For private-equity firms predicting positive performance from their deal targets, the numbers have worked out much to their favour over the past decade. But according to one management consultancy firm, their math has been wrong.
In a new report titled Integrating Due Diligence to Build Lasting Value, Bain & Company acknowledged PE’s impressive performance based on a range of measures. Those include a surge in investment value in 2018, which punctuated the strongest five-year stretch in the industry’s history with US$2.5 trillion in disclosed buyout deal value.
“Yet viewed from the inside, the data is less convincing,” the firm said. It found that out of 65 mature deals invested in since the global financial crisis, 71% fell short of the margin improvement they anticipated at the outset of a deal.
“On average, margins ended up 330 basis points below the deal model forecast,” it added.
The shortfalls in projections haven’t been apparent as they were overshadowed by a general rise in asset prices over the past decade. Citing data from private-capital market data provide CEPRES, Bain & Company said that around half of the value creation that’s happened globally in the past decade has been due to multiple expansion.
“The industry experienced an incredible run of growth and value creation over the past decade," Miles Cook, a partner with Bain & Company's Private Equity practice, said in a statement. “PE firms that want to capitalize on this momentum and generate value going forward need to take a hard look at their diligence processes.”
The problem with most PE firms, the report said, comes from using a siloed approach to due diligence. Most firms and their advisors tend to structure it as a series of discrete questions about the target company’s strategy, commercial prowess, or cost structure.
But the private-equity firms that get it right adopt an integrated approach. By considering key interdependencies and quantifying their impact, such firms are able to build a 360-degree view of the target company’s potential.
In order to move forward, Bain & Company said, private-equity firms must pay especially close attention to three areas of interdependencies:
- Strategy – Aside from building a market perspective and assessing a company’s competitive position, PE firms should identify market or company inflection points. They must also identify potential game-changing trends — technological disruption, consolidation of customers and competitors, and so on — as well as identify adjacency opportunities.
- Operations – Company assessments must unearth opportunities for net working capital reduction, cost management, and asset optimization, as well as zero-based organizational redesign. There should also be an effort to diagnose whether current technology and IT systems used by the organization can deliver for the future.
- Commercial excellence – Along with an assessment of salesforce effectiveness, PE firms should gauge the organization’s pricing, sales channel, and category management opportunities. They should also keep an eye out for ways to optimize marketing, particularly to take full advantage of new digital channels.
After completing these three areas of assessment, PE firms can identify a single value-creation thesis — one that doesn’t necessarily boil down to a single answer, but rather provides a nuanced understanding of options.
“Integrated due diligence is the only way to really understand how pulling a lever in one area of the business will affect assumptions in the other," said Cook. "And most importantly, it sets PE firms up to succeed by spotting the most viable path to new value.”
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