The need for objective analysis is exemplified in one case of a PE-owned distribution business facing financial challenges, still run by its co-founders. Sales had been declining at 5%–10% per year for three years and margins were being compressed as it battled more efficiently run competitors. But the co-CEOs remained confident that the full-service, high-cost business model that they built 20 years earlier would succeed into the future.
To change management’s views, the PE owners and their advisors presented an objective, fact-based analysis that demonstrated the root causes of the financial challenges. There were four primary issues that the business faced.
- First, the business’s product mix had shifted to lower-margin commodity products that were heavier and more costly to distribute.
- Second, as a result of a merger, the business operated twice as many distribution centers across the country than previously used.
- Third, the competitive landscape had radically changed with the growth of mass online resellers who offered the same products at lower prices.
- And fourth, the company had introduced a new sales compensation plan that rewarded salespeople for revenues irrespective of gross margin.
Armed with a new view on reality, management, working with their advisors, agreed to cut the number of distribution centers by half; employed new, cheaper technology platforms; reduced overhead by streamlining the organization; and redesigned the salesforce compensation plan to drive higher profit margins.
As a result, annualized EBITDA tripled within 12 months of implementing the turnaround program.
PE firms often acquire companies that have built layer upon layer of complexity over the course of many years. These layers include businesses that were acquired and perhaps poorly integrated, non-core product lines, multiple management teams and lines of reporting, and a host of irrelevant policies and procedures.
Refocusing on core competencies is typically a first priority for deal professionals and operating partners with an underperforming business. If the enterprise continues to struggle, PE owners should look to see if further operations can be simplified and then, using objective evidence, encourage the management team to take further action.
Recommendations may include simplifying the footprint of the business and divesting assets that are non-core. This review process should become a regular exercise, even after the business is put on sounder footing.
For example, in one industrial products company, management and owners built a national footprint with several manufacturing and distribution sites across the US, believing that geographic proximity to local markets and large manufacturing capacity were sources of competitive advantage. It also considered the company’s ability to offer highly customized products at no additional cost a key part of the value proposition. However, revenue stagnated and profits turned negative.
When the owner and its advisors looked deeper, it became clear that the organization was composed of three different businesses. Its largest line of business enjoyed attractive financial performance. Others performed horribly. To become more sustainably profitable, the business needed to be pruned and streamlined. Four of five manufacturing sites were closed and production was shifted to the company’s primary location. Two of the non-core businesses were wound down so the company could focus on its core offerings.
By concentrating on more volume of standardized products in one manufacturing site, the business was able to increase manufacturing efficiencies, reducing costs substantially. Profitability increased as EBIT margin went from -3% to 15% in roughly one year.
Encouraging management to experiment requires close, objective monitoring of success or failure to quickly modify strategy or kill unsuccessful options. There should be a clear definition of the baseline and high-level metrics to continually track progress of the target state of the company. Regular updates on both successes and failures should be communicated throughout the organization.
For example, sales at one PE-owned manufacturer fell 50% over two to three years after one of its two major retail customers went bankrupt and the other was acquired by a competitor. A new CEO came in and was eager to shift to new channels and products. The PE owner supported this exploration.
The company experimented with a direct-to-consumer online approach, traveling pop-up stores and a joint venture with a specialty retailer. The experimentation allowed the company to identify which new channels were viable. Despite being on the brink of bankruptcy, the company’s growth in the new channels enabled the PE fund to exit the investment with a modest return.
It’s likely that PE owners have other portfolio companies that have experimented in ways that management can learn from. Allowing management the freedom to experiment can lead to options for a successful turnaround.
4. Aligning stakeholders
A turnaround strategy always involves making tough choices. The previous examples include abandoning old business models, and streamlining and closing operations — choices that are likely to affect employees and external stakeholders.
As long as the PE owner is convinced that it has the right management team in place, it’s essential to stay focused on problem solving while being willing to take on high amounts of risk from time to time. In fact, in many cases, the risk was assumed when the PE owner bought the business. PE owners should own the turnaround plan and make certain that management incentives line up with the plan. Keep sight of monthly results, but place greater importance on progress toward key turnaround milestones.
5. Making the tough decisions
Once these steps are taken, if performance is still not turning around — as measured by KPIs and adherence to the turnaround plan — the question PE firms need to ask is, “do we still have the right team in place to execute on the challenges in front of us?”
Making a decision to change the management team midstream can be very difficult. It sets the time frame of the turnaround back and can also be seen as an admission of failure in deciding to back the management team in the first place. But it can also lead to greater success, such as in the example above of a new CEO coming in and being willing, if not eager, to experiment with new strategies.
Just as data-driven analysis should point to the tough decisions that need to be made in changing the operating model, the same data-driven approach should be followed when deciding whether a change in management is needed.