diligence is subject to similar limitations as a resultof the use of estimated information. For example, structuringbenefits are based on income projections and current US andforeign tax rules. Ensure that these assumptions are revisitedon a going-forward basis and discuss inherent scopelimitations with the tax due diligence team.

Exposure quantification practices

Where actual information is unavailable, in order to estimateexposures, the due diligence team may assume a worst-casescenario for certain information, including tax rates, interest,penalties, discovery and applicable tax periods. Alternatively,where actual information is available for only one open taxperiod, the exposure based on that information may beextrapolated across the remaining open periods. Further, theuse of an extrapolation methodology is likely to be based onadditional factual assumptions dictated by the type ofexposure involved. Generally, where estimated information isused to determine exposures, the due diligence team will beconservative in making its estimate (while disclosing theassumptions used).

In determining the exposure, the due diligence team shouldalso apply its practical experience, either in making thecalculation or providing additional information to assist thereport reader. For example, the tax team’s experience withcertain state tax authorities may cause it to recommend avoluntary disclosure process to remediate exposures. Aparallel example in the international context is determininglikelihood of settlement of any foreign tax issue given theteam’s experience with foreign jurisdiction tax authorities. Withforeign due diligence, probe the due diligence team to ensurethat both theoretical and practical exposure are provided.

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Comments on the ‘quality’ of the tax exposures (for example,clarity of law surrounding the tax position, industry standardsand ability to remedy the exposure) help the buyer to refine itsunderstanding of the identified exposures. In order to fullyunderstand the exposures stated in the due diligence report,understand the exposure calculation. The details of thecalculations, particularly where they are not set forth in thereport, should be discussed with the due diligence team.Appreciating the amount and quality of tax exposures assiststhe buyer in determining the appropriate representations andwarranties, tax indemnifications, escrow and ultimately thepurchase price.

Leveraging the due diligence report

Post-acquisition, ‘leverage’ the tax due diligence report inseveral ways. The report can serve as a starting point toconfirm, minimise and remedy identified exposures once thetarget is acquired on both a historic and going-forward basis. Itcan also be used to provide a new target tax team with usefulbackground information or serve as a guide for prioritising taxwork. The due diligence report can be used in evaluating thetarget tax team’s abilities and the tax function in general. Itmay also help decide which processes need to be changed orimproved going forward.

Another way in which the tax due diligence report can beleveraged is to consider how an exposure item may affectother investments in the same or similar industries. Forexample, if the report identifies a certain state tax trend, usethis information to review whether this trend negativelyimpacts other companies in the portfolio.

Key questions when reviewing the tax due diligence report:

1. What are the limitations of the report?

2. Does the due diligence report cover all important issues?

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3. What assumptions were used by the tax due diligence team inquantifying tax exposures?

4. Does the report provide insight into the quality of the exposure(for example, potential remediation steps)?

5. How can the report be leveraged to maximise its value?

Vendor/sell-side due diligence

Vendor due diligence (VDD) outside the US Historically, theVDD process has primarily been used outside the US whenthe seller engages third-party advisers (the VDD team) toprepare a due diligence report. This report is provided topotential purchasers as part of an auction process. The VDDteam should be independent of the seller and, as such,existing advisers generally do not perform the work. Once abuyer is identified, the buyer signs the engagement letter andthe report becomes the buyer’s ‘property’. The buyer then,generally, has recourse against the VDD team for reportdeficiencies. In theory, potential purchasers can then performminimal work to make sure they understand the scope of workand any exposures identified. While VDD can be a good firststep, potential purchasers generally perform their ownconfirmatory tax due diligence.

In a VDD process, a key focus of a buyer’s review is tounderstand the engagement terms. As the VDD eventuallybecomes property of the buyer, the engagement terms setforth the rights the buyer has against the VDD team shouldissues arise. The buyer should also scrutinise the scope ofwork to ensure that it is sufficiently broad and to understand itslimitations, if any. It is also essential for the buyer to gauge theindependence of the VDD team.

Certain issues can arise based on the fact that the sellerengages the VDD team. Questioning tax practices andsearching out tax exposures of the seller can generateawkward situations and may lead the VDD team to be less

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probing than a buyer due diligence team. In addition, thebuyer should understand any report changes compelled by theseller or management as they may influence the drafting ofcontinuous issues. Even where the scope of work is adequateand the VDD team is independent, the VDD process mayhave inherent limitations. For example, a buyer team will likelygain a better understanding of the target business and the keytarget personnel by performing its own due diligence.

Under ideal circumstances, the VDD process is particularlyadvantageous as it can shorten the overall due diligenceprocess, reduce the cost for all parties and lessen the impactof the due diligence process on target management. Further,during the VDD process, identified target tax exposures maybe remedied preemptively in order to improve theattractiveness of the target. However, a deficient VDD reportthat does not conclude on key issues may not be particularlyuseful and may delay the process as each bidder may need toperform its own work.

Sell-side due diligence (SDD) in the US While the benefitsmay be similar, the primary difference between a SDD as usedin the US from a SDD performed outside the US is that, withthe SDD, the seller does not prepare a report to provide topotential purchasers. The seller instead uses the processsolely for its own benefit to prepare for sale. The SDD processcan be used to identify, evaluate and remedy potentialexposures, indentify and quantify deal-related tax value andbetter manage the tax due diligence process. A key advantageof the SDD process is that it allows for adequate time to takethese actions compared to the general due diligence processwhere time deadlines are short. In essence, SDD puts theseller in a better position to control the due diligence processand the dissemination of information, as well as to manageexposures, thereby optimising deal value.

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Pre-sale identification, quantification and remediation oftax issues

SDD provides an opportunity for the seller to better control thedue diligence process and to limit the impact of tax exposureson deal value by allowing the seller to identify, quantify andpotentially mitigate target tax exposures prior to bringing thetarget to market. Identified tax exposures and the seller’sposition on the tax issue can be disclosed in the sellingmaterials. Where the exposure is disclosed up front, perceivedtax risks should generally be considered to have been takeninto account by the buyer in determining the target value. Thiscould forestall subsequent buyer purchase price reductionrequests or negotiations. In addition, identification of theexposure prior to the sale process allows the target additionaltime to analyse, document and accurately estimate theexposure rather than being pressured to accept the buyer’sconservative, worst-case scenario estimate. Additional timealso provides the target with an opportunity to remediate theexposure through, for example, voluntary disclosure, obtainingrulings or filing amended tax returns.

Identifying and quantifying deal-related tax value

Pre-sale analysis of economic benefits from various sellingstructures and seller deal requests (for example, net operatingloss value, buyer benefits from Internal Revenue CodeSection 338 elections and change of control deductions)allows the seller greater opportunity to monetise thesebenefits and may increase the sale price realised. Becausethe SDD commences prior to the sale process, the seller hasthe lead time needed for analysis, quantification and pre-saleimplementation of tax restructuring and planning. Again, theseller can include the value of such benefits at the beginningof the sale process so that it is less likely to be viewed as anadditional seller request. Identification of potential economicbenefits prior to the sale process also provides an opportunity

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to sensitise the target management and seller deal team to thepotential for generating additional value.

Managing the due diligence process

The SDD process can also include preparation for the buyerdue diligence. The target can establish a plan or strategy todeal with anticipated buyer requests for information anddocumentation. This plan can include organisation ofinformation and a methodology for data room population.Gathering information prior to the start of the sales processallows the target to identify missing information and preparenecessary documentation in an efficient manner. These effortscan streamline the due diligence process and free up targetpersonnel to focus on business operations. Further, organisedand complete tax information may give potential buyersadditional comfort with respect to the competency of thetarget’s tax function.

Key questions for SDDs:

1. Does the target have an internal tax function? If so, is the taxfunction sophisticated and proactive?

2. Are there potential tax values which can be captured by theseller on the sale of the target? If so, have these beenquantified?

3. Have potential tax exposures been reviewed and quantified?

4. Can potential exposures be mitigated or documented in orderto manage discussions with potential buyers?

5. If a full sell-side due diligence is prohibitive, can anabbreviated review add value?

Conclusion

This chapter has focused on several points in the duediligence life cycle where a deeper understanding of the tax

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due diligence methodology can add value and increase theoverall effectiveness of the due diligence process.

The initial scoping of the tax due diligence engagement shouldnot be viewed as a perfunctory exercise, but instead tailoredto the target’s unique characteristics and the seller’sobjectives. Further, private equity executives shouldunderstand the mechanics, limitations and potential uses ofthe tax due diligence report to maximise engagement value.Finally, seller/sell-side due diligence can add significant valueand efficiencies to a sale transaction by managing andremediating tax exposures, thereby maximising sales price.

Dawn Marie Krause is a director in PricewaterhouseCoopersLLP’s Mergers and Acquisitions Group, and has over 15 yearsof tax due diligence and structuring experience in the US andCanada. Dawn concentrates on the application andinterpretation of US federal income tax law as it relates toprivate equity and sub-chapter C corporations, as well astax-efficient structuring and reorganisation provisions of theInternal Revenue Code. Dawn spent three years as a memberof PwC’s US tax desk in Montreal, Canada where sheprovided US in-bound tax consulting services to multinationalCanadian corporate and private equity clients. Dawn spent sixyears with District Counsel (Internal Revenue Service)litigating tax cases on behalf of the US. Dawn has an LLM inTaxation from Case Western Reserve University School ofLaw, a JD from Capital University Law School and a BAdegree from the College of Wooster. Dawn is admitted to theFlorida and Ohio State Bars.

Jason Thomas is a senior associate inPricewaterhouseCoopers LLP’s Mergers and AcquisitionsGroup, where he specialises in assisting private equity andsub-chapter C clients with US tax structuring and tax duediligence aspects for domestic and international businessacquisitions. Previously, Jason worked with PwC’s

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International Tax Services Group and assisted USmultinationals with internal restructurings and US tax duediligence. Jason has an LLM in Taxation from GeorgetownUniversity Law Centre, a JD from Syracuse University Collegeof Law and a BA degree from Rollins College. Jason isadmitted to the New York and New Jersey State Bars.

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Chapter seven

Human resource due diligence

By Steve Rimmer and Aaron Sanandres,PricewaterhouseCoopers LLP

Introduction

Private equity firms entering into an acquisition look to identifymaterial human resource risks early in the due diligenceprocess. In this context, ‘human resources’ refers to the targetcompany’s management team and broader employee talentpool, as well the programmes and infrastructure that helps thecompany to attract, retain and motivate that talent. Althoughidentifying (and quantifying) human resource-related risks canbe challenging, those tasked with leading the human resourcedue diligence process will ultimately need to ensure that anyhuman resource risks are appropriately captured in thevaluation model. Specifically, private equity firms will want tounderstand observations that have any earnings and balancesheet impact (or ‘quality of earnings’ and ‘debt-likeadjustments’, respectively), and whether any adjustments tothe private equity firm’s financial model are warranted.

Financial risks specifically include material changes to thehuman resource-related run-rate costs of the target company,financial obligations triggered as a result of the contemplatedtransaction, and unfunded benefit plans. Operational risksmight include high employee turnover, difficult labour relations,concern over cultural fit or change-management challenges/requirements. While these operational risks are often revealedduring due diligence, they are typically addressed during thetransition of ownership.

As a result, while the authors have kept the primary focus inthis chapter on financial risks, management assessment willalso be covered in some depth given the criticality of a strong

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management team to a successful deal outcome. This chapterdiscusses typical due diligence practices utilised by US-basedprivate equity firms when looking at US-based acquisitions.While the general principles covered here are applicable toalmost any human resource due diligence, the potential issuesthat might arise in other jurisdictions are not fully coveredhere.

Private equity firms tend to focus their human resource duediligence efforts around the following four areas, which canyield valuable insights and help to reveal any humanresource-related red flags:

1. Employee demographics and key terms of employment.

2. Material compensation and benefit programmes.

3. Management talent assessment.

4. Human resource transition challenges.

Employee demographics

Understanding the target company’s basic employeedemographics is one of the first steps a private equity buyerwill take. Although the level of detail covered during the duediligence process will vary by acquisition, at a minimum buyerswill want to understand the following: how many employeesdoes the target have and where are they located? Are anyemployees covered by collective bargaining agreements? Forcarve-out acquisitions, buyers will also want to understandwhat, if any, additional staff might be required to operate thebusiness on a standalone basis. Private equity firms will alsouse these demographics to assess whether there is anopportunity to reduce the number of staff, to measure thesavings achieved and the associated one-time cost, and toreflect this in their financial model.

Employee location

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Knowing where the target company’s employees work orreside can help the buyer to anticipate potential labour issues.In the US, a target company with significant numbers of staffin California, for example, may need to look closer into locallabour law issues (such as the impact on existingnon-compete arrangements).

Material open positions

Buyers will want to understand how a target company’sturnover compares to industry norms and whether a materialpercentage of turnover is focused on one employee group ordepartment. Private equity buyers will seek more detail aroundexecutive turnover and whether there were any materialdelays in hiring a replacement, as these events can oftenwarrant adjustments to historical earnings. As an example, ifthe target recently hired a CFO whose annual cost(compensation and benefits) to the target company isapproximately $400,000, buyers will want to burden the targetcompany’s profit and loss statement for the hypothetical fullannual cost since the historical EBITDA would not reflect theadditional costs of a CFO.

Employment terms/agreements

The key terms of employment are generally contained inwritten agreements such as individual offer letters oremployment agreements or, for unionised employees, acollectively bargained agreement. These agreements requirecareful review to ensure that financial implications and anychange in control triggers for payment are fully understood.Some key issues for each employment agreement type areoutlined below.

Individual contracts

Although generally reserved for executives, individualemployment contracts often contain material financialobligations. For example, while most executive agreements

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have severance protections, if the individual is terminatedwithout cause (or for ‘good reason’), these obligations canincrease in the case of terminations in connection with achange-in-control (CIC) event. In addition, some executiveagreements contain ‘walk-away’ rights pursuant to which theoccurrence of a sale transaction gives rise to a good-reasonevent. As well as severance protection, there may also beautomatic payments that come due in a CIC event. Theprivate equity firm will want to understand which payments areautomatic on a CIC event and which are contingent on asubsequent termination, so that these obligations can bereflected in the schedule of cash requirements. Walk-awayrights are typically reflected as an automatic payment forthese purposes.

In addition, it is important to understand whether theemployment agreements contain gross-up entitlements for anygolden parachute excise tax obligations that might arise underUS Internal Revenue Code Section 280G. In general, Section280G denies a corporate tax deduction for any ‘excessparachute payment’ and the recipient of an ‘excess parachutepayment’ is also personally liable for excise tax at 20 percentof such payment (in addition to federal and state income taxdue). Excess parachute payments exist if the total paymentsmade in connection with the CIC event are equal to, orexceed, an amount equal to three times the recipient’saverage annual compensation over the five full calendar yearsthat precede the year of the change of control. Generally, apayment is considered to be contingent on a CIC event if itwould not have been made but for the CIC event.

Note: A payment that would otherwise constitute a parachutepayment with respect to a corporation whose stock is nottraded on an established securities exchange will generally beexempt from the definition of a parachute payment underSection 280G, provided the payment is approved by 75percent of the ‘disinterested’ shareholders. From a practical

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perspective, it is still necessary to perform underlying goldenparachute calculations in these situations but with theexpectation that a qualifying shareholder vote will ‘cleanse’ thesituation. It is typical to perform calculations assuming bothsituations where no employees are terminated and where allemployees are terminated. In some cases, the combination ofautomatic payments on a CIC event and any acceleration ofequity on the CIC event can result in golden parachutethresholds being breached without a termination ofemployment.

Retention/severance agreements

Given the level of employee anxiety that often accompanies aCIC event, it is not uncommon for a company to implement aretention arrangement (or a severance protection plan) inanticipation of a sale. To the extent that retention paymentswill be made following the transaction (for example, 90 daysfollowing the closing of a sale), a buyer will typically expect totransfer the financial obligation for any retention obligations tothe seller (that is, treat it as debt for valuation purposes).

Note: Depending on how long beyond closing the retentionpayment is ultimately made (for example, where a portion ispaid on the CIC event and a portion one year following theCIC, assuming continuation of employment), the seller maylook to split the cost with the buyer, since the buyer will benefitfrom increased retention.

Collectively bargained agreements

Private equity buyers will want to confirm that the targetcompany’s financial projections include any scheduledincreases in wages required under collectively bargainedagreements (CBAs). Buyers will also want to understand what,if any, formal consultation requirements exist as they relate tounions or to work councils. To the extent that any CBAs areset to expire, private equity firms will want to understand the

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key areas of anticipated negotiation and expected outcome.Additionally, to the extent union employees participate in amulti-employer pension plan, it is important to understand thewithdrawal liability of the potential multi-employer plan. Ingeneral, a withdrawal liability is triggered when a companywithdraws from a multi-employer pension plan, but theemployer is required to continue to make cash contributions tohelp fund the plan’s liability for vested benefits. Contingentwithdrawal obligations from multi-employer plans are nottypically reflected in the balance sheet.

Note: Carve-out transactions pose an additional layer ofcomplexity around union contracts. This is because the buyerwill likely need to enter into separate, standalone contractsfollowing the closing of the proposed sale. Accordingly, privateequity buyers will generally want to look more closely at thenature of the target company’s relationship with the union toanticipate whether contemplated changes (however minor) willcomplicate the negotiation around the new agreements.Specific areas to review include any history of work stoppagesor strikes, the existence of a social plan (typical in Europe,where such plans define the process and cost for anyemployee terminations) and the history of the managementteam’s success in negotiating prior changes in terms andconditions.

Understanding the target’s compensation structure

Employee compensation is often one of the largest, singlecosts a company will incur during the course of conductingbusiness. This is why private equity buyers are keen tounderstand a target company’s compensation programmesearly in the due diligence process. A change in ownership mayresult in the acceleration of payment of certain compensationarrangements. Establishing the amounts involved andpotential payment triggers, the timing of payment and who willbear the financial responsibility for making such payments is a

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critical part of the due diligence process. A typical practice isto prepare an exhibit detailing, for each key executive, thematerial compensation structures, the payments that will betriggered by the closing of the transaction, and how thosepayments will differ if the individual’s employment isterminated. Table 7.1 presents an example of the potentialtermination costs and the magnitude of payments across thetarget company’s executive team.

Compensation is typically comprised of a base salary, anannual incentive and, if applicable, a long-term incentive.However, the way in which employees are compensated(structure) and the resulting pay mix (fixed versus variablecompensation) can vary widely by level and by industry.Understanding key compensation programmes can yieldvaluable insights into a firm’s culture and behaviours, as wellas help the buyer to assess whether the firm has properlyreflected the costs of these programmes for financialstatement purposes.

One key due diligence question is: how do executive salariescompare to market levels? Financial sponsors will expectsalaries to fall within a reasonable range of market medianlevels (for example, +/- 15 percent), unless there is a clearrationale for an alternative compensation philosophy.Companies with high salary levels typically put less weightingon variable compensation and will likely require a shift in thepay mix in order to align with the pay-for-performancestructure private equity firms prefer. This shift will often involvefreezing or reducing (far less common) base salary andincreasing the cash bonus or the long-term incentiveelements.

Understanding how the target establishes its annual bonuspool and how much discretion is embedded into the processare important due diligence areas to address. Companies withsignificant amounts of discretion in their annual incentive

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process deserve special attention during due diligence.Private equity firms will generally look to increasetransparency and exert control over this process, at least interms of funding for given levels of performance. Another areato understand is how the company has accrued for expectedbonus payments and whether the accrual will adverselyimpact working-capital estimates.

Table 7.1: Example of potential executive termination costs in aportfolio company

Notes:

1. Cash out of equity awards represents the aggregate spread value (that is, thedifference between deal price and exercise price (if any)) on all outstandingequity awards (both vested and unvested).

2. Cash severance represents the obligations to the executive if (s)he were tobe terminated by the company without cause in connection with the currenttransaction and includes the sum of: (1) 3x highest compensation earned inthe past three years (that is, base + bonus), (2) payout of executive’sunfunded deferred compensation balances, (3) continued participation in thecompany’s medical plans for a period of one to two years and (4) payout ofaccrued vacation balances.

3. The 280G gross-up payment represents the cash payment required to pay forthe executives' 20 percent excise tax under IRC Section 280G/4999, inclusiveof any taxes due on the gross-up payment itself (that is, an iterativecalculation).

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Source: PricewaterhouseCoopers.

Long-term incentives, generally defined as any compensationearned over a period longer than one year, are of particularinterest to private equity buyers. Profit and loss expenseassociated with stock-based compensation is typically addedback from a quality of earnings perspective. Private equityfirms will focus on understanding:

• Depth of the awards (that is, how many employeesparticipate).

• Treatment of unvested long-term incentive awards.

Where a target company has historically granted equity deepwithin the organisation – beyond the level of participationexpected under private equity ownership – private equitybuyers will determine whether it is necessary to budget a‘replacement cost’ for those employees most adverselyaffected by the loss of a long-term incentive. The structure ofthe contemplated replacement plan (for example, annual cashpayments versus cash payment on a CIC event) should bereflected in the private equity buyer’s financial model.

Change-in-control event

There are generally three potential ways to treat unvestedawards on a CIC:

1. Immediate vesting.

2. Vesting only to the extent the awards are not assumed by thebuyer.

3. Company’s board has discretion on what treatment to apply.

The potential payouts from long-term incentive plans such asstock options and restricted stock will vary considerably

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depending on the industry and size of the target company. Asan illustration, if the target company is owned by anotherprivate equity firm, the top executives may share in about 10percent of the company’s overall equity value (with the CEOholding about 3 percent of the fully diluted equity). Notsurprisingly, private equity buyers would prefer that unvestedawards not vest on a CIC event because it allows them to usethe unvested value as a pure-play retention plan, in addition toserving as an effective source of equity financing. In carve-outtransactions, it is not uncommon for target employees whohold equity in the parent entity to forfeit unvested awards onthe sale. This ‘lost value’ will often become a discussion pointbetween the private equity buyer and the seller.

Understanding the target’s benefit plans

Employee benefits represent a significant percentage ofoverall employee cost, typically between 15 percent and 30percent of total salaries in the US. This range reflects theprevalence of employer-provided benefits. Outside the US,where benefit provision is typically more statutory in nature,benefits often comprise a lower percentage of overall costs,but are often more than compensated for by higher socialcosts (particularly in Europe). Where benefit costs include asignificant component that relates to the provision ofhealthcare benefits, it is appropriate to recognise that suchcosts increase at a much higher rate than salaries.Accordingly, it may be appropriate to increase the compoundannual growth rate (CAGR) for benefits by an extra 1 percentabove the CAGR which applies for salaries where suchhealthcare benefit costs apply.

The three key due diligence considerations for benefits are:

1. What type of benefit plans does the target company provide?

2. How is the cost of these programmes reflected in the financialstatements?

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3. What impact, if any, will the proposed transaction have onbenefit plan participation and/or cash contributions to thebenefit plans?

In the US, key employee benefits comprise retirement andhealthcare benefits.

Retirement benefits

Retirement plans generally come in two flavours:defined-contribution plans and defined-benefit plans. Adefined-benefit plan (DB plan) will guarantee a specifiedpayout at retirement according to a fixed formula (generallytied to the employee’s salary and years of service). Adefined-contribution plan (DC plan), on the other hand, willprovide a payout at retirement that is dependent on theamount of money contributed by the employee and company(for example, through matching contributions) and theperformance of the investment vehicles utilised.

Due to the financial risks involved, private equity buyers aregenerally uneasy when it comes to DB plans. The profit andloss expense in any given year generally bears littleresemblance to cash contributions to the plan. Moreover, anyfunding deficit recorded in the target company’s balance sheetreflects actuarial assumptions (such as the discount rate) thatcan be up to 12 months old. Given the importance ofmodelling cash requirements, private equity buyers willgenerally want to refresh the numbers using currentassumptions around interest rates, asset performance andmortality. A current view of the funding deficit and updatedestimate of cash contribution requirements is imperative,especially in light of the falling interest rate environmentexperienced over the last few years. Buyers will often treat thecurrent funding deficit as a debt-like item for valuationpurposes.

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DC plans carry significantly less financial risk for the buyersince they cannot be underfunded. Therefore, risks for DCplans tend be compliance-related; buyers typically limit theirexposure by adding standard seller warranties around plancompliance to the purchase agreement.

Healthcare benefits

Healthcare costs continue to be one of the fastest-growingareas of employee costs, with annual increases averaging 9percent in 2011 according to PwC’s Touchstone Survey1. Inthe US, companies are now required to comply with a numberof changes under the Patient Protection and Affordable CareAct (PPACA), which was signed into law by President Obamain 2011. One significant provision of PPACA is known as the‘individual mandate’ which requires all employers to, by 2014,provide medical coverage that is adequate and affordable tovirtually all employees who work 30 hours or more per week.The individual mandate would also impose a penalty to anyindividual who does not have medical coverage. As a result,participation in medical plans is expected to increase startingin 2014, and the associated potential increase in costs is anitem on which private equity firms will focus. Please note thatas of the time of writing, the US Supreme Court is currentlydebating the constitutionality of the individual mandatedescribed above.

Key non-US considerations

Although the impact on employee-benefit plans outside of theUS is beyond the scope of this chapter, the authors haveidentified the key issues that tend to arise in some of Europe’slargest countries.

• UK. DB plans potentially face significant cash contributions(effectively requiring funding on a plan-termination basis) if theplan trustee determines that the plan’s funding will be

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jeopardised due to a perceived deterioration in the strength ofthe ‘pensions covenant’ as a result of the transaction.

• Germany. Companies typically sponsor defined benefits (forexample, pensions, early retirement benefits and long-serviceawards), which are largely unfunded. Future cashcontributions will depend on the demographics of the targetpopulation.

• France and Italy. Termination indemnities are mandated.These are generally unfunded and should be provided for onthe balance sheet and taken into consideration when valuingthe business.

Management talent assessment

In private equity deals, the approach to managementassessment will very much depend on the nature of the deal.In a carve-out deal, certain executive functions (for example,legal, human resource and finance) may not have all thenecessary experience to operate under the level of oversightthat private equity ownership typically entails. Certainly, anexecutive team that has already experienced a cycle of privateequity ownership will be much better prepared than anexecutive team that has not. For a public company to be takenprivate, the presumption is often that an effective managementteam is largely in place but that certain functions may not beneeded in a non-public environment (for example, investorrelations). Where the acquisition is an add-on purchase to anexisting portfolio company, there may be a need for aselection process to ensure that the private equity firm takesadvantage of the opportunity to improve the talent in theexisting portfolio company together with selected members ofthe target’s management team.

Talent in a portfolio company correlates strongly to thepotential growth in enterprise value. The importance of a fullyfunctional executive team cannot be overstated in this context

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as any delay in achieving an exit due to a lack of cohesionamong the management team has a serious financialconsequence.

At a minimum, the private equity firm should identify duringdue diligence any management member who is not a good fit,who clearly needs to be upgraded, or who may be at risk ofleaving the company based on the value of his or her vestedequity or other compensation arising from the transaction. Thetime frame needed to bring in a replacement should beconsidered and appropriate retention incentives developed tokeep the outgoing executive in place until the position is filled.Private equity firms will often use a search agency to preparejob descriptions, screen candidates and present a slate ofacceptable candidates to be interviewed by a selectioncommittee, which might include the operating partner incharge of the transaction and the CEO of the business. Thepool of candidates can often be supplemented by leveragingthe executives’ existing industry contacts.

The importance of a consistent but flexible selection processcannot be understated. As a baseline, private equity firmstypically conduct thorough background checks on incumbentsand potential hires to ensure they have no history of fraudulentactivity or questionable business relationships. Candidateselection is typically based on a combination of experience,management competencies and fit, both for the open positionand for the organisation under private equity ownership. Thecore business drivers underlying the investment thesis can beused to create a scorecard with role-specific accountabilitiesidentified. Ideally, the same principles used for assessingexternal hires should be applied when comparing twoincumbents.

The process used to assess incumbent management talentvaries by private equity firm. In some cases, the assessment ismore informal and achieved during the course of the

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numerous conversations and private meetings that occur withthe management team during due diligence. For key functionalroles such as legal and financial, private equity firms will oftenask their advisers for an informal opinion of the individual’s fitfor the role based on their command of issues during duediligence.

As more private equity firms focus on operationalimprovement, they have added operating partners who willoversee the management team. Often, these operatingpartners, along with the lead deal partner, will be at the heartof the management assessment. In these cases, assessmentis a more formal process, with a structured individual interviewof each member of the senior management team. Thequestions are driven by the specific role the individual playsand the competencies that will need to be demonstrated to besuccessful in that role. The questions will also seek to identifythe likely cultural fit with the private equity firm.

In any private equity assessment, there will typically be plentyof room for intangibles. For example, an executive whocomplains during due diligence about the volume ofinformation requests, who appears stressed, who is notconsistent in answering questions or who is just difficult toestablish rapport with will likely continue to be difficult once thedeal is signed. Often, the individual is also asked about othermembers of management and the views given are used totriangulate assessments and to get a sense of overallmanagement cohesion.

The assessments may result in a high-level classification ofeach management team member. Examples of theseclassifications include:

• Essential to the success of business.

• Important in the short-term transition but future importanceundecided.

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• Essential only in the short-term transition; no long-term role.

• Not required at all.

The outcome in each case will determine the approach tosetting management compensation packages, including equityincentives and retention/severance payments.

In the authors’ experience, it is rare for private equity firms touse assessment centres or psychometric tests to assessmanagement talent. Private equity firms prefer to be directlyinvolved in assessing management talent.

Understanding human resource transition challenges

Although the discussion of human resource transition is left tothe end of this chapter, it is a process that typically begins oncommencement of the human resource due diligence,particularly where the target company is a carve-out from alarger parent company or where there is a bolt-on or anadd-on acquisition. A key question to consider is: how mightthe target company’s human resource-related run-rate costschange following the transaction? The private equity firm willwant to know the run-rate and one-time cost implications ofalignment of:

• Benefits.

• Compensation.

• Human resource operating platform.

• Human resource function.

The transition challenge involved depends on the situation.

Standalone company

In the simplest scenario, when acquiring a free-standing,standalone company, the starting proposition may be that notmuch will change. The key challenges are to:

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• Get management and employees comfortable with the positiveaspects of private equity ownership through strongcommunications and change management.

• Establish a clear picture of what is required to succeed andensure compensation plans support this goal.

• Exert financial and operational control based on the specificstyle applied by the private equity firm.

However, even in such standalone situations, there may beoperational synergies to be achieved by benchmarking humanresource effectiveness across an array of metrics and byidentifying opportunities for improvement. In addition, theexisting organisation may be in a multi-year cycle of humanresource development (for example, implementing a newhuman resource information system). The private equity firmwill want to understand what activities are planned and thelikely cost, to ensure they are still appropriate.

Add-on acquisitions

Sizeable add-on acquisitions to existing portfolio companiescan represent the most challenging of situations. In this case,there will need to be a clear picture of the degree ofoperational integration in practice. In a situation where thebusiness case assumes significant operational synergy, it willbe necessary to:

• Align organisational structures as each company has its ownorganisational structure. It cannot be assumed that thestructure in place for either company will be efficient once thetwo companies are combined.

• Streamline management to eliminate duplicate positions aftera suitable transition period. While the presumption is that theprivate equity firm is satisfied with the management team atthe existing portfolio company, there may be an opportunity asa result of the add-on acquisition to upgrade talent and fill

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open positions. Effective assessment of talent is fundamentalto these situations.

• Move to one human resource operating platform. This canremove duplicate costs for payroll and human resourceinformation systems.

• Develop a unified compensation and benefits platform.Benefits alignment can be particularly challenging if there aresignificant differences in the underlying benefit platformsbetween the two companies, such as the existence of definedbenefit or retiree medical plans in one company but not theother. The bulk of the effort around compensation alignmentwill be to ensure that salaries are reasonably consistent forsimilarly placed individuals and that incentives are alignedquickly around key financial and operational goals.

Carve-out deals

Carve-out situations are a middle ground and represent theirown unique challenges. During due diligence, the focus will beon understanding human resource cost allocations andcomparing these allocations to the expected run-rate costs ofoperating the new human resource infrastructure on astandalone basis. As the company may not have afreestanding human resource infrastructure, it may benecessary to create one. There are a number of key aspectsto this end:

• Develop a human resource operational structure. Thisincludes a decision on which services will be performedin-house and which will be outsourced. Examples of servicestypically considered for outsourcing include payroll, benefitsadministration, talent sourcing and employee surveys.

• Establish an effective human resource function with the skillsto operate independently. This could involve adding a vicepresident of human resources, a compensation director, a

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benefits manager, a payroll manager (if not outsourced) andpotentially a few human resource generalists. The cost ofthese additional positions will need to be factored into thefinancial model.

• Select vendors to deliver outsourced services. The mostcritical of these outsourced services are payroll and thehuman resource information system. With the advent of cloudcomputing, new vendors and service solutions are coming tothe market, which allow more flexibility and quicker platformestablishment. This is a significant area of activity in currentcarve-out deals.

• Establish benefit programmes. Health, welfare and retirementplans are the most significant of benefit programmes. Manyprivate equity firms prefer DC plans as they have less risk andare simpler to establish. Due to their complexity, theestablishment of medical plans in particular involves a lot ofeffort; private equity firms will often lean heavily on vendorsand other advisers to assist in establishing these plans.Private equity generally prefers to preserve flexibility tosimplify the benefits offered with specific language included inthe purchase agreement.

For all of the above types of acquisitions, the onetime cost ofestablishment of a new human resource infrastructure, as wellas the future run-rate costs, need to be determined as part ofdue diligence and factored into the valuation model.

Due to the time taken to establish a new human resourceinfrastructure and the often rapid time frames between signingand transaction close, private equity buyers typically ensurethat human resource services are covered under a transitionservices agreement (TSA) for up to six months following theclose of the deal. The goal is to quickly establish afreestanding human resource infrastructure – including ahuman resource information system, payroll and benefits –

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and move as quickly as possible away from delivery of theseservices under the TSA.

Conclusion

The financial risks associated with human resources may havea significant impact on the valuation and ultimate purchaseprice the buyer is willing to pay for the target company.However, it would be short-sighted to focus only on financialrisks. The assessment of management talent and navigationof human resource transition challenges will drive the successand economics of the portfolio company during private equityownership, and are therefore instrumental in maximising thebuyer’s ultimate return on investment.

Steve Rimmer is the global network leader ofPricewaterhouseCoopers LLP’s Human ResourcesTransaction Services practice and specialises in the humanresource aspects of mergers, acquisitions and spin-offs. Stevehas 28 years of human resource consulting experience, with aheavy emphasis on conducting human resource due diligenceand addressing integration issues arising on corporatetransactions. Steve has worked with numerous leadingcorporate and private equity clients. He spends a significantamount of his time advising clients on compensation issues,including market competitiveness, retention strategies anddesign, and implementation of equity compensationprogrammes. He has published a survey of equitycompensation practices among private equity portfoliocompanies.

Steve has been at PricewaterhouseCoopers for 23 years,including 18 years in New York and five years in London. Priorto joining PricewaterhouseCoopers, he worked for Bacon andWoodrow, a leading UK firm of actuaries. Steve is a UKqualified actuary, a Certified Compensation Professional andhas a MBA from Manchester University in the UK.

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Aaron Sanandres is a partner in PricewaterhouseCoopersLLP’s Human Resources Transaction Services practice inNew York. He has 13 years of professional experience inhuman resource consulting. He specialises in providinghuman resource transaction advisory services to bothstrategic and financial buyers and specialises in the financialservices industry. Aaron’s core expertise lies in the design, taxand accounting aspects of executive compensation. Hespends a significant amount of his time advising his servicesclients on post-acquisition executive compensation issues.Aaron has written a number of articles around human capitalissues within the asset management industry, most recentlyincluding the 2011 Asset Management Reward and TalentManagement Survey and a white paper on human capitalissues in asset management M&A. Aaron received his MBA,with honours, from Columbia Business School.1 Available at http://www.pwc.com/en_US/us/hr-management/publications/health-wellness-touchstone-survey-2012-form.jhtml.

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Chapter eight

Modelling how ESG factors can impact risk-adjustedreturns

By Vincent Neate and Jonathan Martin, KPMG LLP

Introduction

With any operational improvement initiative, there are alwaysdifficulties associated with proving its worth beyondreasonable doubt: responsible investment is no exception.While there will be a number of trailblazers and trendsetters,there will be as many risk-averse and wary investors seekingconclusive proof before they develop a more structuredapproach to the integration of environmental, social andgovernance (ESG) factors into their investment decisions.

Before we consider the ways in which ESG factors can impactrisk-adjusted returns, it is important to outline some of the keyresearch into this area. Most research into the impact thatESG risks and opportunities can have on corporateperformance has focused on public equities and so hasanalysed share price movements. A more relevant metric forprivate equity is valuations, which often involve a morefundamental assessment of the potential for the portfoliocompany to create and sustain value over a short-, medium-and long-term horizon. However, recent research hassuggested that there is a positive correlation between shareprice and the identification and management of ESG risks andopportunities.

Mercer undertook two literature reviews in 2007 and 2009.Across the 36 separate studies analysed in the two reviews,20 (56 percent) suggested a positive relationship betweenfinancial performance and non-financial risk management; two(5.5 percent) suggested a slightly positive relationship; eight(22 percent) suggested an inconclusive relationship; and only

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six (15.5 percent) suggested either a slightly negative or anegative relationship. A second literature review undertakenby Innovest Strategic Value Advisors with the UK EnvironmentAgency suggested that 51 out of 60 (85 percent) studiessuggested a positive correlation between environmentalgovernance and corporate financial performance. In addition,the performance of Goldman Sachs’s GS Sustain product,which explicitly integrates ESG metrics into a stock-pickingprocess over three to five years (similar to the holding periodfor private equity-owned portfolio companies), outperformedthe MSCI World Index by 25 percent between 2005 and 2007.

It is also worth highlighting the importance of risk at the outset.As with a limited partner (LP) comparing emerging marketfunds with OECD market funds or venture capital with buyoutfunds, an assessment of a fund that integrates ESG needs tobe considered in the context of the potential upside as well asthe potential downside. It is fair to say that the measurementof risk, for example, political risk associated with emergingmarkets, involves intangible factors that are less easilyquantified than the return upsides, for example, GDP growth,disposable income or multiple growth. However, few peoplewould argue that it is safe to ignore the downside risks inemerging markets. Similarly, while the tools and data availablefor modelling ESG-related risks are less developed than thosethat exist for tangible impacts on returns, such as costreduction, sales and margin growth, it would be unwise toignore them. When taking account of the mitigation of ESGrisks, for example, additional costs of carbon permits nolonger required, the avoidance of brand erosion from negativebusiness associations and so forth, the impact of ESGimplementation can actually be viewed as a risk-adjustedimprovement in the long term.

Increased focus on ESG

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It should be clarified that the identification and management ofESG risks and opportunities is not new to private equity.Private equity firms have been commissioning pre-investmentenvironmental due diligence to assess risk and liabilities formany years, as illustrated in Example 1, a case study thatwould not seem unusual to the majority of general partners(GPs). However, following the global financial crisis, at the endof the first decade of the 21st century, where debt is scarceand returns have been lower than the historical trend, thereturn to a traditional value-creation model in private equity –focused on operational improvements – means that thepotential contribution of ESG risk management to returns isgreater than ever before. Beyond this, the economicexpansion of emerging market economies is presenting a newchallenge, as competition increases for markets, naturalresources, human capital and finance. The world in whichprivate equity operates has changed and part of this change isthe increased significance of ESG factors.

Example 1: Aluminium manufacturing company

A GP was considering buying a large aluminium manufacturingcompany located in a non-European Union Eastern European countryand, as a result of lower regulatory factors and less frequentassessments, the safety and environmental managementarrangements and performance were below that of Western standardsand that of the client’s expectations. A number of issues wereidentified that presented short-term financial performance risk,alongside opportunities to improve operating performance throughcost-reduction measures and sensitivities to the business plan. Theseincluded:

• A highly material (multimillion euro) one-off cash sensitivity to beincurred within the forecast period, comprising pollution abatementequipment upgrades to meet European air emission standards andrestoration of onsite waste landfills.

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• An energy efficiency improvement programme, designed to reducedemand for energy throughout the manufacturing process andoptimise the overhead cost base.

• An operational risk in the identification of a government proposal tobuild an upstream hydroelectric power plant, potentially preventing theongoing access of the business to cost-effective hydroelectric power,thus negating the rationale of the acquisition.

• Moral obligations to the local community that was heavily dependenton the employment opportunities directly associated with aluminiumproduction, as well as indirect employment associated with wineproduction on the site’s adjacent agricultural land.

As a result of this enhanced level of due diligence the GP was able tofactor the additional considerations into their negotiations. Thisincluded the potential consideration of environmental insurance andother post-deal activities. Without this valuable environmental insight,the investment decision would have been heavily focused on pureup-front financial information and not the underlying costs that wouldhave arisen as a result of the poor ESG track record of the business.Ultimately, this approach enabled the price to be adjusted accordinglyand therefore set a more reflective cost for the business than wouldotherwise have occurred.

When viewed from this new perspective, due diligenceundertaken on companies acquired at the peak of the marketmay seem relatively narrow in scope. It is considered by manythat environmental risks were not sufficiently taken intoaccount by all private equity firms, and the potentialenvironmental opportunities were certainly not exploredadequately. It is also reasonable to suggest that social issues,and some governance issues, were overlooked, as the extentto which they operate as drivers of value or of costrationalisation is often poorly articulated and understood. Itwould be wrong to imply that every ESG factor hascommercial relevance in all instances: the key to successfulresponsible investment is identifying where it is relevant,quantifying it and addressing it through management

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decisions. In order to assess where ESG factors may bematerial to financial performance, investors need a frameworkfor modelling the potential impacts.

This chapter seeks to address the key issues of modelling andquantifying the impact of ESG in the private equity sector,demonstrating both the thought process and mechanicsbehind measuring ESG actions. Ultimately, it seeks toillustrate why this is vital for the long-term success ofbusinesses and the environments within which they operate.As such, two key areas will be covered:

1. How can the link between good governance, environmentalmanagement, social impacts and risk-adjusted returns beconceptualised?

2. Through what methods the benefits and costs of pursuingthese strategies be quantified?

Example 1 highlights the need to consider more than just thefinancial performance of a business. ESG issues are asimportant in aiding the decision process as to whether toinvest or not, as it is in driving down costs and aiding revenuegrowth.

Understanding the scope of ESG

Before establishing a link between ESG factors andperformance, it is important to consider some of these factorsexplicitly. Many private equity firms, particularly the largebuyout firms, have now developed a checklist for theirinvestment teams: an example of which can be found in Table8.1. Such a checklist should, by sector, set out the mostimportant issues that will repeatedly arise for that industry andthe escalation procedures, including detail on the stage atwhich external advice should be sought. If the firm is in aspecific industry, the checklist will inevitably have a morerelevant focus.

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Link between ESG factors and financial performance

In all projects, it is important to demonstrate that the benefitsof a course of action outweigh the direct costs and the costsassociated with the risk of failure of that action. This should bedemonstrated in order to aid future decision-making ratherthan to retrospectively justify past decisions.

Adopting best practice with reference to ESG means takinginto account a wealth of ideas, issues and possibleconsequences in project appraisal, which are highlighted by amindset that attempts to broaden thinking to embrace andquantify a widely drawn assessment of the project impacts. Inthis context, the term ‘project’ is used broadly to encompassinvestment appraisal as well as company-level decisions suchas make or buy and new market entry.

Therefore, to analyse the cost benefit of ESG practices is tochallenge what may have been an historic assumption – thatin project appraisal only the direct inflows and outflows of cashare considered – and to replace that assumption with a newone – that other, less immediate, matters need to beconsidered. This then becomes a two-fold problem: first,identifying relevant issues for consideration and second,establishing a commonly agreed measurable currency forthose issues.

Table 8.1: Sample ESG checklist

Environmental

• Energy management and carbon emissions

• Compliance with environmental regulations

•Environmental incidents, spills and accidents with impact tobrand or reputation

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•Exposure to environmental liabilities such as assetdecommissioning and clean-up costs

• Waste management and minimisation

Social

• Health and safety risk management and internal controls

•Minimum wage policy – appropriate and in compliance withlocal standards

• Data protection of customers and suppliers

• Discrimination

•Worker representation, for example, the right to join unionsand express opinions

Governance

• Board selection, governance and effectiveness

•

Corporate governance policies and processes, includingwhistleblowing policies, remuneration, ethics andindependence

• Bribery and money laundering – risk, policy and training

•

Corporate governance performance – convictions orsuspicions of association with crime, corruption, moneylaundering; governance incidents in the past five years

• Disclosure of information and transparency

With this in mind, the impact of ESG factors on financialperformance can be assessed in the context of four key areas:

1. Brand value enhancement.

2. Profit improvement – incorporating revenue growth and costrationalisation.

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3. Cash flow improvement.

4. Net impact on stakeholders and the community.

Brand value enhancement

While this is probably the most difficult to measure, brandvalue enhancement is possibly the most valuable to abusiness, certainly in the long term as that is often the periodover which a brand is built. There are many businesses thathave, over a long period, built up a strong corporate reputationfor ESG investments and fair treatment of employees,suppliers and customers. However, the value of this reputationis difficult to quantify and is rarely tested except when theorganisation is exposed to media scrutiny, negative publicityand adverse impact on the brand. The implication is thatachieving ESG objectives may require a long-term view ofmarket sentiment, compounding further the challenges ofplanning, predicting and measuring specific outcomes.

There are few quick wins to be had in this area, although,conversely, there are some quick losses that can be avoided.The perennial linkage between certain fashion chains and the‘sweat-shop’ labour of Southeast Asia will continually lead to asignificant loss of trade compared with their competitors. Itmight be that the competitors are not proactively enhancingrelationships with their stakeholders and suppliers but, with nonegative association, they will still gain an advantage.

Similarly, certain pharmaceutical companies have sufferedfrom negative reports in the media. During the latter part of2010, articles appeared in the press that focused on a privateequity-backed healthcare business whose product had beenused by a secondary customer in the US lethal injectionprocess. To try and avoid these brand mishaps, it is vital tohave sight of the whole supply chain – not just know your ownsuppliers, but also their suppliers, as well as the customers ofyour customers.

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Differentiating a brand is often a long-term concept that needsinspirational leadership and a successful team mentality. Theshort-term costs will be related to research and development(R&D) – usually trial and error rather than any significantcapital programme. Consumers do want to see sustainablebusinesses and, as noted below, are prepared in many casesto pay a premium for this, be it through fairtrade or positivelyimpacting communities. A very good example of the latter isthe KKR-owned Pets at Home, who proactively ask ifcustomers would like to round up their purchase to the nearestpound, with that excess donated to charity.

Environmental labelling provides a further example of a clearlink between ESG and performance. In retail, the ability toattract every additional sale and to push the boundary ofmargins is vital – a significant industry of higher priced, highermargin goods has been created out of inclusion of the simpleword ‘organic’. However, that does not imply that all organicproduce will enable a positive return when compared withmore traditional methods. What has happened, particularlywith regard to livestock and associated produce, such aseggs, is that the cost-benefit analysis of the organic approachhas been proven to be advantageous. In other words, theassociated cost of larger production sites and longer leadtimes is offset by the additional price that can be charged forthose products and these are still purchased by a sufficientnumber of consumers to generate a profit. Another similarexample is the concept of ‘fair trade’. The FairtradeFoundation has helped to enhance the living standard offarmers and raw material producers through a definedprogramme of fair payments for products. Instinctively thismeans more cost, though the associated value added to thebrand and the label helps to create a premium wherebyconsumers are prepared to pay more for the same product.

Profit improvement

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A business has two core ways to generate an improved returnin the short term: sell more or

incur lower costs. ESG initiatives can impact significantly inboth areas and, unlike the issue of brand enhancement, this isoften a short-term achievement.

Cost rationalisation

Reduced costs, provided that they do not dilute quality, willimprove profitability in the short and long term. Typicalexamples of ESG initiatives that are quoted are often inrelation to cost savings (see Example 2). Environmentalaspects are more likely to generate cost savings than social orgovernance issues, particularly in the short term. The ESGchecklist found in Table 8.1 highlights some typical examples,namely energy management, recycling and resourceefficiency.

It can be fairly easy to reduce energy costs simply by applyingsensor-driven lighting and ambient heating but, as discussedin the next section, these potentially have an intensive capitalcost associated with them. Recycling or re-use of product is aless capital-intensive cost and, provided that there is a readilyavailable market, will reduce costs. Carbon capture andstorage (CCS) is an example of capital-intensive investmentresulting in long-term reduced energy costs by effectivelyre-using the energy that was initially generated, although thetechnology associated is not yet fully proven.

The spectrum of ESG-related initiatives is fairly wide andranges between those that add immediate cost savings orrevenue enhancements in the short term, and those initiativesthat either add no tangible financial benefit at all, or do so overa very long time period. Examples of these long-terminitiatives include increased staff training resulting in improvedworkforce morale and the implementation of robustgovernance arrangements. It can be very difficult to measure

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the benefit of additional staff training, particularly until it issuccessfully embedded, but staff retention can be used as asimple measure here. Almost all businesses are impacteddetrimentally by significant staff turnover: the cost of lostknowledge and experience, training regimes not fullyrecouped and the obvious additional costs of recruiting andtraining new staff will be high. Retention is not alwaysconcerned with paying better wages; the social aspects ofemployment, for example, time off in lieu for charitable activityare also important. From a cost-benefit perspective there isalso the efficiency and productivity lost when an experiencedemployee leaves; again, this is difficult to measure accuratelybut is an undeniable cost nevertheless.

