Accelerating Through The Curve: How Value Creation Teams Help PE Firms Weather Economic Storms

We are still in the early part of “the curve” and not all the economic victims of the coronavirus pandemic have been revealed. It would seem the solution to weathering the storm is obvious: Shore up costs, and grab a lifeline in the form of government assistance; then wait it out. Clearer skies are ahead, right? Well, it’s not that simple.

First, show up for the race.

An analysis of the 2008 recession can help us understand what we might expect this time around. Bain & Company analyzed nearly 3,900 companies worldwide and compared “the winners” and “the losers.” During the recession years (2008-2010), winners grew profitability (earnings before interest and taxes, or EBIT) by 17% on average, while their losing counterparts flatlined at 0%. In the years following the recession (2010-2017), winners locked in those gains and continued to grow EBIT another 13%, while losers stagnated around 1%.

What this tells us is clear. Simply cutting costs is not enough, and is irresponsible to your stakeholders.

“Think of a recession as a sharp curve on an auto racetrack—the best place to pass competitors, but requiring more skill than straightaways,” the Bain report authors wrote. “The best drivers apply the brakes just ahead of the curve (they take out excess costs), turn hard toward the apex of the curve (identify the short list of projects that will form the next business model), and accelerate hard out of the curve (spend and hire before markets have rebounded).”

Understand that you need a good vehicle to compete.

In a similar study, McKinsey & Company looked at 120 private equity-owned businesses and analyzed their performance after the last recession. One finding was abundantly clear: Companies owned by funds with value creation teams (also referred to as portfolio operations) produced higher returns during the last recession and raised more capital afterward. This seems intuitive at first glance but is much less obvious in practical application.

Value creation teams are expensive. They are typically composed of high-cost resources with MBAs from programs like Harvard Business School and experience with investment banks or management consulting firms. One team member can earn over $500,000, and bonuses can put them in the millions. It’s not so difficult to make these investments when the economy is humming along and your portfolio businesses are all growing profitably. It’s very challenging, however, to rationalize this expenditure when you’ve witnessed an unprecedented economic slowdown caused by a public health crisis, the magnitude of which remains unclear. Regardless of uncertainty, value creation teams offer a compelling solution.

It’s not too late to join the race — and win.

One commonly held view is that building value creation teams only makes sense with adequate scale. There is some truth to this. Firms that consistently execute a high volume of large deals see a better ROI than smaller ones. Like other cost centers, value creation teams are no exception. KKR, for example, one of the largest private equity firms in the world, has developed a specialized, 70-person team that works under a unique brand name, KKR Capstone.

My experience working with over 50 private equity firms and family offices suggests that value creation groups pay off even at a small scale. There are countless examples of firms with fewer than 10 people, where half are focused on portfolio operations and the other half on transactions.

The alternative, old-school approach is to run a very lean model, where PE firms designate a partner to lead a transaction and then oversee value creation initiatives at the portfolio company. This might sound like a reasonable approach, but McKinsey’s study would suggest otherwise.

Now, start your engines.

There are generally three approaches to developing value creation teams. The first option is to build and deploy. This should ideally be aligned to your firm’s (or fund’s) focus or competitive advantage. If you consolidate health clinics and realize operational and IT efficiencies, then hire people with those backgrounds. If you buy manufacturing businesses and cut costs, hire supply chain experts. “Who” is always secondary to “what” in this case. If you already have a value creation team and are looking to expand, consider where you might have gaps and try to fill those.

The second option is direct deployment to the portfolio businesses. Meet with leadership teams for each of your portfolio businesses, and review their strategic plans. Ask them where they could use help, and hire accordingly. Make sure these hiring goals are aligned with strategic objectives, as opposed to short-term administrative relief. Take note if portfolio companies are resistant to additional support. This is a yellow flag, and potentially symptomatic of a much bigger issue that needs to be addressed.

The last option is to hire mercenaries, or interim portfolio operations professionals, and allocate accordingly. This is a good option if you need a team assembled quickly or have very specific resource requirements. Relevant examples include FDA consultants, who can repurpose supply chains to help launch medical product lines within nonmedical companies.

And finally, don’t wait to step on the gas.

We all know getting out of the next recession will be tough, and getting ahead seems like it will take an eternity. The harsh reality is that the data suggests playing defense will almost surely result in failure. After all, choosing to do nothing is still a choice. Playing offense, on the other hand, and accelerating through the turn, is likely the best way out of this. PE firms and their portfolio companies that have survived and thrived in the past have utilized value creation teams to do this.

On average, it takes about two months to hire analysts or consultants, and probably another two to three months for them to be productive and help portfolio companies execute on their value creation plans. Smart investors are using this time to assemble winning teams to make sure they end up on the right side of the finish line.

This article is originally published in Forbes.