Organic Growth

Key considerations for Private Equity

Private Equity Today

The primary value creation drivers for private equity traditionally include financial engineering, cost take-out and top-line growth – usually in that order. Today, given the financial and economic collapse, top-line growth - specifically organic growth - has become the priority.

While the credit markets are open and generally functioning, most portfolio companies that weathered the downturn have already been recapitalized to a structure that makes sense and their sponsors have negotiated the best terms they can. There aren’t many cards left to play to create value and/or free-up capital from a financial engineering standpoint.

In terms of cost take-out, most (if not all) organizations have “right sized” from a human capital perspective and have worked hard to drive down costs via adjustments to their business models, the selling of underutilized assets and/or improvements to operating processes. While one could argue “there are always a few percentage points more“, at some point, this is just not true.

This leaves top-line growth.

Before the financial crash, the easiest path was inorganic growth via bolt-on acquisitions. Here, value was created via operating synergies and through the advantages increased size and share can bring: additional organizational capabilities, increased resources, pricing power, etc. Even better, multiple arbitrage was a welcome, and not infrequent, “kicker.” Today, these opportunities are rare at best.

On top of this, the lingering economic uncertainty is creating significant differences of opinion between buyers and sellers on valuations -- making it hard to come to terms and increasing the risk firms are just doubling-down on their growth challenges by taking the inorganic route.

This brings us to organic growth.

In a recent survey of leading private equity firms¹, respondents were asked what their priorities had been for the prior 12 months. Key among them was cost take-out (62%), organic growth (54%) and financial restructuring (32%). This is not surprising given what everyone has been through. They were then asked what their focus would be for the next 12 months. Here the message was clear:

Key Considerations to Organic Growth

While the importance of organic growth might not be “new news” to those struggling with the question of how to drive EBITDA and generate returns, our experience is that there can be a meaningful learning curve (and a significant skill set and resource gap) within portfolio companies associated with this shift in value-creation priorities.

To exacerbate the challenge, we have found that private equity firms, even if they have an in-house operations team, typically don’t have specific resources with an expertise in - and a specific focus on - organic growth. Firms are usually deep with general-management talent but thin when it comes to strategy, marketing, sales and business development-specific resources.

We know there is no ‘silver bullet’ for solving the organic growth challenge. That said, similar to financial engineering and formal cost-out methodologies (e.g., six sigma), there are multiple strategies and tactics companies can use to drive the top-line. Before the appropriate ones can be identified and employed, there are several key questions that should be considered sequentially:

1. Are you losing customers at an unsustainable rate?

First, to effectively expand organically, organizations need a solid platform. Everyone has heard the analogy of a leaky bucket as it relates to customer attrition and revenue loss. A solid foundation ensures that the size of the leak is manageable or plugged. Without it, the results of expansion efforts will not be fully realized. Customer retention, churn rates and year-over-year revenue analysis will provide an indication of how the organization is performing as it relates to churn. The challenge in many cases is that this analysis is retroactive. True understanding of the strength of your existing foundation requires proactively evaluating the health of your existing customer relationships.

Through systematic evaluation and understanding of the strength of your existing customer relationships - as well as through gaining an understanding of your current performance gaps - actions can be identified and taken to drive improved satisfaction and blunt (and even halt) attrition. Here, actionable insights can be obtained relating to opportunities to grow within existing markets and ways to expand the company’s served-available market can be identified.

2. Is there opportunity to grow within your existing served markets?

As the fastest place to grow is where you have the most knowledge and experience - in and around your existing served markets - this opportunity should be a company’s second consideration. While this seems obvious at its face, it is certainly not easy in practice. Here, the discipline of strategic marketing focuses on several things:

• Strength of your position (or value proposition) – pretty much everything else hinges on this. How strong is the fit between your capabilities and your target market and how wide is the degree of separation between you and the competition? The right value proposition(s) enable more effective communications and sales velocity.
• Effectiveness of your demand (or marketing communications) creation efforts – if you are advantaged in your marketplace, the last thing that you want to do is keep it a secret. Based on your market model, are you focused on the right players, with the right messages, through the best mediums?
• Effectiveness of your demand (or channel) capture– one of the fastest ways to drive organic growth is through revisiting your channel effectiveness. Do you have the right team, structure, incentives, and processes in place to best serve your market(s)?
• Strength of your market (or brand) reputation – the intangible item that opens doors for your sales team, enables you to capture an additional percentage point margin, and helps you defend your existing market share.

