Value Creation through Divesting: How and Where to Consider Value Drivers Post-Transaction?

Co-Authors: 

Steven Koinis, Managing Director, Private Equity - Catalyft LLC

John A. Bova, Transformation and Operational Excellence Leader in Private Equity Firms and Portfolio Companies

The currently strong Private Equity M&A environment still has legs. Debt options abound and pricing is plentiful. Over equitized deals with dry powder can create easily built structures for close. Value through add-ons is going to stay in vogue. Platform multiples continue to be high and rare. The interesting view could be that subtraction to gain continued addition provides compelling growth. 

High multiples for Platforms not too long ago were perceived as having plenty of lower-cost add-ons to blend down the acquisition multiple. While that data point is still measured in 2021, it may not blend down as far as thought. For instance, acquiring smaller supply chain participants may be easy and come cheap, but they may not move the top line substantially. Add-ons providing core needs such as products & services, synergistic sales organizations, and geographical expansion may be expensive. Thoughtful add-ons aligned with your prevailing Value Creation thesis may tick 80% of the boxes in a meaningful, yet expensive, way.

When considering divesting as a way to free up capital to reinvest in higher returning investments, these questions may pop up:

·      Why not rapidly drive value through the integration of the 80% with goodness of fit and sell off that other 20%? 

·      Can divesting assets that are a drag on results increase value and focus resources better for organic or acquisitive growth?

·      Has the last year forced recent add-ons to look less accretive to earnings due to the changes in the COVID economy or changes in the firm’s microeconomic conditions?

While focused on selling, successful value creation through divesting tends to borrow skills and approaches from buy-side Add-On and Corporate Development functions. Strong sellers think about buyer interests and how they can articulate ways the company will flourish under new ownership. It’s a delicate balance of investing in an existing portfolio firm with enough magnitude necessary to make an impact but not so much magnitude that it cut too deeply into your buyout multiple. In the spirit of investing in divesting, nine ideas to consider:

1.     Empower Value Creation Operating Teams - PE firms must have a strong alignment to the CXOs of the firm’s portfolio companies. Over the past decade, add-on acquisitions have become the major source of growth for PE-held assets. However, in many instances, acquired assets are not fully integrated into the platform due to financial, human capital, information systems or market segmentation reasons. Over the last year, it has become apparent some of the “roll-up” strategies within platform companies have assets that may be more of a drag on earnings than accretive. The sooner possible divestiture candidates can be quantified, the better the platform can utilize its resources more efficiently to drive its investment thesis and accelerate EBITDA. Hence, it requires flipping the Corporate Development function to the opposite side. It requires a simultaneous view of measuring and driving equity value creation and thinking like a sell-side banker, assessing the fit within the portfolio, and what firm capabilities can be synergistic or a value creator for the acquiring firm.

The firm needs to be clear on what activities drive value creation and, early on from acquisition, have clear, consistent criteria defining what does and does not fit within growth plans. Devoting time to a business that does not fit should not be second guessed. The longer the firm tries to force a fit; the more resources are used which, in turn, delays value creation force speed and impact.

2.    Assess Divestiture of underperforming Assets - this drives multiple opportunities for a portfolio company. First, it frees up capital, both financial and human, to focus on the execution of the value creation plan applied to higher returning investments. It also may allow the portfolio company to focus its freed-up resources on accretive add-ons. Furthermore, the path to add-on accretion involves the critical resource – skilled, experienced, talented people - who possess the ability to effectively integrate technologies and cultures to assimilate the asset seamlessly into the portfolio company. 

3.    Capture Corporate Development Best Practices - they are critical to value creation when evaluating an add-on and divestiture list. Focus on key new business capability developments and value creation drivers in the industry are the basis for investment thesis implementations over time. As markets change, the accumulated market intelligence will drive portfolio value further. The firm begins to develop a collective wisdom on day-to-day organic growth but also lessons learned through corporate purchases and asset sales. Portfolio company leadership, PE firm direction and, if the development knowledge is not in-house, third-party consultants and advisors may fill the gaps in identifying and executing the most valuable acquisition practices and divestiture strategies.

4.    Extend Executive Leadership’s Reach - leadership has multiple draws on its time during this process, especially during the first years of entering a PE firm’s portfolio. If this is the first institutional capital injected into a company, existing or newly placed executive leadership must focus the organization on shorter-term cash flow and return on investment metrics versus the typical longer-term horizons of former founder-led or corporate carve-out assets. Drinking from a firehose is a cliché but it’s apt here. Executing an add-on strategy in the near term not only can improve EBITDA, but can also shorten holding periods as the portfolio company grows its top and bottom lines faster. The most important variable with this strategy, however, is the add-on’s integration into the platform. As we suggested earlier, integration can soak up significant human capital and system resources. It is also important to have a data-backed sense when an acquired asset may be a drag on earnings and other critical resources. This alarm bell using too much capital (human, systems, financial) without a commensurate return to the platform should focus management to question the path they are on and even the goodness of fit of the asset in the future. 

5.    Ramp Up Communication – messaging during a divestiture process throughout the organization and with the sponsor is, without question, extremely important. Retaining revenue, talent, and intellectual property of the carve-out candidate must be front of mind in order to not rapidly lose value. Thoughtful consideration of a TSA (Transition Services Agreement) is valuable in keeping management of the carve-out focused on its future. If extending it allows for a deal to get done at the valuation desired, it is a good lever in the deal structure. Buyer diligence of the carve-out Financials, Separation Assessment, and TSA will help the transaction. Working with the acquirer’s program management and value creation plan could provide some new best practices and an ease to deal closure. If the goal of the divesting platform is to free up human capital and financial resources, an extended “through the eyes of the acquirer” sensibilities can be invaluable. The timeliness of acquiring, integrating, and divesting allows for greater value creation of the overall platform company and will lead to a higher risk-adjusted EBITDA, greater operational efficiency, and perhaps, greater clarity of the gaps needing to be filled through the next add-on.

6.    Build a Revenue Roadmap (Thinking About Buyers) – Everyone respects revenue growth – especially potential buyers. Make it easy for potential buyers to understand the business development functions and efficacy a firm has by documenting “current state” Business Development functions such as prospecting capabilities & responsibilities or any existing voice of the customer (VOC) programs sharing insights into current products & services offerings. Assure potential buyers the firm has a customer relationship management system filled with qualified leads, knows their target markets intimately, and has a path to retain current relationships beyond divestiture. If the firm has any stand-out marketing capabilities or integrated, productive content management programs, make sure potential buyers know how these play into current and future customer conversion rates. Share a plan for retaining key Sales talent with incentives and retention programs already in place. If the team has pricing optimization opportunities or even a process or team to improve pricing yields, get credit for this ongoing revenue builder as well.

 For “future state” Business Development functions, let potential buyers know where the team is on their improvement trajectory and what they still need to get accomplished. Essentially, the divesting team wants to get potential buyers to dream about the next big revenue source on the horizon. Sharing this aspiration around what the new buyer could get accomplished may involve pulling back the curtains on innovation and experimentation support within the firm, research & development processes with promising projects underway, internal knowledge management systems (KMS) that may help share revenue-generating opportunities, and most certainly intellectual property examples (patents and trademarks) with further monetization potential. Incorporate “current state” capabilities and “future state” potential into reasonable revenue projection models backed up with a tangible roadmap of what the firm’s functional divisions (Sales & Marketing, Operations, Finance, and Human Resources) need to stop, start, or continue to meet revenue goals.

 7.    Get Information Sources Reliable and Crisp (Thinking About Buyers) – Sell-side experts must recall the buy-side frustration of not having reliable data and employing spotty information to decide on a fair buying price. Why not make it easier for a potential buyer to know what’s under the covers? Provide a compelling way to document and share the current data sources flowing through the tech stack and culminating in usable, reliable operational & financial reporting capabilities. Document ongoing software licensing requirements. Provide a snapshot of what the firm’s technology ecosystem looks like today (tech partners, make vs. buy software, internal capabilities, etc.) to allow potential buyers to know what hardware and software expenditures may be incurred on their watch. The firm may even have servers overflowing with Social Media data points that can be analyzed for demand-sensing cues or customer experience temperature checks to take into consideration. If Marketing is not set up to analyze this type of data, then build a process or team to do so.

Share a view of how the data sources are analyzed and applied by Management to make day-to-day decisions. If Management cannot articulate KPI trending that matters to the business or performance analysis & reporting is weak, then invest in building up the team’s analytical capabilities. If information is reliable and crisp, then potential buyers have less room to discount the selling price due to lurking variables and unknown risks.

 8.    Create Operational Playbooks (Thinking About Buyers) Document how the company runs day-to-day with processes, procedures, and training content. Share roles and responsibilities tied to the current organizational chart. Create instructions for how the new buyer could open up new locations or expand e-commerce capabilities. Provide a detailed summary of the “current state” supply chain and procedures for key components such as procurement practices, inventory controls, transportation sources, and warehousing models. If the firm has a project management office (PMO) in place, there may be value in boosting the selling price by sharing extant project artifacts, lessons learned summaries, or even risk mitigation strategies that worked in the past and will be relevant in the future. Create a plan for any necessary separation strategies or service level agreements after the sale. Aspire to make it clear for potential buyers to see where operational synergies may reside if they sign. Make it easier to see where future operational improvements could, or should, be enacted.

9.    Build A Foundation for Culture & Talent Retention (Thinking About Current and Future Teams) – Share an overview of the current internal communication structure and how a buyer might be able to plug into the communication channels for change management upon ownership. Highlight any talent management processes, compensation clarity measures, or training and development processes in place that will help to maintain cultural consistency and customer service levels. Odds are some Managers will be replaced and some folks will leave under new buyers. Assure potential buyers that the business is built on systematic operational excellence and not just residing in the hearts and minds of a few key employees who may bolt when the deal is done.

 It’s an open secret that Private Equity teams are masters of buying and selling. Yet, there’s still room for improvement when sell-side talent stops to consider what their buy-side counterparts hold dear. We suggest applying these nine ideas not only boosts Management’s effectiveness in the near term but also increases the selling price. 

Steven Koinis leads Private Equity Practice for Catalyft LLC, a practitioner-led, boutique operating partner ?rm focused on strategy implementation and operational improvements in middle market businesses acquired by Private Equity, investment firms and Family Offices. Steven has held several senior executive positions with the sovereign wealth fund Abu Dhabi Investment Company, Huron Consulting Group, and as C-level executive and Board member of private firms in the US, Europe and Middle East. Steven earned an MBA from Harvard Business School and has two Bachelor of Science degrees in Mechanical and Materials and Metallurgical Engineering from University of Michigan, Ann Arbor.

John Bova is a Transformation and Operational Excellence Leader in Private Equity Firms and Portfolio Companies. John has played many roles in the private capital space over 30 years Including senior executive to fast growing middle market companies, Independent Sponsor, PE and Family Office Advisor and Consulting Practice Leader. John has a BA in Economics from Fairfield University and an MBA from Pace University.