Example 2: Road haulage company

A key cost input in the road haulage sector is fuel and the fuelconsumption of vehicles is a major controllable for the businessanalysed in this case study. A new software-based route optimisationprogramme led to significant reduction in fuel consumption and,ultimately, the underlying cost base.

The driver behind this particular initiative was one of cost optimisation.The escalating global oil prices since the turn of the century have putconsiderable pressure on the margins of road haulage anddelivery-intensive businesses. Other financial methods such asforward contracts and hedging, while possible, are very rare for suchbusinesses.

Therefore, to mitigate the spot cost, the business needed to considerhow to continue delivering the same level of sales yet reduce theoperating costs.

Initially they considered capital-intensive options such as largervehicles, liquefied petroleum gas (LPG) and other vehicles powered bynew technologies, and more operational sites. The latter of whichwould, in theory, result in less travel between depots and thecustomers.

All of the above options, where actually feasible, were at a cost thatwas not commensurate with a short-term assessment. The current

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cost of property compared to the fleet costs would make any increasein sites inherently costlier than more vehicles. Equally, while LPG andsimilar efficient vehicles, for example, the aerodynamically designedtrailers that are now used by numerous UK supermarkets, would haveimpacted positively on fuel costs, the short-term cash outflow wasdeemed too great.

The issue was resolved through appropriate route optimisation,identifying how to reach their customers in the shortest possible timeand journey, and using technology to burn less fuel. The latter wasachieved through satellite navigation systems designed to ensure thatthe trailers avoided congested routes and areas with high risks ofaccidents.

This solution proved to be the most cost effective, as fuel costs weredriven down with relatively little capital commitment required and theinitiative resulted in immediate value to the business involved and toits stakeholders. Critically though, it was also extremelystraightforward in the wider context of ESG initiatives and indirectly ledto defined ESG benefits. The reduced fuel consumption in the roadhaulage business led to a quantifiable ESG-related benefit, that oflower carbon emissions. Ultimately, this helped the business to reducetheir carbon footprint, which, when considering potential future capand trading policies, should eventually offer further financial savings.

There are many daily operational aspects of business whereESG initiatives can demonstrate shorter-term and moreobjective impacts, for example, sensor-driven lighting reducescarbon emissions and electricity bills.

Recycling is another example of an initiative offeringshort-term benefits: an enlightened view of waste is as ameasure of process inefficiency. Waste as a byproduct can beredirected away from landfills either by re-use in the processor by recycling. This does not need to be within the samebusiness that created the waste; for example, a retailer willhave considerable amounts of waste packaging, which can berecycled or reused internally. However, it is far more likely tobe recycled by other businesses and often by businesses thatare prepared to collect it directly from the retailer. For minimal

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additional cost, the retailer is able to demonstrate to theirsuppliers and customers an obvious and quantifiable ESGbenefit with negligible cost to the business.

Revenue growth

Revenue growth can be closely linked to brand enhancementbut there are also some quick wins in this area too. A moreenlightened and involved workforce will readily identifyadditional areas that a business needs to focus on and thepositive changes it can make. Employee programmes thatfinancially reward good ideas and identification of requiredchanges are more likely to result in positive outcomes than ifthese aspects are focused on the senior management orexpensive outsourced marketing agencies. These schemesprovide the employees with a sense of belonging to thebusiness, thereby increasing job satisfaction and loyaltywhich, in turn, help to improve staff retention.

Cash flow improvement

ESG factors, particularly environmental and social initiatives,can result in a short-term cash outflow, albeit as part of along-term risk-adjusted benefit. As outlined in Example 3,incentivising the workforce to grow sales and to reduce staffturnover has an immediate cost associated, but does lead to apositive longer-term cash flow position through reducedrecruitment costs and increased sales.

Given that cash return is critical in any business decision, theinitial cost of many ESG programmes can appear to beprohibitive. However, when considering any new initiative, it isimportant to consider the potential longer-term benefits. Forexample, the up-front cost of a fleet of new low emissionvehicles will be high but the subsequent cash savings throughlower fuel costs and lower regulatory costs, among others,may outweigh this.

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Cash flow is particularly enhanced through the improvedgovernance and transparency regimes implemented bybusinesses. Often businesses operate in a silo divisionally andwithin their groups. GPs have an opportunity through goodcentral management of regulatory issues throughout theirportfolio to help ensure that a business is not trying to employexperts across all areas when in fact only one central expert isrequired. Further, central approaches to many otherprogrammes, for example, energy costs and supply chainmanagement can be undertaken, which should lead to clearcost savings and cash flow benefits.

When considering cash generation, the business imperative isto cycle working capital as quickly as possible withoutovertrading or building up excessive stocks and work inprogress, so there is no immediately apparent risk to theoperational return of the business by maximising this.However, when examined more closely, this is not always thecase, as can be seen in some of the examples discussed inthe following section on improving stakeholder management.

Net improvement on stakeholders and communities

All companies rely on relationships with a range ofstakeholders, and the strength of these relation-ships canhave a material impact on the company’s future performance.It is important to develop a ‘win-win’ culture, one where thestakeholders, principally the customers and the suppliers, areincentivised to work together for the good of the entire supplychain.

Example 3: People-intensive organisation

This example considers the benefits of incentivising the workforceusing non-financial methods. In most businesses the primary cost inthe profit and loss account is employee salaries, and therefore thebiggest risk is often that which results in a fundamental weakening ofthe workforce. No matter how strong and entrepreneurial the

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management or ownership, without the commitment and involvementof the work-force the business will not succeed.

In assessing the value of the workforce to the business and how toincrease this, the business being analysed here considered a numberof specific areas:

1. Direct salary.

2. Bonus and other variable remuneration.

3. Training and additional employee enhancement.

4. Non-financial issues – corporate social responsibility involvement andcharitable work.

5. Inclusion in the management process.

Each of the above items was assessed on the basis of the costs to thebusiness and the revenue opportunities generated. The direct costs ofsalary and bonus are obvious, but the indirect costs of these items areless so – if salaries are not competitive, employees are likely to moveto other businesses. While this may result in a short-term cost benefitof replacement employees who are paid lower salaries, the associatedcosts of recruitment, training and embedding new staff into thebusiness will offset any short-term gain.

Revenue opportunities are created through the additional motivationthat the five criteria above can generate. A motivated employee maywork longer hours, more flexibly and be more loyal to the business, allof which may, in turn, increase sales. The cost-benefit curve here,however, is clearly limited. Motivation can be improved but is notlinear; there is a point beyond which extra salary or bonus will notgenerate greater buy-in and therefore sales. Equally, there is a point atwhich time allowed for training results in a negative return to thebusiness due to lower time devoted to the actual role for which theemployee is employed.

Third-party studies on the motivation results of salary and bonus wereused in this case, along with sector comparisons to identify anoptimum level of salary to reduce the level of staff turnover to anacceptable point. From a non-financial perspective, employees wereconsulted with regard to their involvement in management processesand decisions, the level to which they expected or wanted to be

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involved. Boundaries were tested to determine what level of additionalworkload, training and non-work activity would result in a greater orlesser inclination to leave.

The results of the above were then communicated to the workforcewith the aim of ensuring that the conclusions reached wererepresentative of the population and therefore suitable to implement inpractice.

However, it is not always easy to improve stake-holderrelationships, while attempting to optimise cash flow andreturns. The business might attempt to manage its cash flowby putting significant pressure on customers to pay quickly,which may prove problematic if those customers are notparticularly affluent individuals or have significant debtproblems. This became a prominent issue in India during the1990s when statistics began to demonstrate that a number offarmers were committing suicide as a result of a variousfactors including levels of debt and the industrialisation of thecountry. Such incidents are clearly very emotive, and thepublic and regulatory backlash can be far greater than mayhave occurred had appropriate and fair payments or creditterms been in place initially. This is another compellingexample of an issue that at first may appear to impose anadditional financial burden on business, but ultimately leads toa more effective supply chain and lower consequentialregulation.

Alternatively, the business might manage those same cashflows by delaying payments to suppliers. Again there isnothing inherently wrong with that, except if those suppliersare small businesses with little capacity to cope with delayedpayment. An excellent example of this is the transition overthe past ten to 20 years in the R&D processes at many majorindustrial organisations. No longer are both research anddevelopment solely performed by these organisations. Moreoften than not, they will provide the finance and work-force to

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perform the development, but the ideas and creativityfrequently come from universities, small boutique sectorspecialists and other unrelated businesses. Keeping strongand sustainable relationships with these ensures that the largeindustrial organisations are able to continue to develop andsell new technology in this rapidly changing world. It ispossible to negotiate with suppliers in terms of cash flow forpayments and to ensure additional discounts; however, it isimportant not to squeeze supplier margins too hard as this canlead to a culture of suspicion and not one where problems canbe resolved in a constructive manner. It may also lead tosupply chain disruption if the supplier locates an alternativesource to supply their product.

A very good example of this is the UK supermarket sector,where aggressive pricing to fruit, vegetable and livestockproducers, in particular, has resulted in a negative portrayal ofthe businesses involved. Those who are able to demonstratea positive working relationship with the farming sector haveaided their brand awareness and succeeded financially as aresult.

The costs here are not high, but measuring benefit is perhapsmore difficult than with some of the environmental costsavings noted above; however, the cost of constructivedialogue with suppliers and customers is minimal, with onlytime required and a commitment to working through difficultissues.

Therefore, while some companies can believe that they workin a vacuum with little or no real potential negative impact fromtheir stakeholders and communities, this is clearly not thecase. Moreover, it is true that the stronger these relationshipsand links, the stronger the potential financial benefits are.

A long-term owner cannot afford to ignore the well-being andstatus of their suppliers anymore than they can ignore theirstaff. Considering a target company’s workforce as a key

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stakeholder of the organisation, it is an accepted truism that itis important to motivate them. Of course, this is a moreimminent management issue in some industries rather thanothers. However, it is certainly the case now, for example, thatin professional services a core motivational tool is some formof arrangement whereby staff can deliver services pro bono tocharities. In leading organisations, it is not just the cost of suchschemes that is measured, but the effect of theseprogrammes on staff welfare, satisfaction and motivation.Where staff retention is critical to the successful growth of abusiness these areas are vital. Equally, where the pool ofhuman capital is closely fought over, a non-financialdifferentiator becomes very important.

Long-term benefit for private equity

Without clear quantifications and certainties, the cost-benefitanalysis may be very subjective. It might also be argued thatfor a private equity-backed business, often with an expectedownership of three to five years, the business case for ESGmanagement and enhanced reputation is even more difficult.Such a view does, however, ignore the often stated belief thata key advantage of private equity ownership is its ability totake a long-term view without the need for quarterly reportingand the other short-term pressures of listed entities.

If investment is required to raise ESG performance forpotential benefits at some point in the distant future, it isunlikely to prove favourable with management operating in acapital-constrained economy. This is true regardless of theownership model. It is also precisely why it is sensible not toconsider expenditure for the purpose of raising ESGperformance but to consider ESG performance for thepurpose of protecting or enhancing the value of an investmentin a target portfolio company. However, it will always be hardto judge whether it is better to wait for sentiment to change orto lead the way and potentially incur early adopter costs.

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Impact of time horizon on perceptions of risk

As discussed earlier in the chapter, risk management and riskmeasurement are vital aspects of running a business.However, not all risks require immediate or sustainedassessment, particularly from the perspective of a GP or,ultimately, its LPs. Some risks are inherently long-term innature and, while important to LPs such as pension funds, willbe of limited interest to others, including GPs. For example, itis an accepted truism that global oil reserves are beinggradually depleted, although when this will occur is less clear.Therefore, at some stage in the next 50 or 150 years, thebusinesses of the future will need to find a cost-effectivenon-carbon based method for providing energy and power.However, this is clearly not a risk that concerns many privateequity firms or even most investors today.

Therefore, developing processes that use sustainable,renewable energy are only credible if they drive cost savingsand competitive advantage today. A recent Yale Universitystudy highlighted that 80 percent of CFOs would considerrejecting an investment opportunity that would bring long-termgains at the expense of missing a quarterly earnings target.When one considers that many of these long-term initiativesare also capital intensive in the early years, again the ratio ofcost to benefit is not always clear.

Ultimately, the real test of any cost-benefit analysis on therelevance and importance of ESG issues in business will beretrospective and how the private equity industry will adapt tothis remains to be seen. There is growing interest fromstakeholders who are becoming more willing to act on theirinterest for the greater good. However, in a difficult economicclimate, pressure remains on profitability, increasing the needto ensure that ESG policies implemented are the most suitableto drive long-term value in the business.

Exiting responsibly

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The authors cannot complete a chapter on cost benefit in theprivate equity sector without considering exiting investments.ESG as a marketing tool can be a key factor in helping toincrease value on exit, assuming, that is, that the potentialbuyer, especially if a secondary private equity firm, isinterested in anything other than short-term financial return.An IPO is certainly likely to be enhanced through non-financialaspects of the business. Institutional investors, particularlylarge pension funds, are more actively involved in ESGinitiatives, and therefore will see additional value in asustainable business.

This is no less true for a trade buyer: a business that hasidentified, controlled and is actively managing its ESG impactwill have a significantly more stable and probably lower costbase in the future. The threat of additional regulation andfines, such as carbon caps, restricted energy usage and fuelusage, will be a greater concern to a buyer who does notbelieve that the business in question has suitably addressedthese issues while still driven by the ‘carrot’ approach. Thethreat of the ‘stick’ and the associated additional costs of thiswill deter some and reduce the appetite of others to spendwhat is being sought.

In simple terms, good ESG management may not enable aprivate equity firm to achieve significantly more value on exit,but it should be a powerful tool to avoid price erosion throughthe deal process.

What methods are appropriate to measure these benefits?

The key point raised in this chapter is that it is very difficult togeneralise many of these issues, but when specific examplesare encountered, by sector, by business and by issue, there isusually a clear link that demonstrates the relevance of aparticular ESG topic.

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Returning to private equity, ESG encompasses many issuesand opportunities. To quantify all of the risks and opportunitiesin the short time frame allowed by most due diligenceprocesses is simply not possible. The key is to identify themost important issues and those with the shortest deliverytime or largest relative impact. Identifying these will not alwaysbe easy, though experience will often enable the quick wins tobe observed more readily. Financial key performance indicator(KPI) analysis will be invaluable, particularly for environmentalissues such as recycling and energy usage. However,qualitative analysis also helps to drive out the critical issues,such as considering the one thing that could ideally be done toimprove the business.

During the holding period of an investment, the private equityfirm will want to monitor the effectiveness of governanceprocesses and the emergence and management ofenvironmental and social issues. Issues that are highlightedduring due diligence and the actions to address those issuesshould form part of the 100-day transformation plan followingacquisition and the ongoing monitoring of the portfolio.However, for all issues, it is vital to first decide whether it isrelevant and then, importantly, exactly how it is relevant – withrelevance defined with reference to business performance.

Comparability is key to the successful assessment of anybusiness initiative. What would have been the result had therebeen no change at all (the placebo effect) and what couldhave been the change had certain aspects been performeddifferently in terms of timing or input?

Financial KPIs provide the first and most common method inthis process. As noted above, those that link to marginimprovement, improved cash flow and increased sales are allvital; however, it is important to analyse whether thoseincreases would also have occurred without the initiative. It isalso important to consider financial KPIs from an external

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perspective, both from a microeconomic and macroeconomicview. A business that has enabled growth of x percent throughimproved ESG practices may not appear as positive whencomparing with a general sector increase of x+y percent orgeneral economic growth of x+z percent.

Non-financial aspects are equally important. A business thatgrows financially at the cost of employee satisfaction is alwayslikely to stall or decline at some point in the future when thelevels of dissatisfaction result in greater staff turnover, lessbusiness buy-in and therefore less productivity. This isparticularly true during times of recession when cost-cuttingmay be able to maintain the underlying profitability of abusiness but at the risk of preventing it from growingsuccessfully when economic growth returns.

A business must therefore consider all of the above issuesbefore it is truly able to quantify a successful initiative.

Conclusion

In summary, there are a number of key techniques, which, ifaddressed, should ensure a successful cost-benefit analysis.The processes listed below will enable private equitypractitioners to differentiate between those initiatives that areworth pursuing and those that are not:

• Know what you are responsible for (including what you thinkyou have a moral obligation to be responsible for) . This willensure that regulatory and legal issues are appropriatelyconsidered and, therefore, unforeseen costs today and in thefuture can be controlled and reduced.

• Implement objectives and processes to ensure that you canfulfil your responsibilities . To ensure that internal and externalstakeholders are working for the greater good of the business,the right strategy needs to be in place that can adapt tochanges in their needs and the businesses responsibilities.

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• Incorporate any necessary changes into your routineinvestment and project appraisal . Many of the examplesaddressed earlier in the chapter would not have beenconsidered relevant, if considered at all, five to ten years ago.Building in an understanding of the cost of not investingresponsibly, quantifying the impact of environmental factorsinto the investment and understanding the regulatory horizonare all vital to ensure that risk is quantified and value derivedfrom an investment.

• Set key performance indicators and measure against them .This needs appropriate clarification of who should be in thecomparator population and how reliable the data from thatpopulation is. For most private equity-owned businesses, thisshould not look to other private equity businesses only, butshould also address the sector as a whole and thereforeconsider both listed and other forms of private ownership.

Vincent Neate is an accountant and auditor by background,and has extensive experience working with clients across thespectrum of managing opportunities and risks in off-marketinvestment businesses. He was a founding member of KPMGLLP’s multi-disciplinary Private Equity Group in London and inearly 2010 moved roles to take on the leadership of the KPMGUK Sustainability Practice. That practice combines businessexperience combined with specialist knowledge in areas suchas climate change and carbon trading, non-financial dataassurance, corporate responsibility and governance.

Vincent has advised private equity management teams on abroad range of areas including structuring fund andmanagement companies, corporate governance and portfoliorisk management, improving business processes andtechnology. He is chairman of the Professional StandardsCommittee of EVCA and has served on the Legal andTechnical Committee of the BVCA. He is chairman of EVCA’sESG Task Force.

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Jonathan Martin is a member of KPMG LLP’s Private EquityGroup and his career has spanned 14 years at KPMG acrossa wide spectrum of audit and advisory roles. He has worked inboth the corporate and middle-market sectors auditing largeglobal industrial and food and drink clients as well as small UKlisted and private equity-backed businesses. Jonathan hasadvised clients on a broad range of issues and topics fromSarbanes-Oxley implementation and IFRS conversion to ESGinitiatives and private equity regulatory issues.

Jonathan has spent two years on secondment outside ofKPMG working on governance and accounting issues at aFTSE 100 company and running the private equity team at theUK’s largest business lobbying organisation, which includeddirect lobbying of EU and UK political groups as part of theAIFM directive process. Jonathan is also an associatemember of the Professional Standards Committee of EVCA.

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Chapter nine

Setting working-capital targets

By Nick Alvarez, Anthony Dios, Tim Keneally, MichaelMcKenna and Krista Servidio, Alvarez & Marsal

Introduction

Many acquisitions fail to realise their value, in part becausethey fail to achieve their working-capital targets. Workingcapital is one of the least straightforward areas of duediligence and valuation. Issues can exist across all types ofbusinesses, regardless of degree of profitability or industry. Itis very volatile, often exhibiting seasonal and cyclical trendswhich need to be considered when establishing appropriatetargets.

Working capital is often a point of contention after a deal hasclosed. However, it can also be a point of opportunity. Due tounforeseen volatility, or a failure to achieve or maintaintargets, working-capital requirements can lead to bothincreased leverage and finance costs and the need torestructure the company’s balance sheet. On the other hand,acquirers are often able to remove cash by reducingworking-capital needs in a poorly managed business.Businesses with the lowest ‘cash to cash’ or absoluteworking-capital requirements tend to grow with greater capitalefficiency than businesses that require more cash to fundequivalent growth.

When setting working-capital targets for a business, the mostimportant consideration is the quality of the working capital,including an understanding of its accounting treatments andtax implications. Private equity executives conducting duediligence, whether deal professionals or operating partners,should also consider external factors to the business, such asthe macroeconomic environment, the strength of competition,

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and the health of customers and vendors. Lastly, opportunitiesto improve working capital post-close by optimising theprocure-to-pay and order-to-cash processes should beassessed.

Once all these factors have been evaluated, the time comes toestablish baseline working-capital requirements, as well asshort-term and long-term targets for the target business.

This chapter will discuss strategies to conduct due diligenceon working capital and to set working-capital targets for abusiness. Working capital can unlock value, increase liquidity,improve performance and enable companies to better manageuncertainty. Conversely, poorly managed working capital caninhibit informed, tactical and strategic decision-making, limitthe ability to weather unforeseen events and increase the riskof a dire liquidity crisis.

Quality of working capital

The quality of working capital can be summarised as:

• Probability that accounts receivable will be converted intocash.

• Salability of inventory, particularly inventory beyond a certainage or at a late stage in the product life cycle.

• Ability to control the timing of cash conversions and accountspayable disbursements.

Converting accounts receivable to cash

There are a number of factors to consider when evaluatingwhether accounts receivable balances can be converted intocash in the near future.

The first factor is accounts receivable aging. Well-runbusinesses can collect their receivables at or near their statedcollection terms with little delinquency. Significant

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delinquency, however, can be an indication of poor billing andcollection practices, which make it difficult to convert to cash.Alternatively, delinquency may indicate a more serious issuewith overbilling that will never be collected. In addition to theoverall age and delinquency rate, the aging should bereviewed for unusually high balances in the aged buckets,which may indicate dispute payments. The last review looks atunmatched credits or indications that cash is applied to theoldest invoices rather than to the appropriate invoice. Again,this can indicate an attempt to cover up uncollectible agedbalances. Additionally, the time period between the shipmentand the production of an invoice should not be taken forgranted. Artificial delays or distortion in the aging profile mayoccur if delays exist between shipment and invoice. This typeof issue, if it exists, is a good opportunity to rapidly reduceworking-capital needs.

The second factor to consider is the trend in bad debtexpense. While private equity firms typically are concernedwith a company’s high rate of bad debt expense, a rate that istoo low can indicate an insufficient level of reserves. Toproperly evaluate bad debt expense levels and reservesufficiency, the overall trend must be considered and, wherepossible, compared to industry-relevant loss benchmarks.

The third factor to consider is the overall trend in days salesoutstanding (DSO). A large decrease in DSO could signal thatshort-term deals have been made to accelerate cashpayments; these deals may not be sustainable. Similarly,consider the deferred revenue balance and whether therehave been any recent material changes in that balance. Onthe other hand, a large recent increase in DSO may indicateoverbilling or overly aggressive revenue recognition.

The last factors to consider are seasonality and cyclicality.Many retailers, distributors and even seasonal servicebusinesses and distributors suffer from large swings in all

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working-capital areas. These cycles must be understood andconsidered when setting working-capital targets. Further, theremay be intra-month business cycles that cause accountsreceivable or other working-capital needs to spike during themiddle of the month, before settling into a month-end level.When determining the total amount of working capital to befinanced, this peak intra-month level must be used, not justthe lower month-end balance.

Finally, there is a note of caution. Do not be overly optimisticregarding the company’s ability to accelerate cash, at least inthe short term. If it were easy, the company would have doneso. It usually requires changes to billing processes andsystems, changes to customer terms and changes in customerbehaviour. All of these can take time.

Salability of inventory

One of the most critical factors when determining whether ornot inventory will be converted into cash is the relative agingof the inventory on hand. It is crucial to efficiently evaluate theaging variations of products to ensure that a company is onlypaying for the inventory that it truly needs, rather than what itmay have needed in the past.

An analysis of aging can be done in three steps, starting witha look at the financial inventory reserve compared to theexcess and obsolete inventory. It is important keep in mindhow those figures were reached, as well as the true need ofthe business. What are the actual inventory write-offs and howdo they compare to the reserve the company requires?

The second step in this evaluation considers the life cyclesand the transitions driving certain products. It is essential toassess the aging of the inventory based on forward-lookingcustomer demand. Some companies may make estimatesbased on inventory figures that have historical but no futuredemand; these estimates should be ignored in the inventory

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financial reserve process. Previous product records do notprovide a consistent indication of future demand becauseproduct-level forecasts are only valid for six to 12 months dueto seasonality and business cycles.

The final step in the aging determination process is tounderstand how product transitions are handled withcustomers. Companies try to mitigate and limit the amount ofexcess and obsolete inventory as they work through producttransitions driven by engineering changes, model-yearchanges or complete product platform upgrades. Changes inforecasted product-transition timing, as well as the need forfuture projections of estimated daily intake (EDI) and sourcesof demand, can prove problematic in this process. A good wayto prevent such hiccups is to look at historical write-offs relatedto product transitions, and to see what has changed in theseareas to justify an improvement.