3. Do you think you can expand your served-available market?

Finally, if you are reaching saturation in your existing served markets, you will likely get more out of your investment by expanding the markets you serve. Fortunately, there are several possibilities. Unfortunately for many portfolio companies, executing this well can require skills and resources they don’t have and we have found that some companies are not used to the level of rigor required to make this process valuable. The challenge is threefold:

• Understanding the options that are available – as Theodore Levitt once proclaimed, “Strategy is as much about understanding the options available as it is about making decisions." The research and evaluation process needed to thoroughly understand the options should employ formal tools and frameworks – combined with detailed and thorough analysis.
• Prioritizing your options – to help drive focus, establishing decision criteria to evaluate prospective growth options is crucial. Attractiveness and risk are fundamental to the decision set. Of particular importance is developing a fact-based approach to help cut through conjecture and ensure sound investment decisions.
• Taking advantage of the most attractive opportunities – the final part of expanding your served-available market requires commercialization. Whether this involves launching new products - or existing products into new markets - the commercialization path is riddled with challenges that must be anticipated and overcome. Having a clear perspective on the launch process, from ideation to execution, is crucial. As does, among other things, bringing the target customer into the process as early as possible to direct efforts along the way.

A Case Study

While we have numerous case studies across these areas which illustrate the point, a high-profile example one of our authors, Todd Redmon, was involved in is The Home Depot. In 2000, The Home Depot brought on a new CEO, Bob Nardelli, to continue the company’s steep growth trajectory. Up until that point, the company had been a model for retail success and had set multiple industry revenue records. In order to sustain its high growth rate, Mr. Nardelli embarked on multiple strategies to grow within The Home Depot’s existing served markets, as well as a variety of opportunities to expand the company’s served-available markets.

Within its existing served markets, The Home Depot leveraged its value proposition and brand, as well as increased its channel effectiveness, to move further into two high-potential market segments it was already serving via its retail footprint; the professional general contractor and the “Do-It-For-Me” retail customer. As part of this, the company increased its resource commitments, improved its operating processes and refined its marketing communications. Through these efforts, it achieved increased share and penetration in both segments.

In terms of expanding its served-available markets, The Home Depot targeted “non-traditional” geographic markets, such as Canada and Mexico, as well as urban locations, such as New York City and Chicago. It expanded into new B2B segments, including professional landscapers, homebuilders and other trade specific businesses, as well as B2C models, such as its direct-to-consumer catalog business. Here again, the company increased its revenue.

The problem was that The Home Depot did not secure its retail customer base. Moreover, during this timeframe the company implemented a variety of changes which were actually detrimental to driving increased transactions. This ranged from, among other things, reducing the depth and breadth of the associates in the stores in order to lower labor costs -to- a wholesale reengineering of the “people” culture it had established to one myopically focused on process.

The net effect was a widely profiled decline in The Home Depot’s reputation for service, and a not unrelated decrease in customer transactions. While The Home Depot’s revenues grew from $45 billion to over $90 billion during Nardelli’s tenure, the growth was primarily attributable to new store openings, an increase in average ticket and the multiple platform acquisitions it executed to enter new B2B markets. In fact, year-over-year comparable store sales were a healthy 4% prior to Nardelli’s first full year; in his last, 2006, they were -2.8%.

As The Home Depot’s ultimate measure of shareholder value is market capitalization, it is astonishing to note that despite all of the company’s success in growing within its existing served markets and expanding its served-available markets its shareholder value cratered. While top-line revenue increased by 100% from 2000-2006, the company’s market capitalization fell over 50% (from $166 billion to $78 billion).

The moral of the story is that had The Home Depot addressed and managed its growth opportunities appropriately – securing its core retail customer before it embarked on its other growth strategies – the results could have been much different.

In Closing

While the current economic situation and related industry dynamics could lead one to believe that organic growth is the only solution to creating value in the near term, there are two other (and better) reasons why firms and portfolio companies should take on this challenge and dedicate the needed time and resources.

The first is EBITDA and returns. Recent research¹ has indicated that over 50% of returns come from organic growth. Not surprisingly, cost-out and financial restructuring were also important but, here again, there just isn’t that much “juice left to squeeze.”

The second reason is related to fundraising. Recent interviews² with LP’s indicate that their #1 driver for either re-upping with their current GP or considering a new one is having “repeatable value creating processes” in place to assist portfolio companies.

Given that organic growth is of such high priority and importance, it only makes sense that firms and companies should focus their efforts on making it a repeatable process, if they want to raise funds and drive returns.

SOURCES:
1 BDO 2010 PE Industry Survey
2 Bain & Company 2011 Global Private Equity Report