In a challenging exit market, private equity firms now need to focus more than ever on the operational value drivers of their portfolio companies. Market due diligence may hold the key. Mareen Goebel reports.

In a market almost wiped clear of new primary investments, private equity firms have had to focus on their portfolio companies for some time and, despite signs of a recovery, the industry agrees that times will remain tough for a little while longer. However, the focus of portfolio management will gradually shift from fire-fighting to preparing companies for a hopefully profitable exit.

However, the crisis itself may not have been the principal cause behind insolvencies, write-offs and loss of value, but rather it exacerbated existing problems. This is the key finding of strategy and marketing consultancy Simon Kucher & Partners, which has queried 400 decision makers in the European private equity industry for their study "Insolvencies in Private Equity Portfolios - Reasons and Consequences", which points at key issues that can be addressed to not only prevent losses but grow value in the surviving portfolio.

While it is no surprise that excessive acquisition debt was one of two main factors contributing to pressure on portfolio companies, the interesting finding is that operational mistakes were of equal importance.

These could take many different shapes. In some cases, the management failed to adjust to the quick decision making process needed in a crisis and did not have contingency plans in place. In others, companies did not address their key customers proactively, even though they knew that these would be likely to cut their orders. Also, many companies damaged their future prospects by cutting their R&D budgets and did little to reposition, for instance by expanding into new segments and markets and broadening their product offerings to offset the losses.

What is clear is that for private equity backed investments to be successful, managers and backers alike have to find ways of increasing profits even in a crisis and make the most of the current stabilisation and recovery.

"Put simply, they only have three options: reduce costs, increase volume or increase prices," explains Stephan Butscher, managing partner UK at Simon-Kucher & Partners. Most often, the costs have already been addressed and many portfolio companies already run lean and efficient operations. Then, of course, increasing volume in a downturn is not normally the best bet, which leaves pricing.

Here, Dieter Lauszus, senior partner at Simon-Kucher & Partners, sees a large potential to drive value growth: "The calculation is quite simple. If a company with an operating margin of 10% increases prices by 5% with no losses in volume, it boosts profit by 50%. Here is the most powerful lever to grow value."

As well as simply lifting prices, according to the consultancy, many companies would benefit from investment in their sales teams and the optimisation of their sales processes, in an effort to maximise value extraction. But this is not always at the top of the agenda of private equity owners and management.

"In our experience, these factors come into play too late during the holding period," explain Butscher. "After closing, private equity firms often look first at repositioning the company and focus on the cost side, while they manage revenues and prices later. But in many businesses, profits are influenced by annual contracts, so measures take a while to show their benefit. So by addressing this potential for improvement too late in the holding period, private equity owners often lose out on a key value driver, and we anticipate that moving this forward and addressing it as soon as possible will yield the best results for owners and management."