Other areas which must be analysed to determine the correctlevel of inventory is lead-time, customer forecast volatility andsupplier delivery volatility. These relationships are describedthrough many eloquent inventory models including thenewsvendor or G/G/N models; varying degrees ofsophistication can be applied to determining the right level ofinventory. A useful and higher level analysis can be conductedby reviewing procurement and manufacturing lead times, aswell as transit requirements. Once lead times are reviewed, itis then important to recognise both the demand and supplyvariability to develop an inventory strategy at the componentand finished goods level.

The accuracy of the inventory is equally as important as theaging of the inventory. In order to assess this accuracy,analyse several important data points related to thecompany’s recent physical inventories and the way in whichthey were completed.

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Start by evaluating the results of the most recent physicalinventory checks as well as the last 12 months of cyclecounts. It is essential to not only look at the net inventoryadjustment as a result of the physical count, but also theabsolute variance, which is a leading indicator of processcontrol.

Next, view the calendar of cycle counts to ensure there is aprocess in place to count all product categories within a givencalendar year. An auditor’s results of individual cycle counts ora sampling of the previously counted inventory locations canhelp to assess the accuracy of the calendar counts. Often,analysis of cycle count procedures and the training requiredby various locations are good indicators of the accuracy of thephysical/cycle counts.

Lastly, another source of significant inventory issues is the linkto production reporting and inventory relief, either through theissuance of material for work orders or the relief of materialwhen production is complete. Inaccurate production reportingis more difficult to detect, but can be spotted by assessing themetrics and controls the company/facility has in place in orderto ensure accurate production reporting.

Ability to control timing of cash conversions andaccounts payable disbursements

It is not sufficient to know that the accounts receivable andinventory balances will eventually be converted to cash – it isjust as important to know whether the timing of this conversioncan be controlled should it be demanded by the situation.Questions to answer when making this evaluation include:

• Are customers amenable to paying more quickly if cashdiscounts are offered? Has the company done this in thepast? (There is a risk is that customers take the discount andcontinue paying on standard terms.)

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• Are there alternate markets for inventory liquidation, other thanthe company’s primary channels, that can be used for quickconversion? What degree of discount will be required?

• Can accounts payable be extended? How strong are thecompany’s relationships with suppliers? Has the companyever temporarily stretched its accounts payable, or discussedthis with vendors? What was the result? How close is thecompany to being placed on credit hold by suppliers? What dosupplier cash positions look like? Has the companymaintained a consistent accounts payable level, in line withtargets?

• How volatile are accounts payable and accounts receivablebalances on a day-to-day, week-to-week and month-to-monthlevel?

It is not unheard of that a company’s working capital needs togrow by 50 percent or more during the month, only to return to‘normal’ levels at month-end or quarter-end. Since peak levelsmust be funded, the ability to minimise these peaks is animportant aspect in estimating working-capital needs. Manyprivate equity firms fall into the trap of looking at a potentialacquisition’s month-end or quarter-end balances and ignoringmid-cycle peak requirements. This often comes as a rudesurprise after the transaction is completed.

Tax considerations

In evaluating the quality of the working capital of multinationalcompanies, it is important to consider the extent to which anycash located at the foreign subsidiary level is ‘trapped’ in theapplicable foreign jurisdiction. Trapped cash refers to cashthat cannot be accessed without incurring potentiallysignificant foreign and/or domestic tax costs. In the US, thiswill typically occur because, subject to certain limitations, theforeign-source income of a foreign subsidiary of a UScorporation is not subject to US tax until it is actually brought

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back to the US. If the income was taxed in the foreignjurisdiction at a lower rate than the applicable US corporatetax rate, additional US income taxes may be due onrepatriation of those funds. Additionally, many foreignjurisdictions impose withholding taxes on the distribution;these may not be currently creditable in the US because offoreign tax credit limitations.

If such cash located in foreign jurisdictions is a factor invaluing working capital, or such cash is being considered as apotential source of funds to be used in the acquisition, it isimportant to consult with tax advisors to assess and quantifythe tax costs associated with repatriating such cash. Anyvaluation of working capital should be adjusted to reflect suchtax-repatriation costs.

In such situations, consideration should also be given to anypotential modifications to the acquisition structure that canmitigate such tax-repatriation costs. For example, it may bepossible to move some of the acquisition debt to the foreignsubsidiaries and access the cash held by the foreignsubsidiaries as interest and principal repayments. Doing socould result in lower overall tax costs than in the case of adividend distribution.

Additionally, there are several tax-planning techniques thatcan be utilised post-close to repatriate the pre-tax earnings offoreign subsidiaries. These techniques include interest onintercompany loans, royalties for the use of intangibleproperty, cost sharing for research and development,management and other intercompany service fees, andtransfer pricing of intercompany inventory sales.

The tax-related items that typically affect working-capitalvaluations and purchase price adjustments in acquisitions are:

• Current taxes payable/accrued tax refunds.

• Transaction tax benefits.

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• Net operating losses.

• Phantom income.

Current taxes payable/accrued tax refunds

Working capital should only include current taxes payable andreceivables such as refunds. Current taxes payable should notinclude any deferred tax items. In addition, the value of thecurrent taxes payable and accrued tax refunds should beverified. Both of these can be achieved by performing tax duediligence.

Transaction tax benefits

Sellers often negotiate to obtain the economic benefit (via aworking-capital adjustment) of the tax deductions available tothe target company for the target’s transaction costs (forexample, compensation deductions for bonus and stock optioncash-outs, investment banking success fees, and advisorfees) that are currently deductible (as opposed to beingcapitalised) under current law.

In general, transaction costs are either deductible orcapitalisable for tax purposes. The tax treatment of transactioncosts is a factually intense issue and certain documentationmust be obtained to support the tax treatment. As such, atransaction cost analysis should be undertaken to confirm thatany transaction tax working-capital adjustment is properlyvalued.

Net operating losses

Sellers may try to negotiate the economic benefit of thetarget’s pre-closing net operating losses (NOL) that will beavailable post-close to shelter the target’s post-close income.In such situations, the ability to use the NOLs and their valueshould be considered.

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Under complex tax rules (for example, US Internal RevenueCode Section 382), the use of NOLs may be limitedpost-close. As such, tax advisors should be consulted todetermine the impact of any limitations on the post-closingutilisation of such NOLs.

Furthermore, financial modelling of the post-close operationsthat is reflective of transaction leverage should also bereviewed to determine expected taxable income in futurepost-close periods. If tax losses (after interest deductions) areexpected in future tax periods, the value of the NOLs shouldbe appropriately discounted.

Phantom income

Phantom income occurs when there is taxable income with nocorresponding cash. This could occur from the tax change ofaccounting-method adjustments (for example, cash-to-accrualaccounting adjustment required by the transaction or a priortarget accounting method change that results in post-closephantom income). Tax due diligence should be performed toidentify and quantify the tax cost associated with such itemsso that they can be properly reflected in the working-capitalvaluation.

External factors

Once the quality of the target company’s working capital hasbeen assessed, its current and future working-capital needsmust be viewed within the context of external factors that canexert pressure on balance sheet requirements. These externalfactors include:

• Macroeconomic trends.

• Interest rates and customer and supplier cash positions.

• Industry dynamics.

Macroeconomic trends

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Conventional wisdom says that a rising economy is good anda declining economy is bad. While this is generally true forrevenue and perhaps even margins, it is not alwaysstraightforward for working capital. Economic growth canprovide an opportunity to positively impact working capital,although the impact is not automatic. A rising economy mayenable a business to lower its DSO, but it may also requireinvestments in inventory or the total accounts receivablebalance in advance of cash coming in the door. Many a‘profitable’ company has failed due to liquidity problemsresulting from too-rapid growth. However, it is rare that aslowing economy will ever have a positive impact onworking-capital requirements. A declining economy will oftennegatively impact many aspects of working capital.

Interest rates and customer and supplier cash positions

While the economy may influence the revenue trends of acompany, it will also impact the ability or willingness ofcustomers to pay in a timely manner as well as the ability ofsuppliers to demand payment. Changes in interest rates andborrowing costs, and changes in relative cash positions forvendors and customers, will also impact vendor and customerbehaviour. When developing working-capital targets, theexpected and potential for unexpected changes in customerand vendor cash positions must be considered.

Industry dynamics

A company’s competitive position relative to other companiesin the industry can impact its working-capital needs. Strongercompanies have the ability to place greater demands onsuppliers to accept longer terms and to assist in driving downinventory balances. Likewise, stronger businesses may havemore leverage with their customers, and be able to realiseshorter collection terms or have tighter credit requirements.Conversely, weaker businesses have less leverage and may

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need to concede on payment terms, or have less leverage incustomer and vendor negotiations.

Post-close improvements

The baseline current working-capital balance is a starting pointin estimating future targets, but the ability to make operationalimprovements can materially change a company’s futureworking-capital needs. Both the magnitude of change that canbe realised and the time and effort (cost) needed to achievethe change must be forecast. Changes in accounts payablecan be made quickly, but are difficult to sustain. Inventory andaccounts receivable reductions can be sustained in the longterm but often require more time or effort to realise.

Inventory improvements

When assessing areas of improvement regarding inventoryplanning, a recommended place to start is to adjust thecompany’s sales and operations planning (S&OP) process sothat it includes frequency, participation, inputs and outputs.Additionally, it is critical to evaluate how the outputs fromS&OP meetings drive the demand signal, which will ultimatelydrive the material components and production schedulingassociated with supply planning. If the supply-planning groupis not using the latest and most accurate demand signal, thenthere is potential to buy/make the leftover products not neededto support future demand. This demand and supply planningshould be approved by the finance team to ensure it supportsthe business plan and the working-capital requirements. Anyovertime labour and expedited freight should also bediscussed and handled appropriately.

Once all functional groups agree on the demand forecast, it isimportant to understand how the demand signal is loaded intothe material requirements system. Most companies have bothEDI customers and non-EDI customers, but that does not

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change the fact that all demand will drive material componentsupply requirements.

After ensuring that the company is working towards a demandforecast agreed on by both supplier and customer, it is thenessential to measure the forecast’s accuracy at variouscomponent levels and time fences to ensure proper inventoryplanning (see Figure 9.1). The variability of the forecast duringthe product’s lead time is one component that drives thecompany’s inventory management strategy. Therefore, itneeds to be evaluated by various component levels becausethe accuracy can vary by the level driving the differentstrategies on component availability.

Figure 9.1: Cash/working cash operating cycle

Source: Alvarez & Marsal.

While reviewing the performance of overall inventory planning,it is important to take note of the targeted versus actualinventory turns by inventory classification and productcategory. The inventory-turn targets should be collectivelyestablished with the sales team to ensure that metrics take

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into account the committed service levels. The strategy fortrade-offs of turns and service levels should take into accountbatch sizes, and differentiation should be made between highvolume and low volume stock-keeping units (SKU). It is also toimportant to assess the last time minimum order quantitieswere negotiated with critical suppliers, because this will alsodrive goal-setting for inventory turns. By separating the highvolume and the low volume, companies can deploy strategiesthat support both business models but do not raise theinventory requirements to support the required service levels.

Accounts receivable improvement

The best way to achieve a sustainable decrease in accountsreceivable is to increase the speed of the billing process.Many companies issue invoices days, or even weeks, aftergoods or services are provided. In some cases, this is due tothe need to compile supporting documentation. In most cases,however, this is due to a lack of process focus and discipline,which lead to delays or errors requiring reworking. Often,system changes are required to support cycle time and errorrate reductions, but occasionally simple process improvementis sufficient. This is the best way to reduce accountsreceivable since it is both transparent to customers and canbe maintained.

Other options to strengthen the collections function includeprocess improvement, automated tools or financial incentivesto collections staff. Linking sales force compensation tocollections rather than to booked sales is another effectiveDSO reduction technique.

Conclusion

In this chapter, the authors discussed strategies for improvingthe evaluation of working capital at the due diligence stageand setting realistic working-capital targets. The areas of focus

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for this chapter have been accounts receivable, accountspayable, inventory and tax considerations.

The main focus areas of accounts receivable are aging, baddebt expense trends, DSO trends, and evaluating the impactof seasonality and cyclicality on the ability to convert accountsreceivables to cash. When evaluating the salability ofinventory, the main focus areas are aging, appropriateinventory levels and accuracy of the inventory. Whenevaluating the controlling of accounts payable disbursements,it is critical to understand the relationships the company haswith its vendors and vendors’ past reactions to extendingpayment terms with the supply base, as well as theseasonality and cyclicality of the peak business demandsdriving the disbursements required. When evaluating thequality of the working capital of multinational companies, it isimportant to consider the extent to which any cash located atthe foreign subsidiary level is ‘trapped’ and cannot beaccessed without potentially incurring significant foreign and/or domestic tax costs. Other items to consider whenevaluating the quality of the working capital include currenttaxes payable/accrued tax refunds, transaction tax benefits,net operating losses and phantom income. External factors tothe business should also be considered, such as themacroeconomic environment, strength of competition, andhealth of customers and vendors.

Once all of these areas are assessed, the next question to beanswered is: what is the right baseline to set forworking-capital requirements? Once the baseline is set, it isimportant to analyse industry benchmarks to set the short-termand long-term target working-capital needs to support thebusiness. When industry benchmarks are not available, it isacceptable to find similar industries or customer/vendorconcentrations to understand industry averages as well asbest-in-class performers. The authors have outlined some

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specific areas of focus to improve the timing of cashconversion that can be applied to various industries.

In closing, working capital is often a point of contention, but itcan also be a point of opportunity. It is important to evaluateall areas to establish the company’s baseline working-capitalrequirements, and the short-term and long-term targets for thetarget business.

Nick Alvarez is a managing director and national practiceleader for the Alvarez & Marsal Private Equity PerformanceImprovement Group in New York. With 15 years of corporateadvisory, operational improvement and interim managementexperience, Nick focuses on assisting private equity sponsorswith due diligence, post-acquisition performance improvementand portfolio management. Nick brings deep expertise inassessing financial statements, business plans,working-capital requirements, cash flow forecasting,capital-expenditure requirements, operational andorganisational reviews – including SG&A reduction plans,valuation and capital structure, as well as in developing andimplementing first 100-day plans, carve-outs and mergerintegrations.

Anthony Dios is a senior director with Alvarez & MarsalTaxand, LLC in New York. He focuses on advising financialand strategic buyers and sellers on tax aspects of mergersand acquisitions, including reorganisations, spin-offs,financings, repatriations and bankruptcies. Anthony, who hasover 23 years of tax experience, has advised clients ondomestic and cross-border transactions across a wide rangeof industries, including healthcare, media and entertainment,pharmaceutical, retail, consumer and industrial products.

Tim Keneally is a senior director with Alvarez & Marsal’sPrivate Equity Performance Improvement Group in Chicago.

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He specialises in interim management, operationalimprovement and supply chain management in a variety ofindustries including manufacturing, textiles, paper andpackaging, retail and consumer products, and automotivesegments. With over 15 years of consulting and industryexperience, Tim brings significant expertise in leadingcross-functional initiatives focused on delivering corporateobjectives and bottom line results in supply chainmanagement, supplier relationship management and leanmanufacturing process areas. His experience includes interimCOO, GM & VP of operations, developing lean manufacturingoperating models, demand and supply planning, collaborativesupply chain strategies, outsourcing strategy development,component material lead time reductions, inventoryoptimisation, manufacturing efficiency improvement, freightoptimisation and the selection and implementation ofsupporting ERP and supply chain IT systems.

Michael McKenna is a senior director in Alvarez & Marsal’sPrivate Equity Performance Improvement Group in New York.He works with senior finance and business executives toimprove performance of both healthy and distressedcompanies, in particular those going through anenterprise-wide challenge such as a merger, divestiture,restructuring or other large-scale change. His areas ofexpertise include implementation and remediation of ERPsystems, design and implementation of outsourced financeand shared services organisations, improvements to coststructures and working-capital management. Michael hasmore than 20 years of consulting experience.

Krista Servidio is a director with Alvarez & Marsal Taxand,LLC in New York. She focuses on advising financial andstrategic buyers on tax aspects of mergers and acquisitions,including reorganisations, spin-offs, financings, repatriationsand bankruptcies. Krista previously worked with the CaliforniaDepartment of Corporations, where she assisted in bringing

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administrative law cases against securities law violators. Shehas also worked for a corporate bankruptcy firm, where sheanalysed and prepared documents for commercial bankruptcylitigation.

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Section II:

Post-acquisition implications of the due diligenceprocess

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Chapter ten

Getting off to the right start: the first 100 dayspost-acquisition

By Andrew Mullin, Alex Panas and Kevin Sachs,McKinsey & Company

Introduction

No discussion of due diligence in private equity would becomplete without addressing the importance of a privateequity firm’s plan for the first 100 days after acquiring a newportfolio company. Implementing the changes envisioned inthe investment case that justifies a given deal will certainlycontinue well beyond this period. However, with the rightplanning in advance of the deal close, the active participationof the private equity owners and their early actions can makethe difference between modest returns and significantoutperformance.

Past McKinsey research shows that the private equity firmsthat invest significant time on their portfolio companies in thefirst 100 days of ownership are more likely to deliver highreturns. In addition, the impact of spending time with theportfolio company during this period is disproportionatelyimportant1. McKinsey research also shows that investmentsare unlikely to meet their overall goals if savings andimprovement targets are not met within the first two years;given the lead time of some initiatives, a new owner must fromthe start undertake a planning and execution effort thatenables the portfolio company to pursue the right objectives.That pace is important for private equity funds, which typicallyplan to hold their investments for only around five years. Theportfolio company will need to achieve its performance targetsquickly in order to demonstrate at least a couple of years ofimprovement when the sale process begins in year five.

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In the authors’ experience, private equity owners should focustheir time in the first 100 days on creating the conditions at theportfolio company to support the changes envisioned by thebusiness plan. That includes five elements:

1. Putting in place the right management team.

2. Overhauling the business plan.

3. Communicating priorities throughout the company.

4. Aligning incentives with priorities.

5. Establishing a process to track progress and to react to gaps.

This chapter discusses each of these elements in greaterdetail.

Putting in place the right management team

Getting the right management team in place at a portfoliocompany is one key to value creation; even the best-laid plansneed skilled managers to execute them. Without the rightmanagement team, the deal will be unlikely to succeed andwill consume a disproportionate amount of the private equityowners’ time – but without the desired impact, since they cannever fully compensate for the lack of strong, full-timeleadership.

If there are human resource challenges in implementing thechosen strategy, then the new owners must address thosechallenges early. The best owners often seek to have thepermanent management team lined up before a deal iscompleted – and many will have developed opinions duringthe acquisition process on individual members of themanagement team and their performance. Otherwise, they willneed quickly to evaluate both the skill sets and leadershipstyles of individual members of the management team, as wellas their performance record and their ability to execute the keyelements of the new owners’ plan. In our observation of

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top-performing deals, about as many new owners change themakeup of the top-management team as those that do not.While intuitively it might seem that they would be more likely toreplace the management team for some types of deals thanothers – for deals justified by cost improvements, for example,more so than for those justified by strategic plans – we havefound no obvious pattern of this.

From a skill-set perspective, most private equity owners placesignificant value on industry expertise and a demonstratedtrack record of performance against challenging targets. Thisis because the pressures of leverage often create little time forlearning and limited room for mistakes. For the same reason,they look for deep functional expertise in the key areas,particularly those in which they expect significantly improvedperformance and in which they believe the company has theopportunity to learn from other industries. The mix of skills andexperiences should be aligned with the strategic plan for thecompany – for example, a focus on operating skills when thefocus is margin improvement and a focus on deal skills whereinorganic/M&A growth is key to success. Regardingleadership, new owners should have a perspective on the typeof culture that is required to be successful, whether it is onethat the team in place has already created (or can create) or ifthe experience of outsiders is required to drive the requiredchanges.

The assessment of managers from a cultural perspectivedepends largely on the type of culture the new owners believewill best suit both their performance expectations and theportfolio company. The right type of culture will vary bycompany, both based on its strategy and its history2.Therefore, deal partners will need to assess whether thelegacy management team and the organisational culture arecompatible with the culture they envision for the companygoing forward. This can be done through informal interviewsand observations, with the assistance of executive recruiters/

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executive assessment firms or more formally through surveyslike the Organisational Health Index (see Figure 10.1). TheOrganisational Health Index uses employee input to assessthe internal alignment between vision and strategy, the qualityof execution and the organisation’s capacity for renewal. Byunderstanding the gaps between the current and targetculture, the new owners can quickly develop a point of viewboth on the types of changes necessary, including the types ofexecutives that would be best suited for the organisation, aswell as the kinds of cultural interventions that would enhanceits ability to meet strategic goals.

One investment we observed in the pharmaceutical industryillustrates the interplay between leadership and culture – andthe imperative to make changes early. Three years aftermaking an acquisition, the private equity deal partnersrecognised that the portfolio company was no longer makingthe kind of progress needed to meet performance targets andwas at risk of falling behind in a rapidly evolving sector. Toturn things around quickly, they brought in a new CEO whohad both a proven track record and deep expertise in theindustry.

The new CEO realised that for the company to be successful,it needed to simultaneously transform both its performance(through an aggressive cost-improvement programme and aset of sales initiatives to improve its pricing discipline andcustomer targeting) and its cultural ‘health’ (because theculture of the organisation was inconsistent with the type ofculture he believed was necessary for the company’ssuccess). The CEO also recognised that retaining theexpertise in the company’s core functions – operations, salesand research and development – was critical. Therefore, hefocused on bringing in a new CFO and a head of humanresources to help him implement necessary cultural changes.Work began with the management team, and then this groupwas pushed to address culture throughout their organisation.

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Figure 10.1: Nine vital aspects that contribute to organisationalhealth

Source: McKinsey & Company.

Since making these changes, the company has dramaticallyimproved its performance, both in achieved financial resultsand in retaining high-performing individuals across thecompany. However, the deal partners fully acknowledge thatthey should have acted sooner to recognise the deficiencies inthe original management team. The delay cost them manytalented managers and also forced them into a longer holdingperiod, thus reducing their anticipated returns.

Overhauling the business plan

In most cases, by the time ownership transfers, new owners inthe highest-performing transactions have a clear point of viewon what should be the portfolio company’s strategy andmanagement plan. This often requires the owners to challengethe management team’s assumptions about performance, tooverhaul the existing plan and to ensure that managementbuys into both the financial expectations underlying the dealand the associated performance targets. Particularly in highlyleveraged situations, owners and management require clarityon what the company needs to do to meets its targets,

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especially the level of cash flow it needs to generate and howthat cash flow should be invested. That often meanscomparing managers’ sense of customer perceptions withwhat the diligence revealed or testing how well the company’sgo-to-market and operational capabilities support its strategy.

Achieving these targets typically requires a set of changes inhow the business is run. Some will be fairly obvious, such aseliminating public company reporting costs (if no longerrequired) or launching a procurement programme. Others,such as designing a new pricing strategy or pruning a productline, will require greater planning or investment. For theobvious changes, acting quickly also requires understandingwhy similar action had not previously been implemented andtherefore what needs to change. For example, are the metricsand targets clear and appropriate? Are there constraints thatrestrict change or problems with the approach taken? Werethe right people involved, and did they have the right skills?

The larger or more difficult changes typically require moredetailed business planning. This involves completing anyanalysis required to confirm projected revenue or cost-savingestimates; aligning the new owners and managers on theproposed changes or targets; and then designing detailedimplementation plans, including the actions, owners, metrics,milestones, investments and resources required. Whenpossible, the individuals responsible for implementation shouldbe involved in developing detailed plans; this will increasetheir ownership and engagement. Critical to the success ofsuch an effort is an honest appraisal of what the company iscapable of executing in parallel by itself, as opposed toexecuting the changes one at a time or drawing on outsidesupport. The management team will have informedperspectives on what is and what is not achievable and canoffer valuable input, though the new owners may need tobalance them out with their own experience and in view of thefinancial requirements of the deal.

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Typically, this business planning is a joint exercise betweenthe managers and the new private equity owners that shouldbe conducted as early and as quickly as possible. In onesuccessful example we observed, an investor that acquired amedical-device company that was carved out of a larger entityused the pre-close period to gain broad alignment with themanagement team on the key elements of the original dealthesis and on some additional upside areas to explore. Gettingsuch an early start allowed the managers to launchdevelopment teams immediately after close for each of theidentified opportunities. Team leaders – who would also beresponsible for implementation – first developed bottom-uptargets and initiative-level implementation plans. The newowners then used their own expertise and that of third partiesto challenge the initiative leaders’ draft targets and plans andto iterate further drafts. Together, they identified objectivesthat would challenge managers to excel without overstretchingthem, balanced near-term opportunities with longer-term ones,ensured that key initiatives had the right level of resources andfocused the initiatives on the most important sources of valuefor the business and the deal.

In this example, for the highest-priority initiatives, managersand new owners jointly developed a detailed 100-day plan,which included performance targets by profit and loss orcost-centre owners and specific metrics to measure progress.In addition, they put in place a governance infrastructure tokeep the initiatives on track. As a result, the companyexceeded its short- and medium-term cost-savings plans andquickly shifted its focus to the organic and M&A growth effortsthat would be essential to the deal’s longer-term success.

Communicating priorities throughout the company

Changes in ownership inherently foster a high degree ofuncertainty, so the importance of communicating to promoteunderstanding and buy-in can scarcely be overstated. It

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requires a disciplined effort to clarify both what will stay thesame (eliminating unnecessary anxiety) and what will change(creating momentum and alignment around changes inpriorities and objectives). Failure to do so can undermine thebest of efforts in each of the other four areas, and yet too oftenit gets insufficient attention. In one struggling private equitydeal we observed, all of the other elements were in place, butthe lack of communication with the broader organisationfostered a sense of uncertainty that led many important middlemanagers, most notably in finance and operations, to leave.Their departure created new supply chain and cashmanagement issues that offset the successes of the otherimprovement efforts.

The most successful communication efforts we have seen areones that companies execute as carefully planned campaignsrolled out consistently at all levels of the organisation. Fromtop management to the front line, company personnel mustunderstand what is changing, why it is changing and what itmeans to them. This requires managers to tailor theirmessages for each audience and reinforce them frequently.The more detailed and specific the plan, the greater chancethat the most important elements will be communicatedconsistently – and therefore the more likely they are to besuccessfully executed.

At these companies, the CEO and key members of themanagement team each play roles in communicating thestory, with messages coordinated to demonstrate that they allagree yet tailored to show the personal commitment of eachindividual. The campaign then extends the communicationthrough various levels of the organisation (see Figure 10.2),ensuring that individuals hear key messages both from theirown manager and from senior leadership.

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Figure 10.2: The private equity change story should cascadethrough the new portfolio company

Source: McKinsey & Company.

Managers of the strongest campaigns reinforce theircommunications with visible changes, such as eliminatingproducts or initiatives that are no longer priorities andcelebrating quick wins, such as price reductions captured aspart of a procurement effort or promotions of recognisedhigh-potential managers. These efforts signal that theorganisation is serious about its priorities and is alreadymaking progress. Such reinforcements are especiallyimportant where employees are sceptical of or are resistant tothe changes required.

Aligning incentives with priorities

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Creating an incentive structure that aligns performance withthe management team’s new priorities is imperative for anysuccessful deal. We see very few deals that fail to take stepsin this regard. The two primary sources of variation weobserve among deals are how much ‘skin in the game’ seniormanagers have and the extent to which the incentive structureextends beyond them.

In addressing the former, most private equity ownersrecognise and accept that managers are more likely to bealigned with, and focused on, changing priorities when theyshare both the risk of failure and the potential rewards ofsuccess. For private equity deals, this means thatmanagement should both have significant upside potential ifthe deal is successful and have a significant portion of theirown net worth invested in the deal to ensure downside risk.Skin in the game should not only consist of stock options, butalso should include the cash management actually pays tobuy into the deal, foregone salary or guaranteed bonuses.(Investors are wary of deals in which key executives primarilyhave only upside.)

The size of the management team’s investment is driven bypractical constraints regarding its ability to invest, therelationship between the new owners and management whenthe deal is being structured, and the need to attract newexecutives to the leadership team (who may not be willing tomake substantial investments in the deal). While each of thesefactors can be real constraints, the new owners should persist;management’s personal stakes in the deal’s success willgreatly improve their effectiveness and collaboration with dealpartners when they encounter inevitable challenges. Toaddress some of the more practical constraints, private equityfirms often help to arrange leveraged loans that are linked tothe ultimate performance of the deal (or similar structures) forkey members of the management team. We also note thatmost investors do not want the management team so

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financially constrained that they become excessively riskaverse. As one deal partner told us: “Ideally, if the deal goeswrong the CEO should be forced to sell his summer house butnot his home”.

On the second source of variation, aperformance-management system should extend as deeplyinto the organisation as is practical. However, most privateequity owners prefer to limit significant equity-based incentivesto those executives they see as most critical to the success ofthe investment. In practice, the size of this group depends onthe deal thesis and the nature of changes that are required tobe successful. For a deal requiring a broad-basedperformance transformation of a large company or significantentrepreneurship at the local level, the size of the group willoften be much larger than one in which the actions of a smallgroup of executives are seen as particularly critical to success.

Establishing a process to track progress and to react to gaps

Once a deal is completed and the new owners and theportfolio company’s managers begin working together, theymust quickly agree on how to track progress and how todefine their mutual roles in reviewing and in reacting toprogress reports. This should not just span the first 100 days,but last for the entire investment period. At a minimum, it isimportant for them to identify the right set of key performanceindicators (KPIs) and reports, and to agree on the frequencyand format in which share them (see Figure 10.3). The rightKPIs are those that monitor progress toward the goals of thebusiness plan and provide the data necessary for reviewers tonotice and to take action where required. While there may besome similar KPIs across businesses and industries, we find ittakes real thought into developing the right KPIs that will trulybe the barometer for both the short- and long-term health of aspecific business.

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Figure 10.3: Success is correlated with clear metrics to trackand monitor performance

* Figures may not add up to 100 percent, because of rounding.Source: McKinsey Quarterly transformational-change survey, 2010.

Depending on the magnitude of change anticipated in thebusiness plan and the level of complexity or uncertainty inachieving it, tracking progress may be an intense exercise.When large cost-improvement efforts are involved, the mostsuccessful companies tend to put in place a programmemanagement office (PMO) that reflects the nature and scopeof the effort; the more cost initiatives a deal has, the greaterthe need for a PMO. A well-functioning PMO will drive thepace and cadence of the effort, provide centralised controllingand reporting of progress (often for hundreds or eventhousands of individual initiatives), will enable managementand the new owners to identify and focus on the areas that arefalling behind and require intervention, and will ensureeffective communication of progress. The key for any effectivePMO is to bring focus to conversations and to actions thathelp teams to achieve more of their objectives and morequickly, rather than simply reviewing progress in anadministrative manner.

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A recent situation at a global industrial company offers an aptcomparison of deals with and without a structured programmeto track and drive progress. The industrial company’smanagers were successfully implementing an aggressive,broad-based cost transformation programme. They had aformal PMO structure, with systematic tracking of eachinitiative’s progress from idea to execution and centralisedreporting to ensure that they quickly discovered issuesrequiring intervention. As a result, managers were on track toexceed their new owner’s goals for cost reduction. Thecompany’s PMO structure so impressed their private equityowners that they invited the management team of one of theirother investments to visit. The visitors, whosemedical-products company was struggling to make progress inits own cost programme, concluded that they should emulatethe structured and the disciplined PMO processes of theindustrial company. These processes includeimplementation-level tracking for each initiative; standardisedtemplates; and a regular cadence of reviews focused on gaps,deviations from expectation and actions required to addressthem. Since doing so, the medical-products company hasmade significant progress in its own cost-reduction efforts.

Conclusion

The first 100 days post-close provides a unique opportunity toget each private equity investment off to a strong start. Themost successful private equity owners seize the opportunity tospend significant amounts of time building the right foundationfor the company’s success, including ensuring that the rightmanagement team is in place, overhauling the business plan,communicating the priorities, aligning incentives andestablishing tracking systems. In so doing, they set the tonefor the relationship with the management team and shape theexpectations of the organization as a whole. Acting quickly,before the wrong relationships and expectations have formed,

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provides the greatest impact in relation to effort and ensuresthat a seemingly heavy investment has an attractive return.

Andrew Mullin is an associate partner with McKinsey &Company, based in the Toronto office. He has been withMcKinsey for seven years and spends much of his timeworking with private equity, institutional investor, and otherprincipal-investor clients on the topics of strategy, organisationand compensation, due diligence and portfolio companyimprovement. His direct investment and portfolio companyexperience covers a broad range of industries includingautomotive, aerospace, consumer goods, retail,telecommunications, professional services and financialservices. He also works with corporate clients on M&A andpost-merger integration efforts. Andrew earned a BS, summacum laude, from Babson College, in Wellesley,Massachusetts.

Alex Panas is a partner with McKinsey & Company, based inthe Boston office, where he works with private equity firms onstrategy, organisation, operations, and investment diligenceinitiatives, as well as portfolio company efforts for privateequity-owned companies. Alex has deep expertise in theindustrial, retail, consumer packaged goods, foodservice andoperations areas. He also leads the firm’s service line andknowledge development on what it takes to grow and turnaround private equity-owned companies. Prior to joiningMcKinsey, Alex spent six years working for Compaq Computerand Digital Equipment in a number of financial and operationalroles with international assignments in Singapore, Thailandand Vietnam. Alex earned his BS in Entrepreneurship andManagement from Babson College, summa cum laude, andholds an MBA from The Kellogg School of Management, withdistinction.

Kevin Sachs is a partner with McKinsey & Company,currently based in the Silicon Valley office and previously

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based in New York, San Francisco and Warsaw. He has beenwith McKinsey for ten years and spends much of his timeworking with private equity clients on both due diligence andportfolio company improvement efforts. His private equityexperience covers a broad range of industries includingindustrial products, aerospace, high tech, pharmaceuticals,oilfield services, consumer goods, media and professionalservices. He also works with corporate clients on M&A andpost-merger integration efforts. Kevin interrupted his tenurewith McKinsey for five years to join the executive team atSolectron, driving a turnaround effort at the electronicsmanufacturing services provider. He received his MBA fromStanford Graduate School of Business, where he was an ArjayMiller Scholar, and received his BA, summa cum laude, fromWilliams College.1 Andreas Beroutsos, Andrew Freeman and Conor Kehoe,What public companies can learn from private equity,McKinsey on Finance, Number 22, Winter 2007, pages 1–6.2 McKinsey’s Organisational Health Index identifies fourarchetypes that are most successful in high-performingcorporations: leadership-driven, market focus, execution edgeand talent/knowledge core. For more on these archetypes,see https://solutions.mckinsey.com/catalog/OHI.html.

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Chapter eleven

Developing post-acquisition plans

By Jurgen Leijdekker and Josh Sullivan, Welsh, Carson,Anderson & Stowe, and David Buckley, General Atlantic

Introduction

In a book about due diligence, a discussion onpost-acquisition plans is logically the final chapter. While mostof the due diligence process centres on the investmentdecision, it is not normally until the final stages of that processthat post-close actions are addressed. As private equity firmsembrace operational involvement as a core part of theirbusiness, the due diligence process has become increasinglyextended to include the development of a post-acquisitionplan. Therefore, the decision to acquire a company and thedevelopment of a plan for post-close value creation now gohand in hand.

Value creation plans take various forms and carry differentmonikers. The most common term is the ‘100-day plan’, whichtraditionally is limited to governance, financial controls and, ifnecessary, senior team changes. Firms with a restructuring orturnaround focus will make high-level operational decisionswithin this time frame as well.

Nowadays, however, most private equity firms go further. Withlabels such as ‘value-maximisation plans’ (at Welsh, Carson,Anderson & Stowe or WCAS) or ‘growth-acceleration plans’(at General Atlantic or GA), comprehensive, multi-yearstrategic plans are developed at many firms, crafted in closepartnership with management. Effectively, these plans are theoperational manifestation of the investment model. In thischapter, the authors will use the generic term ‘value-creationplans’ (VCP) to refer to this concept. Typically, these plans aredeveloped over the first three to six months post-close,

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culminating in a strategic plan for the portfolio company for thenext three to five years.

Given that the authors’ two firms focus on growth investments,the reader should be aware of some natural bias in thisdiscussion; less consideration is given to restructuring orturnaround situations. Additionally, note that this chapterfocuses solely on the development of these plans, not on theirimplementation.

The discussion is divided into five sections: post-closediscovery; management ownership and engagement;developing the plan headlines; developing the implementationplan; and using outside advisors. To make the discussionmore actionable, each section will end with a few practicalinsights from our two firms.

Post-close discovery

By the time a deal closes, usually the following will be knownabout the portfolio company: the financials and governancestructure in detail, a good sense of the market and thecompany’s positioning, and some first impressions of seniormanagement. Beyond that, operational due diligence mayhave uncovered further areas to focus on post-close; however,it is rare that a significant amount of time was spent on the‘shop floor’, given that access is usually restricted by thecompany and its advisors. Even with access, the due diligencetime-line usually does not allow for a detailed analysis of alloperational processes with the actual people who drive thosework flows. In other words, the more we get engaged with acompany’s operations as private equity professionals, themore we realise what we don’t know at closing.

This is where post-close discovery comes in. Developing aVCP requires thinking like an operator. To fill in anyinformation gaps that were not addressed during duediligence, it is worthwhile to formally structure an

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information-gathering process following the acquisition. Thisprocess can take various shapes, from formal audits,checklists or advisor-led diagnostics, to more informalinteractions with broader/deeper management layers andsimply spending time on the ground.

Table 11.1: Post-close discovery

Areas to focuson

Rationale Suggestedactions

1. Operationalprocesses

Due diligence usually centreson a target company’s financialand commercial viability,leaving little time to analyseoperational aspects which maycontain value-creationopportunities.

• Interviewoperationsleaders,several layersdown.

• Reviewdepartment-levelstrategic andinvestmentplans.

• Conductquantitativeanalyses ofoperationalperformancedata.

• Leverageexternaladvisors toconduct fulldiagnostics inhigh priorityareas.

2. ‘Challenges’Management naturally puts itsbest foot forward during theinvestment process.Weaknesses and risks may

• Hold individualmeetings withmid/seniormanagementon their

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have been glossed over or notaddressed. respective

areas.

• Conductdetailed reviewof past internalmanagementreporting andassociatedcommentary.

• Conductdetailed reviewof salespipeline.

• Go on salescalls.

3. Talent andculture

Access to people is usuallylimited to a handful of C-suiteexecutives over the course of afew meetings.

• Be present atthe company.Walk aroundand talk topeople.

• Ask to seeemployeeengagementsurveys and/orinitiate a newsurvey.

• Conduct 360degree,formalisedtalent reviewsthat includesuccessionplanning.

Table 11.1 lists three areas that are typically hard toinvestigate thoroughly during due diligence, and therefore areparticularly worthy of focusing on when the acquisition is

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completed. As to the process itself, we list a few tips that mayhelp the execution of post-close discovery.

WCAS comments

Now that the company and WCAS are partners, we all benefitfrom full transparency. We hold a one-to two-day session withthe management team immediately post-close, during whichour due diligence advisors present their findings to thecompany. This sets the tone of the meeting: we shareeverything that we have learned and are candid about howthis influenced our thought process and the resultinginvestment thesis. Management usually appreciates theaccess to detailed third-party perspectives and respondsthoughtfully, confirms certain impressions, corrects others andin turn volunteers its own reflections. Through this process, weare able to reach a common view of the company’s SWOT(strengths, weaknesses, opportunities and threats analysis).From there, it is usually natural to hold follow-up meetings withvarious line managers to fully understand their areas ofresponsibility, and also to agree on a diagnostic consultationwith external advisors in certain areas. Note that this SWOTnaturally becomes the starting point for ourvalue-maximisation plan (VMP), which is WCAS’ term for themulti-year strategic plan developed with management,post-close.

GA comments

GA treats a ‘growth-acceleration plan’ (GAP) meeting as afurther opportunity to introduce our firm to our managementteam partners, highlighting in particular the role of ouroperating professionals. We usually schedule agrowth-acceleration planning session within a few weeks ofclosing. The primary goal of the meeting is to understandmanagement’s growth-oriented goals for the coming year andto highlight a few key areas where we may be of help.Assistance may come in various forms: serving as thought

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partners on key strategic issues, serving as a ‘fresh pair ofeyes’ to review key business processes, sharing experiencesfrom other companies in the portfolio, leveraging our extendednetwork or helping to identify third-party advisors who canbring the right expertise to bear. In an ideal scenario, both thefirm and management exit the meeting with a shared sense ofopportunities, and assign high-level ownership for eachinitiative on each side to carry the conversation forward.

Management ownership and engagement

Ownership is the most critical ingredient to a successful VCP.What separates the old private equity model (in which theprivate equity shareholder provides capital and governance)and the new model (in which the private equity sponsor andmanagement jointly own the investment thesis) is jointownership and engagement around a multi-year strategicplan. Without that, the VCP will remain just that: a plan.

Getting to shared ownership and engagement between theprivate equity owner and the portfolio company’s managementteam is an iterative process. Importantly, it starts pre-close.During the due diligence process, the private equity operatingteam is introduced and the firm’s approach to VCPdevelopment should be briefly outlined to the managementteam. Introducing the concept of a VCP, and sharing a fewexamples to bring it to life, creates both early engagement anda springboard for post-close plan development. Implicit in thisdiscussion is the message that this is part of the private equityfirm’s standard approach. Clearly setting these expectationsup front adds a useful self-selection element: a managementteam that recognises the value of a structured post-acquisitionplanning process will favour that investor as its nextshareholder.

Once the deal closes, a typical way to arrive at jointengagement and ownership is to plan successive meetings, tobroaden the circle and to solidify the content of the plan with

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each session. The first session is often a one-on-one meetingbetween the private equity lead operating executive and theportfolio company CEO. In this session, the concept of theVCP is laid out in more detail and a joint approach todeveloping the plan is agreed on. Even at this early stage, astraw man VCP is prepared for discussion, informed inter aliaby the operational due diligence. To provide the newcompany’s management with a better perspective on the VCPprocess, it often helps to facilitate a few calls with other CEOsof existing portfolio companies who have gone through thesame process, particularly as the concept may initially beperceived as owned and driven by the private equityshareholder instead of management.

Following that first discussion, a next session may be with thesenior management team, and eventually with a broadergroup that includes the various owners of the operationalinitiatives from deeper layers within the organisation.Naturally, whereas the private equity operating executive maylead the first few of these discussions, the CEO shouldeventually take over and lead the presentations to the broadermanagement team. Figure 11.1 shows a typical VCP planningprocess, from the initial introduction of the concept to the finalapproval of the plan.

Figure 11.1: The development process of a value-creation plan

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WCAS comments

WCAS’ VMP is introduced in the first few managementdiscussions. We regard our VMP process as a selling point forus, and as (future) shareholders, we emphasise three points inthat initial discussion. First, while the plan is developed jointly,it is owned by management. Our Resources Group is certainlyready to help, even to the point of being involved hands-on.However, we will only do so at management’s request ratherthan at our insistence. Second, we are willing to invest in aplan that materially improves on the investment thesis. Ourinvestment model is naturally based on the target company’sprospects at closing. If we can jointly develop a VMP thatmaterially improves on those returns, then we are willing to putmore money into the company, even at the expense ofnear-term EBITDA. Third, we make sure to quantify thisadditional upside throughout the planning process. Particularlywith management participating in equity or option plans, weshould all be able to see the ‘size of the prize’.

At the end of the planning process, we invite the CEO topresent his or her VMP to our partnership, usually at about sixmonths post-close. This again solidifies the notion that while

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the plan is jointly developed, it is owned first and foremost bymanagement.

GA comments

GA’s GAP is an opportunity to reemphasise the end of the duediligence phase and the beginning of a new partnership. Toensure that all stakeholders are on the same page, it isimperative that the CEO and his or her direct reports, as wellas both the private equity investment team and operationsprofessionals, attend the GAP meeting.

The GAP meeting is an opportunity to establish broadstrategic and operational goals. These discussions benefitboth the executive team and the board of directors, ensuring acommon view of growth drivers, a common language, anunderstanding of where management is focusing time andattention and a reference point for monitoring progress. Wehave found it helpful on many occasions to encourage ourpartner companies to use the output – a set of discreteinitiatives – to frame the discussion for investor calls andboard meetings. Doing so ensures that all parties ‘stay on thesame page’ and provides a forum for regular feedback, reviewand assistance.

Developing the plan ‘headlines’

While VCPs will vary at the initiative level, it is critical that theyare focused. Having a focused VCP essentially requires thatthe initiatives can be easily summed up in just a few themes.These themes essentially function as an agreement amongmanagement, other shareholders and the broader company,so as to not distract each other beyond these key valuedrivers. Logically, this focus also then allows for a higherconcentration of resources on these few areas, dictatesprioritisation of effort and resources, and facilitates thecommunication of a clear direction to the broader company.

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Besides ensuring focus, VCPs usually produce a healthydebate on the balance between the more evolutionaryinitiatives to drive the core business and the moretransformational initiatives that could materially improve thecompany’s growth trajectory. At our firms, we have tended toensure that both types of initiatives are represented in a VCP,for the simple reason that both the core business and futuregrowth options are important to the investment.

Besides focus and a good dose of transformational initiatives,any plan benefits from a few quick wins. In the case of a VCP,these usually come in the form of cost-reduction actions thatare often identified during operational due diligence.Increasingly, private equity firms have procurementprogrammes that a new portfolio company can directly enrollin. This not only helps to immediately ring the VCP ‘cashregister’, but also drives early enthusiasm for the plan and thenew partnership.

A final element of a good VCP is to check the plan against exitscenarios. There are usually a few specific considerations thatcould either facilitate or hinder an exit. Examples from our ownfirms include an additional emphasis on financial governancein light of a potential IPO, tweaks to the revenue model toreduce customer concentration, an increase in the share ofrecurring revenues or a reduction in exposure to acompliance-sensitive vertical, and finally, a separation of backoffices to facilitate partial exits. While these were crucialingredients in each specific case, we should not overstate theimportance of managing to an exit scenario. At the end of theday, the main driver of a successful exit remains companyperformance.

Table 11.2 shows an example of a VCP headline.

WCAS comments

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As growth investors, WCAS finds that we need to explicitlypush our thinking to include transformational initiatives. Wheninvesting in successful companies, there is a natural tendencyto not change a good thing. However, two questions should beasked: 1) whether a company growing at 30 percent couldgrow twice as fast, and 2) whether there is a balancedportfolio of growth investments in the company. On the former,it is often worthwhile to overinvest in key segments andinitiatives of the company that are already doing well, to fullypush their potential. On the latter, segmenting the company’sgrowth areas makes it easier to make an argument fortransformational initiatives in a few areas, thus seedingoptions for future growth.

GA comments

GA sees many outstanding growth-oriented firms that reachan inflection point in their life cycle where some aspect of theirbusiness infrastructure, human capital and/or businessprocesses begin to come under stress as they face thechallenges of increased scale. To unearth some of thesechallenges, we often ask three critical questions: 1) what coreactivities define our business and how do we measure them?,2) how do our operating practices contribute value to thecustomer? and 3) what would it take to transform these coreprocesses to achieve true differentiation? These questionshelp us to focus on the things that really matter to thecustomer and to seek out the operational metrics tied to theseto achieve a balanced view of operations in conjunction withfinancial performance. As a complement to thesecustomer-centric operational questions, we look foropportunities to assist with global growth acceleration throughintroductions to new clients and strategic partners.

Table 11.2: Example of a value-creation plan headline

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Developing the implementation plan

Once the VCP has been agreed on and embraced at a highlevel, the next step is to start the actual implementationplanning.

At our two firms, implementation planning is typically drivenjointly by an internal owner from the portfolio company and byan operating executive from the private equity firm. Theinternal owner has at times been a C-level executive (typically,the COO) or a VP-level executive with some programmemanagement background. As a rough rule of thumb, theinternal owner typically spends one-third of his or her timedriving the implementation planning for the first six monthspost-close. The operating executive will typically spend half ofhis or her time on plan development during that period, sittingin on most of the planning sessions, locating and managingexternal resources, and often actively driving a couple ofinitiatives where needed.

In terms of structuring the implementation planning, we tend toshy away from excessive governance. Generally, a full-scaleprogramme management office (PMO) should only be usedwhen there are complex initiatives that span across many

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departments (for example, a post-merger integration), or whenthe list of initiatives is running well into the double-digits. Moretypically, the only governance we do is to regularly update asingle project planning page (see Table 11.3 for an example)that details high-level milestones and KPIs. If individualinitiative owners prefer to work with more detailed Gantt chartsor to use project management software, it is their prerogative.

Table 11.3: Example of a one-page implementation-planninginitiative

Rather than managing the plan on activities, the real key is tomeasure results. The sidebar titled The importance of metricsdiscusses the importance of managing on just a handful ofpowerful metrics that are carefully selected during theplanning process. Table 11.4 is an example of a VCP tracker.

WCAS comments

In a few investments, WCAS has made the development of aquality VMP part of the CEO’s first-year compensation plan.This is an exception rather than a rule, as managementownership and engagement in most companies is sufficientlystrong to drive the VMP. In cases where this appears to bemissing, adding a financial incentive can be a pragmatic wayto ensure a strong focus on VMP development immediatelypost-close.

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GA comments

To drive value creation, GA tries to not overburden ourmanagement teams with yet more meetings, data requestsand formal work planning, particularly at the beginning of aninvestment. Where possible, we try to gain precise agreementon key goals, metrics and timing for key growth initiatives, butstop short of detailed Gannt-chart plans or formal PMOs. Wesee value in a more informal, decentralised model whereindividual action item owners from GA and our partnercompany meet independently to drive progress withoutinvolving the full group. Often, because of the nature of firmsin which we invest, we find that some of our top executiveteams may already have working teams in place to tackle keyissues. As operating professionals, we can play a key role asadvisors attached to these teams.

Table 11.4: Example of a value-creation plan metrics trackerInitiative Status Results metrics

Drive new productdevelopment

• 12 key products completed in2011

Open direct channel • 85 percent direct sales

Enter overseasmarkets

• Priority countries identified

• Business plans ready for fourcountries

Improve inventory andmargins

• Inventory turns up 30 percent

• $3 million-plus procurementsavings

• $2 million-plus pricing impact

The importance of metrics

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The selection of the right key performance indicators (KPIs) can turnout to be a truly strategic and transformative move in an investment.Selecting KPIs for the VCP is not just an opportunity to enhance theperformance culture at the company, but it can also clarify the ultimatevalue drivers to all parties.

In one example, a practice-management company found that thephysician turnover at each of its locations was a key driver of salesgrowth. Hiring risk-averse practitioners (who are unlikely to start theirown practice) turned out to be a key value driver. In another case, abusiness-services company found that gross margins wereincreasingly compressed as the core product became commoditisedand sales leadership only drove the top-line. Simply relabeling ‘grossmargin’ as ‘net revenue’, having all financial statements start with thisline item and consequently resetting all targets and incentivesrefocused the company and helped to halt margin erosion. In a finalexample, a chain of urgent-care businesses found that repeat visitsand word of mouth referrals were key drivers of volume. Both weredriven by positive patient experience, which in turn was mostly drivenby keeping total visit times below one hour in length. Measuring andmanaging patient net promoter score and visit times focused thecompany on its key value drivers.

In each of these cases, the VCP process brought these KPIs to thefore, with the usual public target-setting, competitive rankings andincentives now all pointing to those metrics. Crucially, the monthlyreviews now focused at least equally on these VCP metrics, next tothe usual financial results. Whereas financial reporting mostly reflectshistory, the VCP offers an opportunity to add leading indicators, thuscompleting the picture. See Table 11.2 for an example of VCP metrics.

The role of outside advisors

Outside advisors are typically involved in any VCP. In fact, it isgood practice to establish an early expectation that third-partyhelp is needed. Depending on the portfolio company culture,engaging external advisors has either been common practiceor frowned on. If the former, advisors have either beenselected carefully and managed productively; if the latter, thecompany may have reached out to big household nameswithout second thought and possibly managed more for

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political cover than for results. Part of the value-add of astrong private equity firm is to ensure that there is no biasagainst outside help and that any such assistance isleveraged effectively.

Outside advisors can nearly always add value. However, thelevel and type of involvement varies widely between firms andcompanies. In our firms, we find that outside advisors areconsistently used at the kick-off stage and in the laterexecution stages, with more sporadic involvement in thein-between planning stage.

Kick-off stage

Involving due diligence advisors in the early stages of apotential acquisition is a logical extension of the investmentprocess. These advisors have been intensely focused on thebusiness over the past weeks/months, based on their variousspecialties. Even though a post-close point of view may nothave been part of their remit, these advisors will naturally havedeveloped some useful perspectives on the business, if theywere to own it.

For this reason, we consistently involve our due diligenceadvisors in the early stages of the VCP process. As notedabove, we invite advisors to present their findings to themanagement team and to facilitate a discussion onoperational priorities post-close. In the planning process, weusually invite the same advisors to participate in the firstproblem-solving sessions in their respective functional areas,together with the initiative teams. For example, we invite our ITdue diligence advisors to participate in a problem-solvingsession on certain technology initiatives that we expect to endup in the VCP.

Implementation-planning stage

Large strategy firms are capable of bringing both industry andfunctional expertise to bear, as well as adding rigour to the

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implementation planning. In practice, our experience has beenthat strategy firms are only a good fit when the core questionin the planning phase is indeed one of strategy. For example,a recent investment required a wholesale reconsideration ofthe company’s business model. We engaged a strategy firm tohelp us think through this process – and they did so,effectively. Typically, however, as growth investors thestrategy of the new portfolio company has generally beenworking well. Engaging a strategy consulting firm thereforemay not be a logical fit.

When growth is more likely to be driven by targeted functionalinitiatives (for example, expanding the sales force or enteringnew markets), smaller niche firms can provide significant valueat much lower cost. These types of initiatives typically requiredeep expertise that often does not exist within the portfoliocompany and therefore a niche firm is well-positioned to turn agrowth opportunity into a tactical action plan.

Whereas consulting firms are engaged on a case-by-casebasis, we consistently use expert networks (such as GLG orGuidePoint) during implementation planning. After all, thework in this stage consists mostly of scoping new initiatives totake the company to new heights. Having deep functionalexperts at hand for one-hour phone calls is an excellent (and avery cost-effective) way to challenge the team and to exposethem to new possibilities.

Execution stage

Once the initiatives are underway, typically some boutiqueconsultants will be engaged on selected projects. Asmid-market growth investors, a typical initiative is one in whichthe company covers new ground, by entering a new market orby building internal capabilities to keep up with growth. Inthose situations, hiring outside expertise is a logical choice,mostly to import best practices. At our firms, we typicallyengage specialised (and often smaller) advisory firms. For

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example, we would hire a market study firm to prepare forforeign expansion, a survey firm to enhance the ‘voice of thecustomer’, a real estate consultant to identify locations for newexpansion, or a sales force effectiveness firm to build a salestraining programme. Where possible, we structureresults-based fees for these execution engagements.Additionally, we often use the powerful network of PE OPENto obtain references on good point-consultants from otheroperating partners.

WCAS comments

In certain investments, WCAS anticipates that significantconsulting resources are required to drive the VMP. In thosecases, we sometimes allocate an incremental budget foroutside resources in the original equity check. In ourmid-market companies, the cost of a consulting engagementmay make management reluctant to reach out for that type ofassistance. To allow for a more open discussion on the meritof an outside firm to support the VMPs, we may pre-fund thepotential consultant engagement at closing.

In exceptional cases, we have also used a strategy firm as anexternal driving force, to ensure that we uncover everyopportunity and/or to create a planning process that will not beignored. More usually, however, the discovery and planningare done collaboratively.

GA comments

Outside advisors often prove critical in driving value creation.In particular, GA has found that our IT partners have beeninstrumental in helping some of our best practice firms copewith the challenges of scaling up. We believe it is essential tomaintain a broad network of proven external advisors who canhelp our partner firms grow. We also feel that it is not justabout identifying the right advisory firms, but getting rapidaccess to the best individuals who can be most helpful to our

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companies. We typically introduce a sample of partners in ournetwork and provide case studies during our initial meetingswith the target company.

Conclusion

A VCP stands and falls with a few key ingredients. Below aresome simple do’s and don’ts to get the mix right.

• Ensure ownership. Start pre-close, when the discussion is stillnoncommittal and the potential private equity owner canassess whether a broad transformation plan will get tractionamong the management team and within the company. Onceunderway, make sure the VCP is owned by a senior executiveand engagement is broad. The plan needs to have an identityand ‘live’ in each corner of the organisation.

• Create focus. A plan that purports to do everything willaccomplish little and not change the trajectory of the company.Focus on a few key items that are new and transformative anddouble-down on the resources behind those efforts.

• Measure results. Be wary of PMOs and Gantt charts. Focusinstead on picking a few leading indicators of value andensure the business rallies around those.

• Get help. A transformative plan almost by definition requiresnew capabilities, both from new hires as well as outsideadvisors. The role of the private equity firm is to leverage itsnetwork and to make sure the consulting fees deliver outsizedreturns.

As noted at the outset, this chapter stops just of whereexecution begins. Although 95 percent of the work is stillahead of us at this stage, incorporating the strategies abovewill significantly improve the chances of eventual success.

Jurgen Leijdekker is an operating executive at Welsh,Carson, Anderson & Stowe in New York. Before joining

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WCAS, Jurgen was most recently president of Paul WinstonGroup, where he led a significant operational transformation ofthe organisation. Jurgen has over 12 years of operatingexperience, in addition to an earlier career in strategyconsulting and economics. In his previous professional roles,Jurgen led operational improvement efforts at several portfoliocompanies of private equity firms. In addition to Paul Winston,he worked at H2 Equity Partners, McKinsey & Company andthe International Monetary Fund. Jurgen received an MA inInternational Finance from the University of Amsterdam.

Josh Sullivan is an operating executive at Welsh, Carson,Anderson and Stowe in New York. Before joining WCAS, hewas most recently an associate principal at McKinsey &Company, where he worked for seven years executingmulti-year operational change programmes for a diversifiedset of corporate clients. In addition to McKinsey & Company,he worked at Procter & Gamble as an operations manager.Josh earned a BS in Chemical Engineering from CornellUniversity and an MBA from NYU - Stern School of Business.

David Buckley is a vice president at General Atlantic and amember of GA’s Resources Group in Greenwich, Connecticut.Prior to joining GA, David worked at McKinsey & Company,where he advised a range of leading high tech, industrial andprivate equity clients on strategic and operational issues.Previously, he served as a captain in the United States Army.David holds a BA from the University of Notre Dame in Politicsand History and an MPP from Princeton University’s WoodrowWilson School of Public and International Affairs. In addition,he studied in Poland as a Fulbright Scholar.

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Chapter twelve

Buy-and-build strategies

By Jason Caulfield and Peter Williams, Deloitte & ToucheUK, Parm Sandhu, Tamita Consulting (UK) LLP, andJeremy Thompson, Gorkana Group

Introduction

Since the global economic crisis began in 2008, many privateequity portfolio companies have battled to deliver growth andto protect or expand their margins. As a result, profit growthhas been suppressed and exit values put under pressure. Tosupplement organic growth strategies, some private equityfirms pursue a strategy that involves acquiring a series ofsmaller businesses to ‘bolt-on’ or ‘add-on’ to an originalplatform investment. By themselves, the individualtransactions may not be transformational for the acquiringbusiness; however, the net result of these serial acquisitionscan result in a substantial change to the overall shape andscale of the subsequently enhanced business.

This so-called ‘buy-and-build’ strategy can present asignificant opportunity to create value. However, it is notwithout challenge. Finding the right businesses to acquire atthe right price and obtaining the financing to support this typeof strategy can be a significant limitation. Debt financing has inrecent years been severely curtailed, presenting particulardifficulties for many small or mid-cap businesses. Therefore,the buy-and-build strategy has become more common forprivate equity-owned portfolio companies that have additionalsources of funding available and the resources to call on toassist in securing financing. Indeed, some private equity firmsspecialise in making these kinds of acquisitions.

In fragmented markets, opportunities exist to consolidate anddeliver returns. Typically, the first stage in a buy-and-build

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strategy is an investment in a platform company in a particularsector with the necessary attributes for further bolt-on dealsand consolidation. This may then lead to acquisitions inrelated or new sectors, markets or geographies (see Figure12.1). Carefully choosing the platform company is crucial forestablishing the basis for subsequent bolt-on acquisitions,particularly if substantial value is only achievable throughintegration of the acquired companies. In Western Europe andthe US, many industries are already highly consolidated,which presents fewer opportunities for executing this strategysuccessfully than in developing markets, such as EasternEurope.

If done successfully, adopting a buy-and-build approach canprovide private equity firms with significant tacticalopportunities. For example, this may include extending currentofferings to new markets, increasing profit from the valuechain, and opening up both new markets and untappedcustomer segments. The advantage is that businesses do notneed to spend time developing the requisite capabilitiesinternally, at the risk of failing to create winning products orinvesting heavily to gain market share. On a strategic level,the potential benefits are even more pronounced. By carefullychoosing the right bolt-on targets, robust platform businesseshave the opportunity to challenge the very basis of competitionby changing the ‘rules of the game’ in their market or industry,to develop entirely new markets that were previously notconsidered, and/or to develop new uses for existing services,technologies or offerings.

However, managing growth through such acquisitions addssignificant burden for management; this strategy requires newskills and experience in order to unlock value. Managementteams must be capable of managing the significant demandsof this M&A strategy while continuing to drive and improveday-to-day business performance across the group.

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Figure 12.1: Companies can find growth through new platforms

Source: Deloitte.

Market activity

An analysis by Silverfleet Capital and mergermarket found thatthe European market activity for buy-and-build transactions in2011 increased both in volume and value in the first halfcompared to 20101. The number of bolt-on acquisitionsundertaken by private equity-backed portfolio companiesreached a three-year high in 2011 with 364 (an increase from335 and 236 in 2009 and 2010, respectively). In the first half of2011, average values reached £70 million. However, in thesecond half of 2011, the volume of transactions fell andaverage values in the fourth quarter were down to a modest£34 million from 74 transactions. This was the lowest levelsince the second quarter of 2009.

The European economic downturn and the sovereign debtcrisis impacted overall business confidence and availability ofdebt financing. This is thought to have contributed to the

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significant decrease in European bolt-on transactions by abouta third in the first quarter of 2012 from the level seen in thethird and fourth quarters of 2011. Buy-and-build activity in thefirst quarter of 2012 is the lowest of any quarter sincemid-2009 (see Figure 12.2).

In contrast, a separate survey conducted by Deloitte in the firstquarter of 2012 indicated a strong improvement in businessconfidence among the UK’s largest companies, althoughperceptions of uncertainty remained at elevated levels2. Thesurvey revealed that confidence among CFOs about their ownfirms’ finances rose at the fastest rate since the survey startedin 2008, bringing it close to levels last seen in late 2010.Worries about the risk of recession and a breakup of the eurothat dominated corporate thinking at the end of 2011 haseased. CFOs also reported an increase in credit availability inthe first quarter 2012, which unwound the deterioration incredit availability seen in December 2011, which at that timesome feared could be the start of the second credit crunch.

Figure 12.2: European bolt-on activity compared with privateequity buyouts and mid-market M&A

Source: Silverfleet Capital, mergermarket.

Rationale for buy-and-build strategies

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The reasons for pursuing a buy-and-build strategy can bedivided into five key areas of value creation, as follows:

1. Drive cost synergies

Businesses can create value by extracting cost synergies frombolt-on acquisitions. Cost synergies can arise in many areas,such as reduced headcount through consolidated back-officefunctions, increased production and operating efficiencies,leveraged purchasing volumes and reduced propertyportfolios.

2. Geographic growth/new products

Revenue synergies can arise from cross-selling or optimisingjoint product portfolios, as well as gaining access to newmarkets, customer segments and distribution channels.Acquisitions can give companies the opportunity to acquirecompetitors and to optimise product and service offerings.Applying a product from one company to a market in a sistercompany can be reasonably straightforward and immediatelyvalue enhancing.

3. Take a leading position and dominant market share inan industry

Often, there is a positive correlation between market shareand the value of a business. Therefore, businesses employinga buy-and-build approach to growth have the opportunity torelatively quickly reap the advantages of size, such as buyingand volume advantages, first-mover access to new products,and marketing scale. Strategically, dominant companies canalso exert pricing pressure and benefit from squeezing theircompetition into less attractive segments and/or marketsthrough cornering a strategic niche or blocking competitors. Inall cases, the competitive advantage arises from the selectiveacquisition of strategic capabilities. The result is a formidablemarket force that can be more than the sum of its individualparts.

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4. Build an investment story for a second buyout or anIPO

A convincing investment story can be created by establishinga dominant or promising market participant through abuy-and-build strategy. The story then can be sold througheither a management or a secondary buyout to investorslooking to support the enhanced and increased businesslooking to take it forward in its next phase, or in an initial publicoffering (IPO).

5. Multiple arbitrage

Previous transactions indicate that the size of an organisationinfluences the multiple at which a company is bought, owing todifferences in the perceived risks of the business. Largercompanies are likely to be perceived to have strongermanagement, brands and customer relationships, thusachieve a higher multiple. A series of companies bought atlower multiples may ultimately sell as a group with a netincrease in multiple, and hence generate significant value.

Challenges to buy-and-build strategies

While buy-and-build strategies can significantly increase thevalue of platform companies, management teams need to beaware of key challenges in their execution, including:

Finding targets at the right price

As markets consolidate, increased competition with strategicbuyers is common, and prices for bolt-on targets are drivenupwards through auctions. Since finding target companies atthe right price is challenging, buyers should look to establishwhether a market is likely to offer an ideal environment for abuy-and-build strategy. Identifying prime consolidationopportunities without paying overinflated prices is key.

Securing a management team with integration experienceand capability

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It is critical either to acquire a platform company with amanagement team that has experience in successfullyintegrating companies, or to bring on board this expertise earlyto oversee the buy-and-build strategy. The existingmanagement team for a single company may not be suitablefor an enlarged group and the changing demands this has onthe operating model of the business. Therefore, managementhas to be replaced or reskilled. Involving an operating partnerfrom the private equity firm can help to ensure a smoothexecution of the strategy.

Integrations may distract management from corebusiness

A common integration pitfall is that management believe theyare able to run their business as usual while managing theintegration projects on the side. It has been shown repeatedlythat managing business integrations requires focus,experienced resources and commitment from the executiveboard to handle the many decisions and challenges anintegration presents. Critical resources should therefore bededicated to the integration programme; business-as-usualresponsibilities should be filled in order to effectively drive theplan and to implement the necessary changes. Establishingintegration skills in the organisation early on will improvemanagement’s ability to execute further transactions.

Unforeseen integration complexities

Weak analysis of targets, incomplete due diligence andinadequate integration planning are common errors thatshould be avoided when undertaking a bolt-on acquisition. Ifnot addressed early on, loss of expertise, customer attrition,weak processes and systems, and incompatible businesscultures can result in significant issues that will ultimatelyimpact the timely delivery of business case synergies andoverall growth. Acquirers should always undertake a thoroughplanning exercise using a consistent approach to identify such

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areas of concern and ensure that mitigation strategies are putin place. Effective and formalised governance processes willfurther encourage fast decision-making to drive the integrationforward, manage dependencies, and tackle issues and risksas they arise.

Incomplete integration creates a value drag on exit

Even though typically overlooked by deal-hungry privateequity firms and management teams, it is critically important toformally establish an integration team that has both the remitand the focus to drive the programme forward over anextended period of time. During the planning stages, quickwins that can be realised immediately should be identified toprovide the programme with momentum and to garner supportfrom stakeholders. Rigorously tracking the realisation ofsynergy benefits will encourage the completion of theintegration programme and thereby optimise value on exit.This also has the benefit of flushing out the issues before theybecome major business problems.

Increased exposure to a specific industry

External factors such as economic climate, political unrest,changing legislation and competition could all result in anuncomfortable level of exposure to a particular sector within aprivate equity portfolio.

Case study 1: Unitymedia

Overview

In January 2010, Unitymedia, Germany’s second largest cableoperator, was bought by Liberty Global for €3.5 billion. Unitymedia hadbeen created through a successful buy-and-build strategy starting withthe acquisition of Iesy, a regional cable operator for the Hessen regionin Germany, in 2002. The sale of Unitymedia created significant valuefor its private equity shareholders which included Apollo Managementand BC Partners. Liberty Global is an international cable company that

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operates broadband communication networks in 13 countries,principally in Europe and Chile.

Background

During the 1990s, the German government funded the rollout of itscable networks, one of the world’s largest, across 25 millionhouseholds. As a result of entry into the European Union and theprivatisation of Deutsche Telekom (DT), the European Commissiondirected the separation of the cable networks from DT’s core coppernetwork. DT sold the cable networks piecemeal to investors, whoaggressively overleveraged the businesses and caused debt levels totrade at distressed levels. This allowed Apollo Management to acquirecontrol of Iesy, the Hessen cable operator, through a position taken onits debt. Iesy’s management turned around the operations in 18months.

Table 12.1: Turnaround of Iesy following the buyout by ApolloManagement

Iesy - Hessen cable operator

2002 2004

Revenue €125m €137m

EBITDA €13m €75m

EBITDA margin 10% 55%

Net debt c. €500m €100m

Leverage 38x 1.3x

Source: Deloitte.

Acquisitions and growth

Management and sponsors transformed Iesy over a period of sevenyears through acquisitions and organic growth. The Unitymedia Group

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was created by merging the Hessian cable operations with those inNorth Rhine-Westphalia (NRW) state in 2005. The combined groupthen absorbed the activities of the cable provider Tele ColumbusWest. These actions effectively established the platform business towhich additional acquisitions would be added over time.

In June 2005, NRW network operator Ish was acquired for €1.6 billionat a multiple of 8.0x pre-synergies or 6.7x post-synergies. A significantproportion of the synergies, €40 million, from integrating the twooperations, was reinvested into marketing activities. A €300 millionmulti-year network upgrade programme was undertaken andinvestment was made to upgrade senior management, to reskill thework-force and to upgrade systems to support the broadband product.

In December 2005, Tele Columbus was acquired for €800 million toallow Unitymedia to establish end-to-end control of the cable networksin its regions and thereby accelerate the rollout of its interactiveservices. The in-region networks were integrated and networkupgrades were focused on these areas. New products were createdfor housing associations and the out-of-region Tele Columbus assetswere sold for €750 million, leaving Unitymedia with the in-regionassets having been acquired at the very attractive price of €50 millionand an excellent multiple.

In December 2005, Bundesliga premier league sports rights for2006–09 were acquired for €750 million to create wholesale marketsfor basic and premium pay tv content. The Unitymedia Digital TVnetwork and basic tier offering, a national satellite platform and apremium pay tv product, were launched in 2006, establishing theexpanded business group as a national German cable player withpremium content.

Outcome and success factors

Unitymedia’s exit price of €3.5 billion represented an exit multiple of8.2x EBITDA in 2009 when the business was sold to Liberty Global inJanuary 2010. This transaction re-rated the European and Germancable markets coming out of the 2008–09 financial crisis. Unitymedia’ssuccessful strategy can be attributed to a number of key factors,including:

• Buying into a historically strong business which was mismanaged.

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• Creating value through driving structural market change.

• A disciplined M&A approach using creative financing solutions.

• A willingness to invest in marketing and infrastructure to drive growth.

• A nimble management team with strong, focused execution acrossmultiple areas.

• Investing in growth and establishing a strong relationship betweensponsors and management with complementary skill-sets and agenuine two-way dialogue.

Figure 12.3: Value creation at Unitymedia using a buy-and-build strategy

Source: Deloitte.

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Case study 2: Gorkana Group

Overview

Gorkana Group, a UK private company backed by Exponent PrivateEquity, provides integrated media services to the public relations andmarketing industries. The key feature of the group is its uniquenetwork that brings journalists and public relations professionalstogether. The company currently supports over 4,000 organisationsaround the world, including over half of the FTSE 350.

Background and acquisitions

The group was formed through a series of acquisitions. In April 2006,Exponent Private Equity acquired Durrants from August Equity.Durrants provided news monitoring services across all media,including print, online, newswires and social media.

In September 2009, Durrants acquired the UK print monitoringbusiness of Cision.

In October 2009, Durrants acquired Metrica, a UK media analysiscompany, to bolster its analysis services by adding social mediaanalysis and return on investment metrics to its offerings.

In April 2010, Durrants acquired Gorkana.

Gorkana Group’s acquisition strategy has been built on the followingcriteria:

• To create market leadership in each step of the public relationsworkflow.

• To create an integrated business which is difficult to replicate.

• To aggressively grow revenue from cross-sell and up-sell activities,and maximise subscription income.

• To invest in businesses that can be scaled internationally and have ablueprint which can be replicated in other markets.

• To realise synergies as a result of professional management.

To ensure that key individuals were retained, an element of thepurchase price was rolled over in the form of preference shares. Key

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individuals were also provided a share of equity in the combinedbusiness.

As part of the final piece of the integration, the group moved to adoptthe name ‘Gorkana’ as it had the strongest resonance in the publicrelations market and the best reputation with the journalist community.

Outcomes

The three acquisitions – of Cision UK, Metrica and Gorkana – havebeen successfully integrated into the original acquisition of Durrants.Cross-selling opportunities have been aggressively pursued, leadingto revenue growth of 26 percent between September 2009 and 2012on a normalised basis. Additionally, the group expanded itsbusinesses into North America. A more corporate style of businessexecution has been implemented and cost synergies of circa £1 millionon an annualised basis have been realised and reinvested intomarketing and business analytics support, enhancing customerservice, an integrated customer interface portal, improvements ininternal systems and US growth.

This is evidenced by the EBITDA multiple paid for the businesses atthe time and what that would now equate to, based on the forecastedEBITDA figures for the full year 2012:

• Metrica and Gorkana, at expected 2012 results, will be worth severaltimes their original acquisition prices.

• Cision UK was operating at a loss in 2008 and 2009 but is now ahighly profitable business as a result of the additional revenue beingsupported largely within the existing Durrants production capacity. Theoriginal investment was repaid within the planned 18 months.

The integrated business is the recognised market leader in the UK andis set to dominate the market with a unique integrated propositionincorporating the most accurate journalist data and media monitoringwith insightful analytics, giving public relations professionals truevisibility over the effectiveness of their activities. With an additionalinvestment in Brandwatch, a leading social media monitoring servicebased in Brighton, UK, Gorkana Group is set to become therecognised leader in the ‘earned media’ space.

Key lessons

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Management acknowledged some key findings from the buy-and-buildstrategy:

• A clearly articulated strategy and benefits case are critical.

• Benefits should be tracked and plans adjusted as necessary.

• There is value to be unlocked by acquiring owner-managedbusinesses.

• Earn-out clauses can cause some constraints on integration; equityparticipation in the combined business is a more effective reward forthe group.

• It is beneficial to have external expertise on board at an early stage.

Managing the integration

Based on the authors’ experience of managing successfulintegration programmes in private equity portfolio companies,five key principles should underpin an integration of any scale:

1. Clear purpose

The vision for the combined business and the degree ofintegration should be established by the private equity firm. Inturn, these should be agreed on at an executive level with theacquiring platform company as part of the bolt-on deal.Misaligned expectations at the top will soon translate intopolitics and emotions and are likely to cause distraction andunrest throughout the organisation. Protective entrepreneursand earn-out clauses in the purchase agreement are commonchallenges to consolidation into a group of companies. Themanagement of the acquiring platform company will need tolead the integration effort, supported by an operating partnerfrom the private equity firm, if there is one.

2. Strong executive leadership

Strong leadership to sponsor the integration should beestablished at the outset. It is critical that a clear

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understanding of the private equity firm’s rationale for theacquisition is shared across all areas of the business and thatthe vision for the integrated organisation is clearly defined.The sources of synergy/growth and the requirement toachieve them as quickly as possible should be articulated bythe operating partners of the private equity firm andcommunicated to the platform company’s senior leadershipteam as clearly and as early as possible; both parties will thenwork together during the integration phase to realise theexpected synergies.

3. Control

The integration programme should not damage the ability tomanage the combined day-to-day operations. It must,however, be given a high degree of focus from a dedicatedteam with excellent management skills. An increasinglycommon approach of private equity firms is to install anoperationally focused programme management office (PMO)in the platform company; the PMO’s sole purpose is to trackand report on transformation programmes that are driven bythe private equity firm. In these cases, bolt-on integrationsshould be added to their remit to ensure focus and alignedexecutive decision-making processes. Either way, strongprogramme management needs to be established and robustplanning and programme management processesimplemented at the planning stage within the platformcompany. Risks and issues must be tackled quickly and thetough decisions taken early on. Benefits should be trackedrigorously and plans aligned to deliver the financial targets.

4. Managing people

During an acquisition, uncertainty caused by the change inownership and anticipated headcount reductions affectsemployees in both the acquirer and the target. To mitigatethis, a new organisational leadership and overall managementstructure should be put in place as quickly as possible.

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Cultural differences should be identified and a single cultureneeds to be established across the group. Human resourcesand communications teams will need to be fully resourced,skilled and sufficiently empowered to accomplish these oftenunderestimated, yet critical tasks.

5. Team alignment

The management team, the deal team and – to the extentdeployed – the operations team should be as aligned aspossible throughout the process. This means always using theright people at the right time to identify, approach, structure,execute and integrate acquisitions in order to maximisereturns in the shortest possible time. At the same time,alignment requires that those individuals with true industryexpertise, hopefully among them executives in themanagement team, are driving the identification of suitablefuture targets.

Conclusion

Bolt-on acquisitions are integrated into platform companies toform enlarged entities. Because bolt-on acquisitions canprovide significant upsides, private equity firms are able tofactor this value-enhancing effect into their valuation, as wellas offer the target company’s shareholders an opportunity toparticipate in the growth of the organisation by granting equity.The latter also serves to align the interests of managementwith the private equity firm.

As a result of realising cost and revenue synergy benefits,economies of scale and improved access to finance,management can maximise opportunities to grow theirbusinesses. By increasing the size of the business and at thesame time reducing the risk of its future earnings, the privateequity firm is pushing up the earnings multiple and canmaximise exit value.

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Dr Jason Caulfield is a partner and leads Deloitte’soperational due diligence team in London. He advises avariety of private equity houses, including TPG, 3i, HgCapital,Francisco Partners, Vision Capital, Exponent and ApaxPartners on pre-deal operational issues and post-transactionperformance improvement. Jason focuses primarily on theconsumer business, media and manufacturing sectors and isa carve-out specialist. Jason also advises a variety ofcorporate clients. He recently supported Geely, a Chineseautomotive Group, with the successful acquisition andcarve-out of Volvo Cars from the Ford Motor Company. Jasonalso supported Wolseley UK, a building products distributor,with a number of disposals. Jason has a PhD in Solid StatePhysics from Oxford University.

Peter Williams is a director with ten years experience inDeloitte’s post-merger integration team in London, focusing onthe execution of business integrations and separations. Headvises private equity portfolio companies and large corporateclients prepare, plan and complete operationally complexacquisitions and disposals. Peter has advised on over 30transactions across a variety of sectors with a specialisation infinancial services. Advice is typically to executive boards andsteering committees on the execution strategy, programmemobilisation and delivery. Peter has a BSc degree from theUniversity of Bristol.

Parm Sandhu is an international media and telecomsexecutive with a deep expertise in the TV and broadbandcable industry. In 2010, he founded Tamita Consulting (UK)LLP to provide advisory services to financial investors in thissector. Until January 2010, he was CEO of Unitymedia,Europe’s third largest broadband cable operator, leaving afteroverseeing its successful sale to Liberty Global for €3.5 billion.During his seven-year tenure at Unitymedia, Parm led anoperational turnaround, multiple M&A transactions andintegration efforts, the launch of new cable and satellite

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platforms to support the exploitation of sports rights and thesuccessful implementation of new product introductions thattransformed the predecessor company of Unitymedia from abasic cable provider to one of the leading triple-play cablefranchises in Europe.

Jeremy Thompson has 15 years of frontline experience inthe B2B information market in multinational organisations likeThomson Reuters and United Business Media to privateequity-backed businesses. Jeremy is currently managingdirector of Gorkana Group. Jeremy began his career inpublishing on The Thomson Corporation graduate scheme,and held a number of roles in sales, marketing and productdevelopment at both Thomson and United Business Mediabefore moving into the media monitoring sector in 2001.Jeremy initially ran Durrants operations, and he workedclosely with the Deloitte post-merger integration team to leadthe integration of Durrants and Xtreme News in 2004 prior toits sale to Exponent. Since 2006, Jeremy and his team haveled three acquisitions and delivered a three-way integration tocreate the Gorkana Group.1 Available at http://www.silverfleetcapital.com/de/medien-center/news/buy-and-build-activity-in-europe-significantly-weaker-in-h2-2011/.2 Available at http://www.deloitte.com/view/en_GB/uk/research-and-intelligence/deloitte-research-uk/the-deloitte-cfo-survey/index.htm.

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Chapter thirteen

Beyond the board pack: leveraging key performancemetrics to drive results in private equity investments

By Seth Brody, Apax Partners

Introduction

Private equity firms inherently base their investment decisionson a series of assumptions within a forward-looking andcomplex operating model. However, when deal teamstransition from due diligence to ownership, portfolio companymanagement teams are frequently overwhelmed with requestsfor performance data at a seemingly boundless level ofgranularity. Almost every 100-day plan includes thedevelopment of a board reporting package (or board pack),which provides periodic visibility into the company ororganisation’s performance, and gives board memberscomfort on the trajectory of the business and visibility intocritical cash flow and balance sheet items.

A board pack will answer ‘what’, ‘when’ and ‘how much’, butwill rarely become a source of day-today operational data thathelps to lead a company and its managers on atransformational journey. It will not create the operatingleverage that drives investment outperformance. Movingbeyond the board pack and working with managers totransform their views of key performance metrics or indicators(KPIs), with a particular focus on action-orienteddecision-making, is a critical part of the private equityownership process. If executed properly, private equity firmscan use an integrated approach to reporting to drivemanagement accountability and excess returns.

This chapter will discuss the people, process and technologychallenges the author has experienced as an operator inestablishing the right key metrics for success, and in building

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management frameworks that leverage data efficiently to driveresults. The Apax Partners model is an integrated approachfocused on achieving rapid results while simultaneouslybuilding lasting management processes (see Table 13.1).

The first 100 days

Underpinning every private equity investment is a 100-dayplan, an almost universally ambitious set of objectives for thetarget portfolio company defined during the due diligencephase. The plan aims to jump-start value creation in line withthe deal team’s core investment thesis. A rapid results processrequires that a focus on ‘results-oriented’ KPIs beginsimmediately after an investment is made (and if possible, evenbefore the new private equity owner has ownership).

Table 13.1: Process objectives for achieving rapid results by leveragingkey performance indicators

Default objective Rapid-results approach (Apaxmodel)

Comprehensive reporting Achievable analytics

Perfect data integrity 80/20 focus on drivers

Data warehouseimplementation

Cross-functional integrateddashboards

Source: Apax Partners.

Identifying unambiguously positive metrics

‘What are the three metrics you look at every morning todetermine if you are winning or losing?’ This is always the firstquestion we ask management teams during due diligence.Generally, every member of the executive group will show upwith a report that they are focused on every day. The key inthis first step of the process is to align on goals as a team, as

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opposed to a particular functional vertical. Having key metricslisted on one page, and on one dashboard, dramaticallyincreases the conversation about and accountability forperformance among the executive team members. Moreimportantly, the relationships between the various executiveareas will become more apparent.

These metrics should be positive and focus oncross-functional relationships within the organisation. Forexample, sales growth may not be an unambiguously positivemetric if it increases commission and service costs; a bettermetric may be contribution margin per acquired customer.Customer service costs can be reduced by increasing holdtimes and eliminating toll-free numbers, but this may come atthe expense of satisfaction metrics. The management teamshould identify the key relationships across the teams – thepros and cons, and the gives and takes, to align on ashort-form executive dashboard.

Avoiding the data integrity trap

One of the critical aspects in developing a short-formexecutive dashboard is to make sure that the underlying datautilised for its production is universally agreed on to beaccurate and without prejudice. Data is a funny thing incompanies, especially in larger organisations that haveoperated in silos. Over time, independent variables morph intodependent ones. A ‘customer’ may be defined differently bythe marketing organisation and the sales organisation. Clientprofitability is frequently dependent on allocations made by thefinance department. These issues create tension among teammembers, and may lead to a lack of dashboard adoption. Theexercise of creating a dashboard is as much a political andmanagerial task as it is a technical one.

Dashboards are distinct from reports in that they should focuson actionable metrics and should provide an ‘at a glance’ viewof performance relative to a set of well-defined benchmarks.

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This author recommends implementing a simple colour-codedsystem that compares relative performance to budget, as wellas prior year, prior month and trailing 12-month performance.

Focusing on narrow inputs necessitates the creation of narrowoutputs. It is nonetheless better for the entire managementteam to be aligned around a small and agreed on set ofmetrics than to allow the dashboard to perpetuate perceivedmyths of misattribution. It is imperative that teams movequickly to establish this decision-making framework. Once the‘what’ of successful operating performance has been defined,then the questions of ‘why’ can be explored more deeply. Thiswill be covered in the next section.

Building the foundations

The first 100 days of an acquisition and the establishment ofan executive dashboard will help the team to align incentivesand success metrics, and to capture low-hanging fruit.However, the answers to ‘what’ will invariably lead toquestions of ‘why’; a skyscraper cannot be built on faultyfoundations. Below are some recommendations for preparingan organisation’s management systems to support thetransition from reporting to analytics.

Defining the operating terms of the business

As discussed in the previous section, most organisations havea legacy of ‘scope creep’ when it comes to defining the mostimportant operating metrics in a business. Seemingly obviousKPIs like ‘customer’, ‘client’, ‘contribution’, ‘churn’ or‘conversion’ often have multiple definitions within the sameorganisation. Sometimes, multiple independent systems arecreated to normalise data to support the different reports thatare sent to different parts of the portfolio company or tocustomers. This has led to more than one boardroom battlebetween the CFO and the COO. For the new private equity

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owners, the lack of consistency compared to what they mayhave seen in the diligence data room can be quite distressing.

Once the initial dashboard has been set up, the seniorleadership team must lock themselves in a room and hammerout specific details and definitions in a series of face-to-facesessions. This critical step in the process should involve theentire executive team, led by the CEO in a formal projectsetting. Off-site meetings where the team is free of dailydistractions are also helpful in breaking down barriers in thiscrucial step of the process.

This is another instance where the private equity ownershipmodel allows for a more flexible approach to defining criticalmetrics. Doing so should be based on making actionableoperating decisions as opposed to being forced to fit within theconstraints of historically reported metrics (in a publiccompany setting) or centrally mandated approaches (in acorporate parent-subsidiary relationship).

The definition of a unit of revenue or a unit of profitability has adeep implication for both line managers and employeesthroughout the organisation. This process should be properlymanaged; if not, there can be a serious backlash to changedreporting or incentive structures. It is also critical to havealignment and broad communication of the outputs from thisprocess, because the next step is to very quickly apply thenew definitions to existing reporting frameworks.

Squashing the cockroach

In large organisations, and in fast-moving companies of everysize, reports are like cockroaches. They are impossible to kill.If you have them, you can bet that your neighbour has them,too. Everyone has them, even if they don’t want them.Chances are high that the Daily Sales Flash report wouldsurvive a nuclear holocaust. You get the point…

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Reports are necessarily static, and only answer a fewquestions. Particularly in their most virulent PDF format, theylead only to additional questions, calls for ad hoc reportingresources and more data. The perverse truth for a businessintelligence professional is that every report created raises asmany questions as it answers, and leads only to additionaldemands for reporting.

The first payback from the ‘truth definition’ exercise above isthe elimination of all reports that are not in compliance with theagreed on definitions. At the same time non-compliant reportsshould be eliminated, duplicate reports – or those that largelycontain the same management information in a differentformat – should be, as well. This initial culling is necessary tobuild further alignment and to eliminate reports that raise morequestions than they answer. It also frees up resources in theorganisation to pursue the more noble goal of delivering aflexible analytics platform to the management teams.

Technical considerations

As this is not a technical chapter, the author will not delve intogreat detail regarding the IT and capital implications of arapid-results approach. It is worth noting, however, that privateequity owners frequently underestimate the complexity ofgathering data and often become frustrated with a portfoliocompany’s inability to answer what they view as basicquestions about the business.

The underlying data systems of most mature companies aretypically disaggregated, having been built over long periods oftime, and are therefore frequently internally inconsistent. Datawarehouses are complex and expensive systems, and manyprivate equity owners’ lack of understanding of thesetechnologies often leads to underinvestment and instability.Especially in cases where the data warehouse is a tool forreporting instead of an integrated part of revenue generation(for example, in a logistics business or manufacturing

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business, data warehouses are frequently essential parts ofthe minute-by-minute management processes), it becomes avictim of capital constraints due to its apparent lack ofimportance. You don’t notice it until it isn’t working.

Data integrity and technology issues are particularly acute incompanies that have grown inorganically, are being carvedout of a corporate parent or conglomerate, or rely heavily onthird parties as sources of revenue or services. The morecomplex the business model, the more likely it is that theback-end data structures are held together with duct tape andbailing wire. These are all considerations in due diligence thatwill be relevant to the ability to confidently assess a company’sperformance as an owner.

Do I need to spend millions on a data warehouse?

The answer to the question without the ‘millions’ part is almost always‘yes’. If analytics is to be taken seriously, the data systems andprocesses must be scalable and flexible. However, before investingmillions of dollars in a data warehouse and management reportingframework, the CEO of a portfolio company should be able to answerat least three of the five questions below with a ‘yes’.

• Are there critical revenue-producing activities that rely on an ‘alwayson’ source of the latest management information where the loss ofaccess to that data would translate into immediate revenue and profitloss?

• When you last adopted a company-wide effort to train line managers touse a technology tool meant to enhance their productivity, was theadoption rate for the new tool at least 75 percent in the first year?Have at least 25 percent of the company’s eligible employees used thetool in the last week?

• Would you be comfortable exposing the reporting tool to yourcustomers so they could better understand their relationship with thecompany on their own?

• Can you list at least five critical questions that you cannot answertoday that a data warehouse solution would enable you to answer

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tomorrow? The answer to these questions must have a meaningfulpotential impact on the company’s strategy and operations.

• Is this a technology project, a marketing project, a sales project or afinance project?

For mid-market companies with limited capital resources, it is possibleto achieve results and pursue many of the recommendations in thischapter without investing a significant amount of up-front capital todeliver a full data warehouse. SaaS (software-as-a-service) providersor offshore options can keep costs down. The key to success with alimited budget is to very clearly define the scope and objectivesupfront. The cost traps with SaaS providers are always in the changerequests and one-time upgrades, so having an excellent internalrequirements champion is critical to avoiding missteps.

From reporting to analytics

Organisations are naturally siloed and reporting frameworkstypically perpetuate these issues. So far, the author hasadvocated for the creation of a more cross-functionalmanagement dashboard, followed by a collaborative effort todefine a single approach to defining the key operating metricsand the elimination of all static reporting that are not incompliance with the agreed on definitions. This processinevitably leads to the ‘who moved my cheese’ phenomenonacross the rank and file in an organisation.

The next step is to empower the organisation’s members notonly with the capacity to answer their own questions, but alsoto view and leverage the data from across the organisation toanswer the second-, third- and fourth-level questions. The aimis to empower them with the capacity to proactively answer the‘why’ questions.

In Apax’s portfolio companies, we strive to create unified,flexible data sets that integrate the key managementinformation from all areas of the business into an analyticalframework that is dynamic and shows the key relationships

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between the various parts of the organisation. This usuallytakes the form of Excel spreadsheets that are distributed on aweekly basis. The format is as critical as the process; thedistribution of the raw data directly to the line managementteams enables additional self-directed analytical work withoutthe aid of a business intelligence professional, the creation ofanother static report or another ad hoc data request.

This process creates a unified ‘single source’ of data acrossthe organisation, which in turn builds transparency across alllevels and accountability at the executive levels (see Figure13.1). Debate shifts from various philosophical versions of theanswer to concrete, fact-based discussions.

Frequently, adoption is bumpy across the organisation. Acritical part of the process is for the leadership team to takethe lead on compliance. In cases where a manager makes acase with data that has been gleaned from a source otherthan the unified approach, the executive team must refocus onthe central data source.

Figure 13.1: Bringing multiple data sources into one single datarepository

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Source: Apax Partners.

Once the organisation has successfully adopted the newtoolkit, another run should be made at eliminating the‘cockroaches’ in the static reports produced within theorganisation. Additional cost savings and fewer e-mailedreports are ancillary benefits that may result from this process.

Truth to transactions

The payoff of this rapid transformation approach is anempowered management team focused on actionable metrics.The following are a few tangible examples of where thisprocess, in parts or its sum, has led to operationalperformance that drove tangible equity value.

Case study 1: Sales force effectiveness in informationservices

Data sources integrated into the unified framework: Productusage, sales history, customer revenue, content productioncosts, retention information

By bringing all these data sources together into a flexibleExcel dashboard, sales team members were empowered withinformation not only about what their customers were payingfor the service, but also specifically what those customerswere getting for their money. Before visiting with clients ordiscussing potential renewal pricing, individual salesrepresentatives could review the parts of the service that thecustomer had accessed, the number of individual licenses thatwere being utilised and the frequency of utilisation. Thisenabled more targeted selling, customised pricing and productbundles, and increased client retention based on return oninvestment.

On the other end of the spectrum, the framework has givensales managers visibility into the types of clients that are most

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profitable based on the content they consume relative to thecost of producing that content. This data can be sliced byregion, by industry and by job function. Armed with thisinformation, sales managers can be more efficient in advisingsales representatives to target specific customers as opposedto going only after volume.

Case study 2: Marketing effectiveness in classified leadgeneration

Data sources integrated into the unified framework: Televisionspend, online media spend, lead generation statistics,classified advertising volume, revenue

As has been famously said, about half the money spent onadvertising is usually wasted. However, with a propercross-platform integrated marketing dashboard, anorganisation can be much more tactical in measuringresponse across mediums and platforms. Using the integratedapproach allowed us to evaluate our media effectiveness at aregional and a channel level. As we read response rates, wemade rapid spend allocation decisions on direct responsemedia, and were able to make more effective long-term mediainvestment in mediums requiring longer lead times liketelevision and radio.

In addition, by bringing offline and online spend and responserates into a central location, the portfolio company was able tomore effectively identify the halo effects of brand advertisingon the direct response channels where it was spendingmoney.

Case study 3: Product development in online financialservices

Data sources integrated into the unified framework: Displayadvertising revenue, web traffic, multivariate testing data

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Fundamental product overhauls are always a riskyproposition. They frequently involve significant capitalinvestment, cross-functional collaboration, and can tie upresources for months or years. Defining success in theseefforts is frequently about avoiding catastrophe at the outset.Integrated dashboards can be quite useful in aligning across-functional team on a set of objectives for success in aproduct launch. While project teams frequently discussmilestones to getting the project out the door, the successcriteria for each functional area frequently remain isolatedfrom the overall success of the project.

In the case of our financial services platform, our 100-day planincluded a significant change to the platform’s core productset. Beyond investing in the technical aspects of projectdelivery, we also invested in the underlying reportingframework that clearly defined success with a narrow andunambiguously positive metric. The team was able to agreethat if more revenue for every unit of traffic to the platform wasgenerated, the new product would be considered animprovement over the old. Fewer than ten metrics formed theexecutive dashboard for project success. Raw data wassourced from multiple systems, integrated into a dashboardand distributed on a daily basis in Excel. Combined with atesting platform for continuous improvement (see Figure 13.2),the results of the effort were greater than a 20 percentincrease in revenue performance over a 15-week testingperiod.

A note about online businesses

Online businesses are inherently data intensive, which creates asignificant opportunity for optimisation and performance above andbeyond what can be achieved in more traditional arenas. Whentackling reporting, and in particular when approaching productdevelopment efforts, companies should take the time to develop thecapacity to iterate and test their way forward to success. Integrated

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dashboards are still a critical part of this success, but performance canbe measured on a more granular level. Moreover, performance alsocan be unambiguously scientific in guiding continuous improvementefforts.

There are many technology solutions that can empower A/B andmultivariate testing in online businesses. Successfully implementingthese frameworks is a more comprehensive management task than acomplex technical one. Below are a few guidelines for successfullyimplementing a testing platform for continuous improvement:

• Make it blind. Inviting customers to try your new product will lead tosignificant selection bias and can result in difficulty interpreting theresults compared to the prior versions. To the extent possible,customers should be participating in a ‘blind’ beta test. They shouldexperience the new product as if it were the only product available.

• Plan to fail. Always assume that the first iteration of a new productdesign is going to underperform the existing one. Resources assignedto the project should view the initial A/B test as the start of thetransformation effort, not the end of the project. IT resources shouldnot roll-off a project on launch day.

• Make a list. Engage teams prior to launch to determine the elements ofthe product that you think are most impactful to test, and plan multipletest phases after the launch so that all constituents of the project feelthat they have ownership.

• Small stuff matters. More than in offline businesses, the impact ofsmall issues, bugs and minor site changes can be critically impactful.Multivariate testing of every page element or inline interaction pointfrequently yields as much upside as the ‘big ideas’ embedded in thenew product.

Figure 13.2: Sample approach to data-driven onlineoptimisation

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Source: Apax Partners.

Conclusion

This chapter necessarily assumes that a ‘miracle happens’and that underlying systems and technology are not ahindrance in getting access to the management datanecessary to build the analytical tools described. The focus ison the management systems and processes needed to drivevalue creation as opposed to the technical obstacles to theirachievement.

Bringing data together into a single unified platform andmaking it accessible in its raw form to line managers cancreate accountability for executives, transparency for ownersand drive improved company performance. The journey tosuccess is (at least) equal parts a management alignmentexercise as it is a technical investment. The leadership of thecompany, from the CEO down to employees, must be broughtinto the key performance metrics integration process. Theprocess is as follows:

• Step 1: Create a narrowly defined executive dashboard that isaligned around cross-functional metrics that all constituentscan view as ‘unambiguously positive’ business drivers. Avoid

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data integrity traps by selecting inputs whose definitionscannot be disputed.

• Step 2: Build the foundations for your analytical framework byaligning on the definition of key operating terms likecustomers, clients, costs and conversion. Break down thereporting frameworks that perpetuate silo-specific definitionsof those key terms. Cull existing static reports to eliminate allartefacts that are not in compliance with the agreed onapproaches. Integrate management data from acrosscompany siloes into a data warehouse or equivalentframework.

• Step 3: Deploy cross-functional management dashboards thatcan be easily manipulated and contain all the necessary rawdata from various parts of the organisation to enable endusers to answer the ‘why’ questions that arise from standardreporting. Ensure compliance in analytics from the top down.Proactively communicate throughout the entire process toprevent backlash at the line management level and carefullymanage downstream impacts to employee pay orperformance.

