PE value creation tactics in a high-interest, long-holding environment

PEs can leverage tactics focused on managing working capital and cost optimization to enhance or preserve value.

In brief

• With 2024 starting, private equity firms continue to navigate a challenging environment – a trend that is expected to persist into the new year.
• While investors express cautious optimism for the 2024 outlook, private equity firms are tapping into previously unaddressed levers and exploring value creation tactics for the next 3-6 months to preserve and increase the value of their portfolio companies.
• Optimizing working capital and costs delivers tangible short-term improvements, helping to boost or preserve value, unlock liquidity, and enhance exit value.

The year 2023 has been a challenging year for private equity (PE) funds, driven by high inflation, increased interest rates, disrupted supply chains, and the economy in general taking a hit. These challenges have resulted in a decline in deal value (-48,5%1), total number of deals (-18,7%1), accumulation of dry powder (+7,1%2), and often a prolongation of holding periods for European PE dealmaking in 2023 compared to 2022.

With a new year starting, investors are expressing some optimism looking towards 2024, as bond markets demonstrate a decline in yield and the US Federal Reserve indicates that borrowing costs may have reached their peak in this cycle. But until the number of deals and overall deal value start picking up, PEs must go beyond conventional ways of value creation and leave no stone unturned to ensure continued value creation, and in some cases prevent portfolio companies (portcos) from going into distress. This poses the question what areas of value creation PEs should prioritize, and within those areas, which initiatives will allow portcos to drive performance to the next level.

Throughout the year, many publications have described how PEs adapt to the macroeconomic situation by focusing on aspects such as cash and liquidity, cost, talent, technology, and sustainability. A recent EY survey of PE investors from different regions and fund sizes revealed that investors have increased attention to managing liquidity and working capital, and cutting costs. Drawing on the experiences of supporting PE funds over the past year, we outline practical value creation tactics focused on working capital management and cost optimization with tangible impact on portcos’ valuations within the next 3-6 months.

Drive incremental value through working capital optimization

As interest rates were near zero in the past years, PE funds were especially focused on EBITDA maximization rather than cash management and working capital optimization. However, with the recent rise in interest rates, working capital and cash performance have become critical levers for value creation and building resilience, especially in the following scenarios:

1. Decline in revenue and raised interest rates having impacted liquidity: Working capital improvements can help release locked liquidity to prevent supply chain disruptions and lost revenues, offset margin/ cost erosion, improve service, and reduce net debt.
2. Underperformance in working capital compared to peers: Bringing working capital to industry standards can improve exit valuation.
3. Lack of funding for value creation initiatives: Liquidity released through working capital improvements can support funding.
4. Distressed situations: In times of distress, working capital management becomes a matter of survival.

To manage working capital more effectively, many PE-owned businesses have followed typical cash improvement methods, such as extending supplier terms, running down old stock or factoring some of the debtor book. While these tactics can help to some extent, PEs should also consider adopting holistic tools that enable firms to optimize working capital management.

A possible initiative would be to employ tools and processes to sharpen cash forecasting. Increased accuracy in predicting what is needed where and when and the inclusion of cash pooling and repatriation measures, will help optimize the use of existing cash. While cash flow forecasts are a requirement for most businesses, they are not always deployed effectively. A short-term (bottom-up) direct cash flow forecast for at least 13-weeks, with a weekly cadence of variance analysis, re-forecasting and mitigation actions typically proves most effective.

Another potential opportunity to improve working capital could be the use of advanced data analytics  for managing receivables, payables, and inventory. Leveraging advanced technology can improve trend tracking and digital processes. Moreover, transactional data analytics increases transparency and provide the business with actionable insights enabling improved cash performance .

Furthermore, the treasury management discipline is critical for supporting the cash forecasting and process improvements, as well as optimizing the liquidity of a portco’s cash position through cash pooling, releasing trapped cash and flexible financing structures. 

Address missed opportunities in costs

In the past favorable economic environment, most PEs pursued growth and executed buy-and-build strategies. Now that growth is more challenging to attain in the present economy, PEs need to reexamine cost streamlining possibilities that were previously ignored when the value creation strategy was centered on growth.

Streamlining operating costs starts by determining and implementing a well thought-through cost optimization strategy (COS). An effective COS typically aims at strengthening cost structures and providing transparency in processes. This increases operational leverage, leading to short-term profitability and long-term competitive advantage.

To determine the scope and intensity of the COS, PE operational partners need to have a true understanding of the real cost drivers of the business and benchmark these to peers. The benchmark study should identify best in class performers and indicate areas for improvement. PE operational managers need to evaluate the time and associated costs required for improvement initiatives and identify quick wins.

Four key areas for cost reduction and value creation are:

1. Control Spending: Focus on both direct and indirect spending, harmonize product ranges, and apply value engineering.
2. Simplify Operations: Reduce complexity and increase productivity by building an efficient operating model. Remove redundant roles and systems, unprofitable products and services, and right size the operations and overhead.
3. Efficient and Resilient Supply Chain: Optimize supply chain costs, integrate ESG agendas, and ensure tax efficiency.
4. Focus on Talent: Manage labor costs by enhancing productivity and talent retention, and developing high-quality leadership.

Looking ahead

To drive value creation and even avert distress, PEs and their portcos must streamline working capital and cost structures. Prior to doing this, PE operational managers should ask themselves whether their portcos demonstrate the right competencies and mindset to rapidly deliver on value.

Interested in how we at EY-Parthenon assist PE portcos on their value creation journeys? EY-Parthenon provides professional services to PE firms to unleash hidden value through various initiatives, such as working capital- and cost optimization. For more information, please contact one of the experts below.