A CFO’s Life in Private Equity – Part IV - Onboarding And Getting Used to a New Dance Partner
You have learned the ground rules, you prepared the business for sale and even learned what it’s like to close with a private equity buyer. Those might be the easy bits when compared to onboarding and becoming familiar with your new owners. In Part IV Kevin describes working side by side with private equity owners. Here is Kevin with the next in his series.
All private equity firms are in the business of generating a return with someone else’s money. The ultimate metric of that is ROIC and there is a lot of research shows that it is linked to long term value[1]. While most finance people know it is Net income / Net Assets, what makes up that metric is viewed quite differently by the private equity firm compared to the previous owners of your company. Here are the major items that you need to navigate as the finance leader in your organization:
(a) Debt: Get Used to It
After the deal closes, the first conflict you are likely to have is around debt. Adding leverage to a company is a way of life for private equity as it significantly reduces the equity the new owners must invest in the acquisition. Further, depending upon how much debt is put on the company, it can significantly improve ROIC as it reduces the net assets invest in the company. The amount of debt used by a private equity firm varies widely, so find this out during the deal stage to make sure you are comfortable with it!
Most entrepreneurs I know have come really close to running out of cash in the past so most are naturally opposed to any type of debt in their company. Part of your job as the finance leader in your company is to bridge concepts like “cost of capital” and “available cash” in to plain English reasons why assets should not be bought with cash – this can start now. I have yet to see where this is a five minute conversation…or even an issue that gets resolved in a week! But it is a topic that will never go away!
Some companies, however, don’t know that private firms often put debt in to the companies that they invest in. If you are in this group and didn’t find out how much debt was being put on the company during the deal, you will quickly have to educate your previous owners how to be comfortable with debt and how that, assuming the company has enough cash flow, can be handled by the business. Cash flow forecasts are an important tool here to be able to project what the company will look like with debt and how much margin of error you have from week to week to manage cash flow. If it is tight, you will have to get more aggressive on cash management activities and quickly!
And of course, with debt comes reporting and compliance activities. Build those process and capability before the deal closes, which is made much easier if you have good financial closing and reporting processes.
(b) Why Are You Buying That?
Entrepreneurs tend to like to own assets as it gives them comfort that they have something that they can get their arms around. A first conflict comes when an owner is looking to buy their building and create a 5% to 8% annual return when the private equity firm expects an average return of 30% on net assets[2].
You have an education role to play to teach about how capital allocation decisions are made in this new world. And just like adding debt to the company as part of the transaction, you have an education role to play in how lease or asset loans work. And if you are rusty in calculating effective rates embedded in leases, I suggest you improve your abilities quickly as many lenders will fleece you on interest rates if you aren’t prepared. I have seen portfolio company leaders ask for signoff on leases that have high double digit interest rates and were unaware of it. Your private equity partners will expect this type of analysis done to support the right decisions to optimize returns.
(c) How come you aren’t getting people to pay sooner?
It doesn’t matter what your DSO is right now – cash inflow is crucial to any business and it always needs to get better through billing faster, following up with clients more often, and being more efficient in the collection process. And if you don’t believe it, guys like me will find another benchmarking study that shows that your industry leaders DSO are continuing to get better so should you, as an industry leader!
Again, invest in your processes and technology now. Get used to asking about working capital performance each week and always be looking for ways for it to get better. The payback of improved working capital is usually very short and will make your business healthier. If you make these improvements before the transaction it will add value to the current management team’s negotiating position and sets the company up for even better performance in the future.
(d) Why are you paying people so soon?
Yup – in the same breath as us asking you to get continue to get better at getting money from your customers faster, we may ask you to forget some of that when paying your vendors! We will ask you to look deeper in to ways to make payables go farther:
- Early pay discounts
- ·Volume discounts
- Extending payment terms beyond what has been traditionally paid
- Cut down the number of cheque runs
- Using data from your ERP to understand better lead times of inventory versus when they are consumed to reduce/optimize purchasing
There is nothing unique in the list above, but as mentioned earlier, many companies are either complacent or not as thorough in the management of working capital as they could be. Tools like the thirteen week cash flow forecasts can be invaluable here to allow you to optimize the use of cash coming in from customers and when you pay suppliers.
(e) So we would like to see…
We love data and analysis in private equity. In fact, the more of both, the better. A report that was fantastic for the last six months may suddenly stop being requested or completely reworked to look at the company in a completely different light. These requests will sometimes come up completely at random and often have unrealistic expectations as to delivery and level of detail. Other requests will be a natural query brought as a result of due diligence or the month end close cycle. The reason we do this questioning and asking for analysis is that we are always looking for ways to make the company more profitable, improve the balance sheet, or find other data and trends that management may not be currently looking at so we can make better returns. Take a hard look at your systems and processes today – are they able to answer all of these questions:
- Customer pricing levels and changes: are you able to see where customers purchase and have you optimized (and measured) how this has improved profitability?
- Inventory usage, turns, and waste: do you know where and how?
- Labour: can direct and indirect labour be traced back to individual projects and customers? Are all shifts equally productive?
- Overhead allocations: do they truly represent the economic activities and give management the driver(s) to better manage their efficiency?
- Bottlenecks: have you quantified where they exist? How efficiently are you managing them? How do you know when they have changed?
- Fixed assets: which ones are productive? Which ones are not generating the required return?
- Lines of business: are you able to calculate a fully allocated (including total company overhead) ROIC for each division? How has it changed? Where can it be optimized?
- Below margin costs: what makes it up? How it is efficient? Where are there opportunities for savings?
- Working capital: can receivables/payables as well as unbilled/deferred revenue and accruals be allocated down to the job/inventory and customer level?
Do not underestimate the volume of reporting that you need to provide to the new investors or how many different review meetings you will now participate in. Don’t get me wrong – many companies today don’t have CFOs that truly report on the performance of the business or where things are heading so a lot of good opportunities are missed. But going from nothing much to having an in-depth business review, complete with metrics and a forecast, five days after month end can be a very painful transition for both the private equity firm and the portfolio company. My month end review usually looks like this to gauge where your process is in terms of being “private equity ready”:
- The close process – how did it go?
- Leading non-financial metrics – how did they perform vs. expectations?
o Why?
- Current month income statement vs. budget
o Revenue (see my article on sales analysis for some ideas)
o Cost of sales
o SG&A
- Balance sheet
o DSO (AR and unbilled)
o Days Inventory Outstanding
o Days Payables Outstanding
o Cash conversion cycle trend - Trailing Twelve Months (TTM) this month vs. TTM last month
- Cash flow statement
o Discussion on difference operating income vs. cash from operations
o Capex and funding/leases
- ROIC - TTM this month vs. TTM last month
- Current forecast
o Income statement - bridge from last month’s forecast
o Balance sheet
o Cash flow
o Capex and funding/leases
- Current 13 week cash flow forecast
o Cash distributions coming to the investors
- Finance improvement initiatives - status
A few rules:
- We say we know your business but we are most likely still learning. Use graphs, waterfalls, and other visual tools to articulate the variances or issues. It helps everyone focus on the important items or explain the magnitude of how much something has changed.
- Use stories to explain what is happening…but make sure the data supports what you are telling as a reason why. Again, we are data people so we will dig in to understand more and if the data doesn’t support your story, you will have to do more work!
If you are using Excel as your reporting tool, this can be managed as long as your data comes out from your ERP or other system and can be manipulated quickly. Otherwise, get moving cleaning up your data to be consistent as well as implementing a reporting tool that can leverage this data. Having data at your fingertips allows you to spend more time analyzing and digging in to root causes than spending time putting together reports – it will make your life easier both now and in the future. We aren’t patient when you can’t produce a report because you can’t get Excel to prepare it for you.
Get used to it…but the best approach is to know that you own your own fate. So if you come in with a structure to explain the business or performance, you are more likely to determine what will happen after.
Part V of Kevin’s series, A CFO’s Life in Private Equity – