Unlocking Value in a Low Multiple Environment
Private Equity capital cycles are clogged, in part due to depressed valuations leading to longer hold periods. In time valuations may rebound, but what if they don’t? Or what if it just takes longer than projected? While no one Private Equity firm can change the market, there’s no reason to give up hope and just play the “wait and see” strategy. There’s a better path forward, a no-regrets move that will best position your investment regardless of market dynamics. The answer: find new ways to grow EBITDA.
First, let’s level-set on the challenges.
Valuation multiples are down.
According to PitchBook’s Q2 2023 PE Breakdown report, “Prices paid on PE buyouts are in full correction mode… The median enterprise value (EV) to EBITDA multiple now stands at 10.5x for the 12 months ending Q2 2023, down from 12.1x in 2022.”
Many Private Equity firms are holding onto companies for longer in hopes of multiples rebounding.
“Mostly what we’re seeing is when there’s a gap between buyer and seller valuations, they may hold onto that asset a bit longer. Once the disruption in the market settles, they can get the valuation they expect,” says Anne Philpott, Churchill Managing Director, commenting in the Institutional Investors Private Equity Firms’ Return Expectations Remain High Despite M&A Slow Down
So, what’s the right path forward?
For those not willing to wait on the sidelines for multiples to rebound, the clear call to action is to find additional ways to grow EBITDA.
“To ensure that distributions are flowing back to LPs, that means that you have to have businesses that are on track to have margin expansion. Multiple expansion is not something that we’re seeing in the market right now. Your only other real lever is to make sure that you’re getting the margin expansion that is in line with the equity story. Private equity firms just have to ensure that they are doing everything possible they can to support their portfolio companies,” says Joshua Maxey, co-founder of Third Bridge This Miserable Market Could Be a Catalyst for Private Equity Firms
There are three ways to grow margins: cut costs, sell more, or raise prices. Each lever can add value to the bottom line, but not all levers are created equal. According to the famous McKinsey study (cited in the Harvard Business Review article Managing Price, Gaining Profit), raising prices is the single greatest profit lever a company can pull, with a 1% price improvement yielding an average 11.1% increase in operating profit.
Price increases can be daunting for a company to execute, especially in a softening economy. But achieving a 1% price improvement does not mean you have to raise every customer’s price. Such a small incremental improvement could come from any of the following scenarios that are typically ripe for opportunity in Industrial companies:
- Low / no profit business segments: There are likely subsets of the business – specific products, customers, or markets – that are unprofitable or disproportionately low profit compared to the rest. Finding and addressing those trouble spots can yield a 1% improvement, if not far more. Actions can be as low risk as slightly higher price increases for the trouble spots or shifting product mix, or as aggressive as firing unprofitable customers, which sounds scary but does wonders for the business in the longer term.
- Unnecessary discounts: Most Industrial companies give sales reps a lot of price autonomy in the name of getting the deal done. In aggregate, this may result in reasonable average selling prices, but at the deal level it can lead to very high price variation. If that sounds like your portfolio companies, then odds are they’re leaving a lot of money on the table. In our experience, unnecessary discounts can leave more than 3% of the price on the table.
- Profit leaks: The price on an agreement doesn’t typically tell the whole story. Often there are other pricing-related concessions such as favorable terms, rebates, or other incentives that chip away at the realized price and profitability. Finding and stopping any excessive leaks will easily yield a 1% improvement.
The other profit levers – cutting costs and growing volume – have merit and are worth exploring. But our bet is you’ve captured all the low-hanging fruit on cost-out initiatives, and you’ve been hard at work helping your portcos grow volume through organic and inorganic measures.
These economic times call for additional margin expansion activities. Faced with the choice of where to focus, smart money should be placed on price improvements.