Seth Brody is an operating partner at Apax Partners based inthe New York office. Since joining the firm in 2008, Seth hasbeen extensively involved in driving operational performanceand accelerating growth across Apax’s global portfolio. Hisprior executive operating experience includes roles asexecutive vice president and general manager at RazorgatorInteractive Group, as group vice president and generalmanager at Orbitz Worldwide, and as director of marketing atPriceline.com. Seth serves on the board of directors forBankrate, Inc. (NYSE:RATE) and is a member of the advisoryboard at NETRADA Management GmbH. He also serves asan advisor or board member for several privately held

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companies. Seth received his BA from Yale University and hisMBA from Harvard Business School.

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Chapter fourteen

Exiting by design: building the best way out

By Shyam Gidumal, Ernst & Young LLP and Martin Hurst,Ernst & Young GmbH

Introduction

In private equity, getting ‘out’ means getting rewards. Althoughthere may be interim payout events, exits remain the principalgenerator of private equity returns. A typical exit may take theform of an outright sale to a strategic or secondary financialbuyer, or an initial public offering (IPO). Prior to the 2008global financial downturn, such exits were easily executed asthere was a large pool of active buyers. More important,financing was readily available and the M&A market wasbuoyant. In today’s comparatively more cautious,financing-deprived and uneven capital markets, sellers needto be more flexible and to be prepared to move fast.

Tougher competitive conditions are driving a more intensefocus on business fundamentals. Potential buyers are, forexample, more insistent that an asset be more than merelyprofitable today – assets must also demonstrate a trend ofsustainable growth in top-line revenues. Absent a compellingbusiness vision or cost-rationalisation plan, any uplift in assetvalue at exit will be reduced.

This leads to a situation where finding a path to a profitableexit – the right to claim the sort of returns expected by privateequity limited partners – requires considerably more effort. Togain favour with prospective buyers, a portfolio companycannot merely be tweaked from its state at the time of theoriginal investment. It must exhibit thoroughly improvedfundamentals and a clear path for continued growth.Accordingly, a growing number of private equity firms arerecognising the need to delve more deeply, not only into the

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strategy, but also into the operations of their portfolio holdings.Private equity firms are also becoming more open tonontraditional alternatives to enhance value – for example,looking to spin-offs, joint ventures and acquisitions – as ameans to transform individual portfolio companies.

Leading private equity firms are also now applying moreresources to discern the key attributes valued by potentialbuyers. Through a clearer recognition of sector trends, privateequity firms believe they can be more effective in guiding thedevelopment of their portfolio holdings to appeal to a futurebuyer’s needs. Overall, by combining a sense ofentrepreneurial spirit with execution, speed, creativity,planning, flexibility and follow-through, private equityexecutives are improving their prospects for earning a morefavourable conclusion to their investment. They are aligningan exit plan to connect with today’s market participants in thekey sectors in which they invest.

This chapter explores the state of play for profitablytransferring portfolio interests and how private equity firms canbest position their portfolio companies for a successful exit.

Current market conditions

Prior to the global downturn of 2008, exits were morestraightforward for both private and public companies. Equitymarkets were more optimistic, demonstrated by highvaluations correlated with forward multiples and EBITDAprojections. Banks were ready to provide large amounts ofleverage, a vital driver of initial investments and subsequentexits. Strategic buyers were more active, often providing a keysource of investment capital. All of this contributed to a robustand lucrative array of both initial investment and exitopportunities.

Figure 14.1: European private equity exits, 2005–2010

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Note: Number of deals = 381.Source: Ernst & Young.

Figure 14.2: European IPO exits as a percentage of privateequity exits, 2005–2010

Note: Number of deals = 381.Source: Ernst & Young.

Today, however, the environment is very different. In general:

• Bank lending has substantially decreased from historic levelsand credit standards have risen.

• Public markets remain highly selective, limiting the number ofsuccessful IPOs.

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• Strategic buyers are less active, despite holding record levelsof cash.

• Conditions have improved relative to the depths of the globalrecession. Moreover, certain sectors have observed dramaticspikes in IPOs and an uptick in corporate acquisitions.Nonetheless, the reality is that many of the more traditionalexit routes remain difficult. For at least the time being, manyprivate equity firms are holding on to their portfolioinvestments for a considerably longer period than initiallyenvisioned.

Figure 14.3: US private equity exits, 2006–2010

Note: Number of deals = 441.Source: Ernst & Young.

Figure 14.4: US IPO exits as a percentage of private equity exits,2006–2010

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Note: Number of deals = 441.Source: Ernst & Young.

Improved conditions, but still a backlog

Since 2005, Ernst & Young has been performing a study ofvalue creation in private equity portfolio companies, both in theUS and Europe. While new investments, exits and the size ofthe portfolio all reached a peak in 2007, the number of exitsfell by half in 2008. By 2010, the number of exits climbed to anew high – demonstrating a recovery in the exit market1. (SeeFigures 14.1 to 14.4)

However, problems persist. Most notably, there continues tobe a backlog of private equity portfolio companies that haveexceeded the traditional hold period. In 2010, in the US alone,the number of these companies reached a record level ofapproximately 6,0002. Of these, a large percentage wereacquired during the peak of the M&A market, from 2005–07.Having paid an acquisition premium during that cycle adds tothe challenge of creating value on exit.

The result, Ernst & Young’s analysis finds, is a continuedincrease in hold periods. The average holding period for dealsexited in 2010, at 4.4 years, was the longest observed sincethe study began in 2005. Meanwhile, with cash conservation apriority among corporate institutions, a reduced M&A activity

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level in both the US and Europe only increases the backlog ofprivate equity-held companies. Trade buyers have historicallyprovided the most significant exit route for private equity.

The situation going forward remains challenging. Exits viaIPOs, for example, rose substantially through the secondquarter of 2011. However, given cautious and selective globalpublic markets, success via the IPO route remains reservedfor best-in-class companies only. Meanwhile, the improvementin IPO exit volume that began in 2010 now appears to beslowing. In short, the right to a profitable exit must be earned.

Focus on fundamentals

Today’s potential buyers are broadly cautious, highlysophisticated and laser-focused on a would-be acquisition’sfundamentals. As a result, securing the interest of new buyers– and therefore an exit – requires an array of impressivecredentials. Some of the necessary attributes include:

• Sustainable performance. Today’s buyers delve deeply into abusiness’s cash flows. They want to know how the company isachieving its earnings and what drives its performance. Inparticular, they are assessing more closely whether pastresults are repeatable and whether assets are being squeezedto deliver short-term results.

• Recession-resistance. Buyers are looking to see how thebusiness performed during the last downturn, paying closeattention to how well the cost base adjusts to revenue swings.

• Top-line revenue growth. EBITDA matters. However, today’sbuyers want to see clear evidence of strong and sustainableorganic growth. They want to see a dynamic market and aproduct story with evidence of innovation and adaption tochanging customer and market needs. Market leaders willearn a premium over followers.

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• A compelling vision. Those guarding the exits – buyers – wantevidence that a portfolio company is not only running profitablytoday but is also poised for strong future growth.Consequently, buyers will want to hear detailed projectionsand see tangible evidence of ongoing success.

• Confidence in cash flows. During the recent downturn, highlevels of leverage forced numerous, otherwise healthybusinesses into difficulty as unexpected and oftenunprecedented cyclical swings led to covenant breaches.Many companies were forced to focus on survival viashort-term debt servicing, depriving the business of capitalneeded for fuelling longer-term growth. Buyers today look forstronger assurances that businesses can adapt to short-termvolatility. They will therefore more carefully scrutinise financialstatements and projections in search of evidence of not onlystrong growth, but also an ability to withstand volatility. Forexample, what are the company’s contingency plans amidweakness? How have demand shifts impacted margins? Howflexibly can it adjust capacity?

• Honesty, openness and thoroughness. Buyers today expectgreater transparency relative to transactions of the past. Theyneed a strong sense that all representations are reliable andthat an owner is communicating fully, clearly and openly.Much of this behaviour is on display in the due diligenceprocess.

Absent any of the above characteristics, the likelihood of adeal being struck to conclude an exit will be greatlydiminished.

Forging a response

Rather than lament about today’s market conditions, savvyprivate equity firms are instead hard at work to achievepositive outcomes. Some of the more compelling and effectivestrategies in evidence today include:

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• Anticipating market needs, then customising plans.

• Demonstrating an intense focus on operations.

• Expanding the focus on management, starting with executivemanagement.

• Taking incremental actions to make the asset more attractive.

• Incorporating M&A into a new investment thesis.

Anticipating market needs, then customising plans

Traditional exit routes are by no means closed; markets aremerely more selective. The focus today is on real value. Inorder to gain access to traditional exits, private equity firms arehard at work at driving both high-quality revenue growth andsustainable cost reduction. Simultaneously, however,executives are working overtime in terms of moulding theirportfolio companies to match the needs of today’s marketconditions and, in many instances, the specific attributesattractive to buyers.

Developing a sophisticated view of the future is equal partshard work, innovation and intuition. The broad objective is tolook ahead to future needs and trends in specific sectors andask the following questions: what capabilities will be most indemand? Within various sectors, what is it that specificpotential strategic or financial buyers will be seeking? Whatare the capabilities and characteristics of the assets thesebuyers will likely need?

Such insights are then being used to drive specificdevelopment within portfolio companies. The key to growth inone business-to-business (B2B) sector might be access to agiven set of functional executives among corporate customers.In such a case, the private equity firm might guide its portfolioholding towards a broader product and service line to plungeinto still-deeper relationships with its customers.

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One high-risk, high-reward strategy is to become a marketleader or a specialist in a sub-sector. Niche businessesexhibiting a competitive advantage often command a premiumprice. The ability to demonstrate technological anddevelopment leadership requires considerable focus andeffort. If successful, this has the benefit of differentiating theasset in the eyes of both private equity buyers (who like toinvest in niche businesses) and strategic buyers (who will seethe target as filling a void in their portfolio).

Alternatively, the growth driver in a more consumer-orientedsector might be emerging market exposure. Here, the portfoliocompany might lack the contact base and local know-how tobuild a stronger foothold, for instance, in India or China.Leading private equity firms are stepping in, using theirexperience and contacts to help their portfolio companies buildand/or acquire appropriate capabilities and market access inorder to become more attractive to a future strategic buyer.

Private equity firms are also finding value in paying closerattention to developments in the M&A markets. In particular,they are noting the number of large companies executingspin-offs and carve-outs as a means of driving greater focuson the core while looking toward a future exit. Private equityfirms are asking themselves: what are the specialised needsof these newly minted businesses? Once an entity is carvedfrom its parent, it might, for example, begin to seek scale in itsnow more pronounced specialisation. A portfolio company cantake note of the carve-out and begin focusing more intently onareas likely to be of interest to a new strategic buyer.

A conscientious owner may take additional steps to improve aportfolio company’s valuation. Developing a set of carve-outfinancial statements can give a buyer a sense of addedconfidence, as can third-party market assessments orbusiness-plan benchmarking.

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Developing a deeper understanding about how largerenterprises are decoupling and recalibrating can help guidethe development of a private equity firm’s portfolio holdings.The more skilfully a private equity firm can anticipate the futureneeds of these companies, the more capably it can tailor thedevelopment of its portfolio holdings via step changes instrategy and operations or via a series of incremental shifts tofill buyers’ gaps.

Demonstrating an intense focus on operations

It is now much more difficult to stand out from the crowd.Financial engineering and market knowledge still play a role,but today, there is a real recognition of the need to moredemonstrably achieve the above-described fundamentalattributes of a successful exit. The key is working more closelywith the portfolio holding’s management team.

Private equity firms are exuding a shift in mindset. Inparticular, they are becoming decidedly more hands-on. Theprospects of a private equity firm and the performance of itsportfolio holdings have always been inextricably linked;however, the competition for exits is leading to an evenstronger sense of common destiny and therefore an increasein commitment, passion and collaboration.

In lockstep with this shift in orientation is a sea change instrategies and tactics. Private equity firms are, for example,getting more involved at the operational level. They are drivingimprovements in all aspects, from supply chain managementand vendor relationships to channel management andcustomer strategy. Loosely described, whereas private equitymanagement historically took place from a primarily top-downperspective, today, a growing number of firms are expandingtheir focus to include vastly more work from the ground up.

This is leading to the development of best practices. Prior topulling the investment trigger, private equity firms are

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developing detailed operating plans. For example, the creationof 90-day or 100-day plans (depending on circumstances)itemises action plans and execution steps detailing every keyvalue driver in the investment thesis. While the existence ofsuch implementation tools is not new, what is new is thedegree to which private equity firms are getting involved in thedevelopment and ongoing oversight of their portfoliocompanies.

Expanding the focus on people, starting with executivemanagement

Some private equity firms have played an active role insecuring and motivating top talent in their portfolio companies.However, in order to accelerate the achievement of milestonesalong the path to an exit, talent strategies are becoming evenmore hands-on and sophisticated, as well as more deeplyapplied.

Achieving goals requires having the right people in the rightplaces at the right times. Today, leading private equity firmsare taking steps to ensure that the management teams at theirportfolio companies are supported by an array of experiencedmanagers, former CEOs and other appropriate humanresources. Whatever the objective, be it expansion into new oremerging markets, deployment of new technologies or pursuitof new customers, private equity firms are recruiting andproviding their portfolio companies with access to top talent.

Some firms are developing what could be described asportfolio support teams – groups of experienced managersready to jump in with as-needed sector, technical or functionalexpertise. In addition, a growing number of private equity firmsare partnering with other private or public companies, oroutside consultants, to ensure access to top-qualitycapabilities. Still others, in pursuit of not only talent but alsobroader organisational capabilities, are implementingcorporate development strategies within specific portfolio

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businesses. (See the section titled Incorporating M&A into anew investment thesis below.)

Private equity firms are also going deeper with their humanresource strategies. No longer focusing solely on a target’ssenior management team, private equity firms are now takingtheir hands-on approach to a portfolio company’s operations.This means assessing talent needs from bottom to top.Increasingly, for example, private equity firms are gettinginvolved with not only recruitment and retention at theoperational level, but also with job descriptions, training andcompensation.

Charting a course to an exit is no longer enough. Privateequity firms are recognising that they need to be more activein ensuring that their portfolio companies have the rightresources to accomplish stated objectives. If the strategy callsfor more aggressive marketing, the private equity firm ismaking certain its portfolio company has the right sales,marketing and business development teams. If emergingmarkets are a key focus, then the private equity firm will aid inidentifying local contacts and partners to execute overseas. Inshort, private equity firms are learning that the more they cando to get the right resources in place, the shorter is the path toexit.

Taking incremental actions to make the asset moreattractive

The more that can be done to enhance the attractiveness ofan asset, the more value it will command in the marketplace.Current owners are no doubt intensely focused on quantumimprovements in their portfolio companies. Strategic actionssuch as the pursuit of new markets, optimised distribution orstreamlined supply can lead to a step change in performanceand value. In the meantime, however, private equity firms arenot overlooking the basics – the full set of tactical or

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operational actions that can help to convey significant value toa new owner.

For example, the longer it takes a buyer to assimilate anasset, the more value is lost. For this reason, leading privateequity firms are doing more to improve the odds that theirportfolio companies will be ready for business integration onday one after the sale. This means, for example, having anaction plan for transferring titles and obtaining various licensesfor doing business in all of the countries in which the portfoliocompany operates. It can also be beneficial to create a meansfor obtaining additional financing. Here, a private equity sellercan proactively develop the sort of financial informationneeded to launch a capital markets offering (for example, abond deal). This creates value, as the buyer will have moreopportunities to adjust financing immediately after takingcontrol, rather than waiting the many months it could take todevelop such information from scratch.

The key concept is to begin thinking of the steps that will needto be taken once a new owner takes control. To the extent aprivate equity seller can anticipate and address such needs –and communicate the value of such actions to a potentialbuyer – the attractiveness of the asset for sale increases.

Incorporating M&A into a new investment thesis

The traditional private equity model may be described asacquire, transform, then exit. Such a strategy can be executedin two basic transactions: a buy and a sell. However, agrowing number of private equity executives are recognisingthat driving a portfolio company to where it needs to be at exitmay require one or more additional transactions to bolster thestrength of the company. Such circumstances could bedescribed as the pairing of traditional corporate developmentwith the traditional private equity model.

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The passage of time increases the likelihood that more add-ontransactions will be the path to growth. The longer a companyis held within a portfolio, the more changes will likely havetaken place within the company. By having to hold on toportfolio companies for a longer time period than expected,private equity firms often face vastly different circumstancesthan on entry. Not only have the portfolio companiesthemselves changed, but significant evolution is also likely tooccur throughout the markets in which they operate. Shifts intechnologies, channels, costs, regulations, competitors andthe like tend to alter the drivers of performance and success.No longer is it a case of continuing on the path of the initialinvestment thesis, but rather one of establishing what might bean evolved and enhanced vision for value creation particularlypost-recession.

Core initiatives

In the past, private equity firms could create value in their portfoliocompanies by combining market arbitrage, financial engineering andrestructuring with a few key a adjustments to executive compensationpackages. Today, however, private equity firms are putting forth morehands-on managerial effort to build value in their holdings. Some ofthe areas garnering the most acute focus today include:

Growing top-line revenue

• Revisiting customer relationships and customer value.

• Strengthening the sales force.

• Adjusting compensation and incentives.

• Expanding the set of new products and services.

• Developing more differentiated pricing.

• Pursuing opportunities in the emerging markets.

Optimising costs

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• Introducing shared services/outsourcing.

• Improving purchasing processes.

• Developing labour force flexibility.

• Optimising the supply chain.

• Re-examining capacity utilisation.

• Re-engineering IT.

Optimising resources

• Performing talent gap assessments.

• Developing and sharing core resources.

• Ensuring access to specialist expertise as needed.

A fresh take on an investment thesis can lead private equityfirms to look more closely at M&A – not as an exit, but more asa tool for positioning the existing portfolio company moreattractively for an exit. Is there a need to get more involved inemerging trends in the industry? The right M&A strategy cantransform a company from average to a leader. Does thetarget need scale? Seek similar companies – this can lead notonly to scale but also operating synergies. Are emergingmarkets important to future growth? Execute one or moreBRIC or other high-growth market acquisitions, or create ajoint venture or two. Are some of the assets initially acquiredno longer appropriate for the vision going forward, or is thevalue of the business as a whole being diluted by theperformance of a small portion of the overall assets? In suchcases, consider a spin-off (creating two or more specialisedentities) or a carve-out (not a full but a mini-exit).

Becoming more active in M&A will, in many cases, requireprivate equity firms to seek out or to develop a range of newcore capabilities of their own. Certainly, many firms have

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considerable M&A experience. However, some firms may stillneed to hone their skills relating to the integration of acquiredassets. While many private equity firms have substantialexpertise in fine-tuning the operations of a single business,combining unrelated entities introduces a wide array of newchallenges such as culture, management, composition,systems and reporting.

Conclusion

Traditional exits for private equity portfolio companies are byno means closed. Corporate buyers are in fact awash in cashand searching for growth. While relatively reluctant to invest ingeneral, for the right fit even cautious executives can bemotivated to transact. Similarly, for private equity firms with thecapabilities and vision to take a portfolio company to the nextlevel, financial buyers are willing to move on appropriateopportunities. Even an IPO can still be successful today, giventhe right fundamentals and market receptiveness.

However, the emphasis in all cases goes back to the coreprinciple that the value of the company on the auction blockmust be demonstrable and sustainable. With buyers morecircumspect and with such an increased a focus onfundamentals, achieving an exit in today’s context meansmore effort is required.

Private equity firms are indeed responding. They are, forexample, doing more to address fundamentals, such as thequality of cash flow, earnings and top-line growth. In addition,they are doing more to anticipate the needs of potential buyersand then engineering their portfolio holdings to meet thosedemands.

Questions for further reflection

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• How much have conditions changed relative to the development ofyour initial investment thesis? What have you done to update yourinvestment thesis?

• What are you doing to drive top-line revenue growth?

• How sustainable are your strategies and business plans? Are youmanaging your holdings for short-term or long-term value? Are youadequately balancing the need to protect your managers fromshort-term earnings requirements with long-term value creation?

• Do you know who will likely be your buyers? Are you aware of thechanges in your buyers’ own strategies and business structures?

• Do your portfolio companies have the talent they need? How do youknow?

• Do M&A markets present any opportunities to acquire additional,needed capabilities for your portfolio holdings?

All of this requires a greater operational focus. Leading privateequity firms are responding by forging closer relationships withtheir investees and, in many instances, by adopting agenuinely entrepreneurial mindset. In the same vein, privateequity investment professionals are pulling out all the stops tomake sure that the executives managing their assets haveaccess to all of the skills and expertise relevant to thebusiness strategy.

Indeed, markets have grown more cautious and selective.However, by adapting strategies to meld with today’s businessrealities, private equity firms can improve their odds ofsuccess. The above examples, a broad outline of the waysleading companies are adjusting their operations, are merelyindicative of what can be accomplished once executives beginto focus on the challenges of securing the most profitable exitpossible for their portfolio holdings.

Shyam Gidumal is the markets leader for the OperationalTransaction Services practice of Ernst & Young LLP based in

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the Northeast US. He has been active in the private equitybusiness for the past 20 years. Before joining Ernst & Young,Shyam had served as an operating partner and a generalpartner in institutional private equity funds, as well as chiefrestructuring officer, president and CEO of portfoliocompanies. Over the years, Shyam has worked in multipleindustry sectors including consumer products, retail, realestate, technology, telecommunications, manufacturing andlife sciences. He holds an MBA from Harvard University’sGraduate School of Business Administration and a BA inMathematics from Columbia College in New York.

Martin Hurst is the Transaction Advisory Services’divestments leader for EMEIA at Ernst & Young GmbH, basedin Frankfurt, Germany. He has over 20 years of experience intransaction support within Ernst & Young’s TransactionAdvisory Services practice and has a background inaccounting both within the profession and working as afinance director in industry. Martin has been a partner of Ernst& Young GmbH since 2001. For the last ten years, Martin hasfocused on sell-side advice to both corporate and privateequity clients. He has led more than 50 large successfulsell-side transactions, many of a cross-border nature. He hasa university degree in Economics, is a UK qualified charteredaccountant and is a member of the Australian Institute ofChartered Accountants.1 Ernst & Young, Return to warmer waters: How do privateequity investors create value? 2010 North American and 2010European exits reports, available at http://www.ey.com/Publication/vwLUAssets/A_study_of_2010_North_American_exits/$FILE/How_do_PE_investors_create_value_N_America.pdf andhttp://www.ey.com/Publication/vwLUAssets/Return_to_Warmer_Waters_PUBLIC/$FILE/Return%20to%20Warmer%20Waters%20PUBLIC.pdf.

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2 PitchBook.

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About PEI

PEI is the leading financial information group dedicated to thealternative asset classes of private equity, real estate andinfrastructure globally. It is an independent company with over70 staff based in three regional offices – London, New Yorkand Hong Kong – and is wholly owned by its management andemployees.

We started in London in November 2001 when a team ofmanagers at financial media group Euromoney InstitutionalInvestor PLC, with the backing of US-based investors, boughtout a group of assets that centred on the websitePrivateEquityInternational.com. At the time the new companywas called InvestorAccess, and the aim was to grow aspecialist media business that focused on alternative assets –and private equity in particular.

In December 2001 we launched our first magazine: PrivateEquity International. A year after, we had run our firstconference in London and published our first book. A yearlater, we had opened our New York office and launched twomore magazines: PE Manager and PERE. Next came thelaunch of our fourth magazine PE Asia in 2006. In 2007 wereleased our first online database and the year after we addedspecialist training to the portfolio as well as an awardsbusiness. In 2009 we launched our fifth magazine,Infrastructure Investor.

In May 2007 the same managers completed a secondaryMBO that enabled us to own all of the business we had builtand give our original co-investors a great exit too. RenamedPEI, the company remains one of the few independentfinancial media groups active worldwide.

Today we publish five magazines, host five news websites,manage a very extensive set of databases dedicated to

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alternative assets, run in excess of 25 annual conferencesglobally, publish a library of more than 30 books anddirectories and have a fast-growing training business.

We have grown into a well-known and highly regarded mediabusiness that delivers detailed coverage of the mainalternative asset classes of private equity, real estate andinfrastructure. We have worked hard to build a reputation fortop-quality journalism that is written by our own staff and isdelivered via accomplished print and digital channels. Thesame principles of accuracy, genuine market knowledge andexcellence of delivery also inform our data, events andspecialist publication activities.

In April 2009, PEI won The Queen’s Award for Enterprise2009. The award was made in the international trade categoryas we have more than doubled overseas earnings in just threeyears and we now conduct business in over 80 countries. Aswell as looking at our commercial performance, the judgingprocess also examines the company’s corporate socialresponsibility, the company’s environmental impact and ourrelations with customers, employees and suppliers.

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