Podcast transcript: How COVID-19 is transforming the PE operating model

29 min approx | 8 June 2020

Winna Brown

Hello and welcome to the EY Next Wave Private Equity Podcast. In our series we explore the impact that private equity can have on the economy and society capturing insights from industry thought leaders and private equity practitioners from across the globe. I’m Winna Brown from EY and I’m your host. In today’s podcast we will explore the impact that COVID-19 has had on private equity portfolio companies’ revenue and operating models. 

Joining me today are my fellow partners, Tim Dutterer and Greg Schooley. Greg is a Leader in our Value Creation practice and Tim is a Leader in our Private Equity practice at EY-Parthenon. Together, they have years of experience advising many of private equity clients on the design of portfolio companies’ operating models and revenue strategies with the aim to optimize performance and results. Gentlemen, welcome to the podcast.

Greg Schooley

Thank you.

Tim Dutterer

Thank you very much.


So, gentlemen, before the podcast we spent some time discussing what the optimal operating model for companies looked like before COVID-19. At high level, it would be great if you could perhaps describe to our listeners how companies predicted revenue and designed operating models over the last ten years.  


The last 10 years have been a very unique period in our economic history. Revenue and economic activity have been quite predictable. Many people had complained about the low levels of growth, but it was always 2% to 3% CAGR year over year. And what that allowed management to do is really optimize their businesses for efficiency. So, they would take lean six sigma practices that have been employed in the manufacturing field and use those practices across the company.

What that meant was managing manufacturing at very high levels of utilization. That means consolidating your spend with fewer suppliers to drive better pricing and often those suppliers were in China. That meant going to shared service centers where, again, you were looking for maximum productivity per person in finance, in HR, in IT. And so basically, you were trying to run the business as hot as you could.

This also extended to the financial engineering of the business where with predictable revenue predictable profit investors were able to leverage their balance sheets a great deal, and that is both in the private equity and the corporate space, especially given the relatively low cost of the debt that had been available to companies of many sizes over the past ten years. So, when COVID hit, you had these companies that were optimized for efficiency and then all of a sudden demand fell off a cliff and that obviously left them in a difficult spot.


So, companies have really adopted this really lean operating strategy that was based on predictable growth and now you’re hit by something very unpredictable, being a pandemic.

With COVID having caught everyone by surprise and many businesses were caught flatfooted through this, do you think that companies, and particularly private equity-backed companies, should they have been able to predict that this was going to happen? Should they have known? I mean, obviously not that a pandemic was going to happen, but perhaps that this cycle of having predictable growth and having no bumps in the road was not really as sustainable or, arguably, a reasonable expectation. Tim, what are your thoughts on that?


I think the short answer to that question is that I don’t think they should have known per se, but I think the consensus is that they should have been more prepared than they probably were. And as Greg was talking about, some of the reactions that we’ve seen, and we’ll get into this later in our discussion, there’s definitely been a variance across sectors that we’ve seen with regards to how various businesses have been able to respond. Whether you’re a manufacturing company, a distribution company or a software company based on whether you’ve been a business that’s been very closely tied to economic growth or a business that’s been in much more hyper growth trajectory over the last several years.

The other dynamic I think that we’ve seen is that the way that folks thought about risk up until the last three months through this economic lens has been very much simplified through the lens of what folks experienced during the global financial crisis. And the events that were anticipated with regards to an economic shock were very much thought with regards to how deep and how long a traditional economic cycle might impact a business not so much as the impact that a complete succession of economic activity might have on the activities of certain sectors of the economy.


Tim, thanks. Yes, certainly, I mean, we’re all in unprecedented times. You hear that word a thousand times a day. But I think one interesting item that I put on the table is the whole notion of the black swan, which is supposed to represent a once-in-a-lifetime event that will never ever happen again, at least not in one’s lifetime. Unfortunately, we’ve had two black swans in about 12 or 13 years. And this just begs the question to me how resilient do businesses need to be?

Tim, I think you’ve been in many due diligence meetings with our clients where people have been asking over the past several years, “Well, what would happen to the business in a normal recession?” Not the great recession, of course, but a normal recession. What we’re seeing is that we may need to be thinking about what would happen to the business in a very significant economic time like what we’re experiencing now.

So, I think people really need to start considering our black swans, as we called them, truly black swans, or are they more like one every 10- or 20-year events that businesses are going to need to survive through. And what are the plans, like you said, Tim, both in terms of operation as well as capital that will support a business through a period like this. So, I think that’s one of the big questions here; how do we look at black swans going forward?


