What is private equity value creation? How can PE increase the value of a portfolio business by making further investments in the business’ strategic pricing capability?

 

More often than not, private equity corporations don’t know they should be devoting more time and resources to improving pricing in a portfolio business. The pricing capability of an ‘investment’ is very often not on the PE 100 day agenda. Especially when PE are either looking to acquire a new investment business or sell an existing investment for a higher price. Most of the emphasis and money goes on a combination of cost optimisations and debt restructuring.

 

The main reason for this oversight is down to the private equity value creation model. In simple terms, the private equity value creation model has traditionally relied on financial engineering (utilising debt). Combined with a renewed management focus (often through management shareholders driving the turnaround). Meaning, for so many years, PE firms have focused on the final exit price of an acquired business or investment. Less time and effort has been spent on a portfolio business’ pricing strategies, models or operations to generate more sales and profitable revenue growth.

 

At Taylor Wells Advisory, we believe this traditional PE model is flawed and limited; essentially leaving many PE firms unnecessarily exposed to buying underperforming investment businesses when they don’t need to be.

 

In this article, we will continue to discuss private equity value creation in relation to pricing. We will explain how strategic pricing can help PE firms accelerate value creation across their portfolio of investments.

 

We argue that pricing is one of the best levers for PE firms to extract maximum value from acquired investment; also a highly reliable measure of the total lifetime value of a prospective investment pre-sale.

 

At the end of the article, you will have a better understanding of how to use pricing to generate a higher exit price for a portfolio investment. You’ll know how to use pricing to avoid margin risk and turn an underperforming investment into a profitable investment.

 

 

private equity value creation

 

The Problem with Private Equity Value Creation

 

Oftentimes, private equity investors think of pricing and growth initiatives as a trade-off. Just like saying, “I can either spend my time working out the best price to maximise margin, or I can focus on cutting costs.” Most choose the latter as this is more commonplace and accountancy driven. However, a repeatable and sustainable pricing system will complement growth and cost strategies and even speed them up.

 

We find, for example, that by establishing a clear pricing system in a portfolio businesses PE firms can seize early pricing opportunities much faster than other firms. A pricing system, in short, enables much faster and more effective sales execution. Not to mention more sales growth at a frequently higher margin.

 

What determines a good pricing system in the first place (from an average one) are the following strategic pricing capabilities:

 

  1. A clear understanding of the market and customer base
  2. A value-based approach to strategy development
  3. Customer agreements that grow share of wallet
  4. A price governance system that facilitates a faster and more effective decision-making process
  5. Pricing team skills that improve the efficacy and reliability of each decision made
  6. Decision support such as tactics menus and dashboards that help sales teams win more profitable sales each time
  7. An integrated data systems and tools that make it easier to manage prices and revenue
  8. Better price models and structures that align price and product relativities to discount levels and terms to avoid excessive discounting

 

Unfortunately, many portfolio businesses leave money on the table without even realising it. The main reasons are largely unknown to PE firms, yet deep-set in the culture of the portfolio firm. For example, often the executive team in the portfolio business don’t know they have a pricing problem, to begin with; and think setting arbitrary markups on cost is the best pricing method available.

 

Another common cause of margin loss in portfolio businesses is the late detection of pricing errors. Which is due to human error or poor automation. For example, portfolio businesses commonly run with limited to no price controls in place to set and manage price.

 

Having a clear and consistent price architecture with a value-based price and discount structures (as shown above) will help management teams in portfolio businesses avoid many price errors and remove price complexity. The real problem though is that many PE firms continue to underplay the role of execution. And in turn, under-invest in operational price improvements. When this happens, many great initiatives don’t deliver expected results.

 

Many PE firms will argue, however, that they already use their industry expertise and operational know-how to identify and manage attractive investments and/or develop value creation plans for those investments.

 

However, when it comes to implementing strategic pricing initiatives, our research clearly indicates a problem. In fact, when we have reviewed PE portfolio businesses, there was frequently no systematic pricing system. Not even an approach in place to set and manage prices or revenue. What’s more, there was very limited evidence of the private equity value creation plan working out as planned. This includes: evidence of a plan or how the PE plan actually helped to improve the portfolio company’s price and sales operations or investor returns.

 

Overall, then it is highly recommended that in the area of pricing – including diagnostics and price optimisation – it’s best that PE firms get additional advice to guide their first 100-day due diligence. And, even consider hiring pricing managers to plan and execute pricing strategies in specific portfolio businesses.

 

How Can Private Equity Value Creation Accelerate Using Pricing?

 

It is already common practice for PE to exercise careful due diligence of an asset both prior to buying the asset and in the first 100 days of investment, and also pre-exit. We strongly believe that included in due diligence of an asset is a rigorous evaluation of an asset’s pricing capability.

 

The purpose of improving pricing isn’t opportunistic or a one-off price adjustment to reach an arbitrary sales or margin target. Rather, it’s a change in mindset and skills to utilise pricing as key leverage to drive profitable revenue growth. Also, healthy sales and volume levels through each stage of the assets life cycle – from acquisition through to exit. This is what ensures a high final exit price.

 

Below listed are some more tips on how PE can create and accelerate value creation; using pricing from when they acquire a new business (i.e., first 100 days) to when they exit the business (final sale price):

 

  1. Measure an asset’s pricing capability properly to determine the potential ROI from pricing improvement initiatives & the potential lifetime value of the asset

 

Evaluating the size of the prize in pricing is a challenge involving two elements. Minimal price data analysis and methods can really help PE firms and their assets find new pricing and revenue opportunities in a new or established market segment or with specific customers.

 

However, data alone will not tell PE firms if those opportunities are right for their assets or aligned with the growth strategy PE have mapped out for a given asset. Because like any due diligence, understanding an asset’s pricing capability requires a consolidated approach and methodology. You need to know what questions to ask, the symptoms to look out for, to then determine the next steps. Otherwise, any subsequent roadmap and pricing strategy is really just guesswork.

 

PE firms, then, want an objective read and measure of pricing including a clear understanding of an asset’s customer base, competition, market forces before they even think about buying or selling an asset. The key to determining lifetime value properly and avoiding risk (or an underperforming asset) along the way is understanding the asset’s total economic value to customers.

 

Also, a PE wants to find out pretty quickly whether the company they are thinking of buying has the necessary tools, people, and capabilities to perform the latest pricing strategies, analytics and processes effectively. This also includes a full evaluation of the executive team and their management teams. The right mix of leadership, experience and ambition to utilise pricing is critical to ensure pricing works as expected.

 

The major advantage of a clear pricing diagnostic prior to buying a business is that you gain a realistic view of the total economic value of the asset – rather than a rose-tinted view. Viewing the asset with a pricing lens can help PE firms to identify how market opportunities match with in-house capabilities. It tells PE firms what EBIT uplift they can expect from pricing, the risks they are likely to face based on the asset’s current capabilities, what resources they need to drive growth or address problems in profitability, and the ongoing EBITDA uplift they can expect at each stage of growth.

 

  1. Verify ROI and firm up a realistic pricing roadmap in the first 100 days of acquiring a new asset

 

When it comes to pricing, the first 100 days of acquiring a new asset is essential to margin maximisation. PE firms want to take action and get the requisite pricing expertise in-house to help them develop a coherent, functional private equity value creation roadmap for a given asset. A roadmap that drives value creation for the newly acquired asset from day 1 to day 100. Moving fast is crucial.

 

Oftentimes, PE firms turn to the current incumbents for advice on pricing capabilities. However, this can be a mistake. Pricing is an established and specialist discipline that surpasses most executives operational knowledge on pricing. And it’s this lack of pricing discipline from the top down that often results in inaction, bad leadership, pricing error and a fondness for the status quo.

 

For all these reasons, bringing in high calibre pricing managers to assess an asset’s pricing situation is highly recommended for PE firms. Pricing managers can give PE firms and their asset businesses guidance and support to deliver significant EBIT growth. And, this is where value creation from portfolio businesses really gathers momentum. A good pricing manager with use the first 100 days to assess the pricing capability of an investment and then start building the right pricing strategies, structures and operations for that investment so the ROI rolls in as expected.

 

  1. Create lasting value in ownership

 

Pricing skills are key to executing a new approach to value creation. High-calibre teams working to a best in class roadmap, for example, can do a lot in the first 12 months of a pricing initiative. Such as: develop a list price, restructure discounts, adjust terms, add new talent or build sales capabilities.  However, skills without clear ownership, demarcation of responsibilities and accountability for decisions will only get you so far. Great teams are great because they know what they are doing, can do it well and are connected (in a meaningful way) to the mission, vision and final outcomes.

 

  1. Re-assess pricing before pre-exit to understand the real profit potential of the asset you are selling. (Don’t underestimate or overestimate an asset’s real value)

 

During the pre-exit period, revisit your due diligence process; clearly laying out the pricing opportunities for the next owner. PE firms that are in a hurry to take advantage of growth opportunities often divert their focus from pricing. In turn, shifting the focus away from the value of the asset they are trying to sell to prospective buyers.

 

It is important, therefore, to prepare the investment for sale and keep your pricing in check. For example, have all results of previous pricing strategies recorded. Model pricing opportunities (past, resent and future) and compare to facilitate better forecasts. Then, update the equity strategy and roadmap for the new buyer so they can see evidence of value.

 

private equity value creation

 

Discussion: Improve a company’s profitability by building new pricing capabilities

 

In the last 10 years, Taylor Wells Advisory team find it encouraging to be approached by more Australian PE firms. A frequently asked question from PE firms has been “Where’s the best place to start?” “What type of pricing talent do we need?”

 

PE firms are often keen to explore pricing and pricing talent because of their strong impact on the P&L. However, only a handful of PE make the changes internally to ensure price initiatives and talent are set up properly and thus successful.

 

But the reward from doing pricing properly for PE firms is compelling. Better pricing positively impacts the final valuation of the new investment. Especially using the EBITDA multiple view investors typically apply.

 

For example, a 2% price improvement on 200 million addressable revenue commonly delivers c.$2M dollars for PE firms in the first year; especially if the asset business is using basic cost plus or ineffective rebates schemes. That’s net of any changes in volume or investments created in tools and resources.

 

This means, if you are forecasting the final sales price of an asset to be between 4-15 times the multiple of the profit it generates, then investing in an asset’s pricing capability is well worth doing well.

 

Implications

 

  • PE firms can seize early pricing opportunities faster than other firms by establishing a clear pricing system in a newly acquired investment business. What’s more, evidence indicates that most pricing issues, opportunities and changes resulting from due diligence turn out to be long lasting i.e., the business continues to enjoy the financial benefits of price changes long after the initial changes were made and the PE firms exit an asset/investment.

 

  • It’s the planning and execution of pricing strategies to market that is the key to achieving higher returns for investors. Improving all listed pricing capabilities in this article is critical to value creation.

 

  • PE firms and their investors earn higher returns on an asset when the portfolio company increases its sales, EBITDA, employment, and capital intensity during the holding period. Pricing is an enabler to profitable revenue and sales growth. As well as the driver of financial and organisational growth and capability.

 

Conclusion

 

It is encouraging to see that private equity value creation in Australia is beginning to include some strategic pricing initiatives. However, there’s still a lasting PE legacy of buying an asset and leaving it rather than investing in it and managing it.

 

PE firms investing in pricing as a means to drive higher asset prices at the point of exit generally are much more hands-on than the run of the mill PE firm. For these small select group of PE firms, the full benefits from any investment come with close management and involvement in day to day operational improvements. Gone are the days of just waiting for an asset to mature in value or applying debt engineering.

 

To accelerate value creation in highly disrupted and changing markets, then, PE firms want to invest in a portfolio businesses’ strategic pricing capability; and tackle any issues and opportunities in the first 100 days. This includes setting up a roadmap and talent to build a new price architecture. And improving ways of working. Starting from the leadership team to the go-to-market organisation.

 

Click here to download the whitepaper.

 


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