It sounds like what you’re saying is two things. One, companies are at a little bit of a crossroads as they emerge from and recover from COVID-19 they’re going to have to consider what’s the future that they’re building their operating model around? Is it a lean model where there’s no margin for deviation or are they building their operations in anticipation of that next black swan? Have you seen any indications or trends of how private equity is thinking about this?


Winna, I think that private equity has reacted extremely quickly and effectively to the current situation. I’ve had dozens of discussions with management teams of a variety of companies, both private equity-owned and corporate, and what I’ve seen is that PE reacted more quickly. They understood the severity of the downturn more quickly and they were very fast to mobilize to increase the liquidity of their portfolio companies.

So, I think from that standpoint, private equity has reacted extremely well to the current crisis. But what I think they’re starting to grapple with now, and I’m looking forward to hearing Tim’s thoughts on this, is that there is a trade-off that private equity as well as corporate clients or companies are going to need to chew on. And that trade-off is resiliency versus efficiency.

As I described earlier, in the past 10 to 12 years of economic growth, which has been very stable, very predictable, it has been perfect for management teams to drive efficiency through their operations, whether that be supply chain, SGNA, etcetera. Going forward, we need to think about resiliency. Because it’s my view that there will be more crises, hopefully nothing like this again, but there will be crises in the future. And then how do you bake in resiliency into your operating model without destroying the efficiency that generates the economic returns that private equity investors are looking for?

And when I say resiliency, what do I mean? It means a more diversified supply chain. So, you’ll be relying on more suppliers from more countries, and thus by fragmenting your spend across more suppliers you’re going to have worse pricing than you might have had otherwise. You’re also going to see people trying to variablize their cost structures as much as they can. And by that I mean rather than having an in-house shared service center for a given activity, people will turn to outsourcing, people will turn to technology, people will look for ways to make sure that their cost structure can move up and down with the demand that they are seeing.

Another thing that I expect to see is people using less leverage. Corporate America as well as private equity owned companies have greatly capitalize on cheap capital and debt to leverage up their balance sheets, and in doing so drive high equity returns, which certainly made sense for the last 10 to 12 years. Going forward, are people going to do that? And if they don’t leverage their balance sheets as much how are they going to be able to drive the IRR that private equity investors expect?

But Tim, I’d love to hear your thoughts on this.


I think one of the overarching themes that we’ve seen across the board is that everyone in the value chain is trying to process so many of the same issues simultaneously and so quickly, which is really one of the capstone themes of what we’re all experiencing. And to drive that home, when we think about the impacts that that’s having to help businesses that are needing to make decisions right now, that means that everyone in the value chain is trying to make a call about what that means with regards to how the demand changes in the market are going to affect their business and their business model, and how that is going to affect all of the participants in the ecosystem or in their value chain that they work in and that they place demands on.

It is a game within a game, so to speak, that organizations that are forced to think through. And to drill down into that and think about how that differs when you think about different business models that are closer or further away from the direct demand impacts of what’s going on in the market, for example. I think everyone has a very clear example that they can bring to mind where they understand the direct impact to a restaurant, or to a hotel, or to a major entertainment venue, for example, that’s being impacted during this period based on the current environment.

But as you work your way back in the chain or as you work your way back into businesses that serve those end markets or that are operating at varying degrees of capacity, you start to have more questions about what the secondary and tertiary impacts are on those businesses. But many of those businesses continue to have to operate their businesses and adapt their business models to make a judgment about what the demand is going to be in many of those primary industry sectors.

One of the themes that we hear from folks a lot is, “Gee, you have the writing on the wall as far as what is happening in the primary sectors today, but there are a lot of question marks that are out there for some of the secondary and tertiary exposed businesses.”


And so if we think about it, if each one of these players in the value chain in the ecosystem has to make those decisions around resiliency versus efficiency, and let’s for argument sake say that many of them make that choice toward resiliency given they’re starting to realize that there is a lot of unpredictability in the future, what does this mean in terms of the end consumer as we think about the consumer pricing and the new revenue models of the new normal as we cascade this impact and choice? That’s assuming resiliency wins.


One of the things that we’re going to see at cross-sectors is companies getting creative and getting more aggressive in figuring out how to match value propositions between what they can deliver and what the consumer demand might be in the market.

For example, if you can run a particular venue or a particular restaurant or a particular airline, I'm going to stick with those examples for now, at half capacity or a third of capacity in some industries, for example, you may be able to be amenable to a value proposition where you might be able to run an event or run a service at much lower capacity utilization, but be able to create an experience for a consumer in the short and medium term that could be two or three times value or priced at two or three times the prior value because you’re delivering a better experience.

Or at the other end of the spectrum, you may very well find that in a restaurant-like setting, while you may be able to pursue other channels for the distribution of food, at the end of the day a consumer can’t eat the meal twice. Right? So, your pricing and some of the fundamental dynamics that you may see in the ability to change models in some sectors may be different in others. But it’s going to force innovation, as you think about ways to potentially think about tiering of offerings, value of offerings, etcetera.


I had two meetings today. One with a senior vice president of a supply chain of a cleaning products company, and the other was with a CEO of a food distributor that services both the grocery and the restaurant channel. Obviously, I’m not going to give away anything confidential here, but when you start thinking about how these two companies are looking at the future and how they’re trying to navigate both the next few months, but also what future demand looks like two years from now, it’s striking.

So, you know, with the cleaning products company, they’re going through a situation where they can’t make enough of their product right now. Demand is outstripping supply by multiples. So that’s a good thing. So, they’re thinking about ramping up internal production considerably. They’ve already increased production a great deal. But this is a company that has historically produced everything in-house because it’s cheaper and they don’t want to pay a co-pack manufacturer or a third party to manufacture for them because the third party is going to need 20% to 25%gross margin to survive, and they would prefer saving that money.

The discussion quickly became: Are you sure you want to double, triple, quadruple your production? Because what happens if demand returns to a more typical level and then you’re sitting on a series of fully owned manufacturing sites that are largely idle? And so, this is exactly the kind of tradeoff that I think many, many companies are going to need to be considering. Do they want to be resilient and have more variablized manufacturing that they can outsource to handle excess demand, or do they want to be efficient and drive high utilization rates of fully owned and operated manufacturing facilities?

The food distributor is another interesting one because obviously half their business is booming with the grocery side of the business and the other half is severely under pressure. What’s happening there, and Tim you were talking about the secondary and tertiary effects of this, is they’re now thinking, ”All right, well, I need to turn to my supply base and I need to start extracting price concessions from them because of the situation I’m in.” And I suspect that they will get price concessions from their supply base because their supply base needs demand as much as they do.

So, this is the ripple effect that’s going to be cascading through the economy over the next 6, 12 or 18 months.


Just thinking about that, how will baking this resilience into the operating model impact other economies? You mentioned, Greg, the example of the cleaning manufacturer who has to either outsource manufacturing or consider to, bring it in-house and expand their capacity. If I think about a lot of the operating models that have been developed over the last 10 years, many of them have relied on China. You mentioned this earlier today. And there’s a whole ecosystem that’s been built in China around them being the world’s manufacturer.

Do you think that as companies sit back and revisit their operating model, do you think that this is going to change? Are they going to build in more resilience into using China? Are they going to think about diversifying? And what does this mean on a full-on effect, if you will, on the people and skills that not only private equity has built around being able to manage a workforce in Asia, but companies themselves have built around relying on China?


I think there are a couple of ways to answer this. The short answer is yes. It’s going to affect China. I expect that they will lose a significant amount of their export market to other countries. It’s not going to happen overnight. China became, as you said, the world’s manufacturer over a period of decades. So, this isn’t turning off a light or on a light. This is something that’s going to play out over the next 10 to 15 years.

But the second element of this answer, I think, is that I believe this crisis will really accelerate trends that had already been in place. And just because of the economic pressure we’re all under, those trends will accelerate. And by that, I mean China was already losing market share to other lower cost countries for some of the industries and products that they have dominated for many, many years. Think of apparel going to Bangladesh.Think of semiconductors going to Vietnam, etcetera. And I think this only accelerate. And the reason for that is China’s labor force has become increasingly expensive, number one, relative to many other countries.

And now, number two, with the risk of having a China-dominated supply chain most companies are going to look to having a more diversified supply base. So, I expect the supply base to fragment considerably over the next five to ten years. I’ve heard many supply chain executives explain this view to me over the past couple of months.

But the other things that I think will really accelerate as a result of this is, first of all, automation. We talked about that earlier, but I expect that automation will be introduced across the enterprise more and more as we try and make these back-office functions more scalable, more efficient and also more variable. So, I expect that to happen.

I also expect outsourcing, especially in mid-market private equity-owned companies to become more prevalent. Currently, you really only see payroll as a function that’s commonly outsourced. I expect to see that kind of outsourcing in areas like IT help desk, IT infrastructure and accounts payable. You name it.

And then lastly, and we’ve all felt it, especially those of us in the professional services space, but I think the value, both intrinsic and economic, that companies are willing to place in real estate is going to be severely, how should I say, challenged. Because we’ve all learned to harness new technologies whether that be Zoom, Microsoft Teams, etcetera, to work efficiently from our homes or wherever. And I just don’t see companies returning to very expensive, very large real estate footprints unless they absolutely need to. So, I think this crisis has really been an accelerant to many trends that have been going on for the last 10 to 15 years.


During the great recession one of the debates that many folks had around consumer behavior was around whether the consumer would be able to bounce back? They’ve become less frugal as a result of going through that period. The rearview mirror economic lesson of looking at all the consumer data during that period is that the consumer behaved actually 100% rational during that period with regards to behavior and reacting to changes in employment, changes in income. Exactly how you would expect throughout the 08, 09, 10 and 11 period.

And you know, I reference those two examples because I think there are some examples now where we can look back and we can say that there are some overgrown trends that either now have been accelerated that we know are here to stay. There are folks who have accelerated through the adoption curve of the use of various technologies. There are some automation themes that Greg touched on that enterprises are now saying, “You know, it’s cheaper, better, faster. Why are we only applying this to somewhere between zero or 30% of our processes? We should be applying it to 50% to 70% of our processes. We need to accelerate that.”

There are other things, when you think about the implications of, commercial real estate is an interesting one. Because, Greg, I agree with the conclusion that the real estate model as we know it is definitely changed, but the long-run expectation of what an office culture looks like, what working in the office part-time looks like, what does capacity utilization look like in an office. What does that really mean in the long run and what are the implications of that for real estate values and the commercial real estate market, and then all of the secondary and tertiary industries that feed into commercial real estate? I think that is a lot more uncertain than folks imagine.

Maybe said another way, I’m not quite yet ready to expect that everyone will be working from home full-time, so to speak, indefinitely for a long period of time.


As I listen to both of you, I mean, there is certainly a lot of movement towards choices that need to be made, the discussion between resiliency and efficiency. And there’s certainly a very compelling argument for companies to be more resilient as they make these choices around their operating models going forward. There’s going to be a lot of impact, as we talked about today, throughout the ecosystem on these choices and it’s going to impact ultimately the secondary and tertiary businesses, as well as the consumers at the end, and the investors in these companies that make these choices.

The question I’ve got is, in a long-winded way, is there a path do you think that companies may take where they’re going to say, “Resiliency, I’m not going down that path. I’m going to go efficiency, I’m going to go margin, and damn the black swan.”


Well, certainly, like I said, it’s neither black or white. I think companies will grapple with both. Companies have shareholders, whether they be private equity investors, shareholders in the public markets, etcetera, and they need to generate a return for their shareholders. So, efficiency will remain extremely important.

I think that these last two economic cycles, you know, the great recession and the pandemic that we’re living through today, will increase the need to do more dramatic scenario planning. I think people are going to start spending more time thinking about the black swan and figuring out what are we going do in these situations? And that could be relating to their supply chain. That could be relating to their labor force, their end markets, etcetera.

And I think there will be solutions where, as Tim said, by employing technology you’re able to get resiliency and even more efficiency. So, I think there will be some of the proverbial win/wins. And then in other situations there will need to be tradeoffs and companies and executives will need to understand where the resiliency is worth the extra money and where it’s not.

Some companies will run more risky strategies for higher return that may work for a period of time, but then ultimately they’ll run into challenges and they’ll have to be nimble and react to those challenges where other companies, like say companies today with less leverage on their balance sheet are actually taking advantage of the situation and trying to acquire weaker competitors or use pricing power to grow market share, etcetera. So, it will become a debate in many boardrooms to come over the next 5, 10 or 15 years.


Gentlemen, thank you. I think this has been a really insightful conversation. Thank you both very much. I think it’s going to be really interesting to be a fly on the wall in some of the boardroom debates that are going to happen, to both your points.

The disruption that’s happened over the last few months has really been almost a wakeup call and the discussion around what is the right level of resiliency to bake into your operating model versus efficiency and profit is going to be something that’s going to be, I suppose, hotly debated. And interestingly, maybe the passage of time will also impact the way companies view those decisions as well. So immediately now this crisis is on our minds and so there will be a lot of focus around resiliency. As we move away from COVID-19 into our “new normal” and people get more relaxed it will be interesting to see if that shifts back to efficiency and profit.

I hope you both will join me again in about a year’s time just to see how this has all transpired and what the new normal is looking like. I’d love to see how some of these predictions have turned out.


It would be my pleasure.




Tim and Greg, thank you again for your time. I know, as I said, I’ve learned a lot from our conversation and I’m sure our audience will really enjoy your perspectives and find them very informative as they plan ahead.

And to our audience, I hope you enjoyed this episode of The Next Wave Private Equity Podcast and found it to be informative and valuable as you navigate these unusual times and move forward into the new normal. Please subscribe, review, and of course, share this episode with your colleagues and friends.To find out more about the topics we discussed check out ey.com\privateequity. I’ll see you on the next episode. And in the meantime, please stay safe and healthy.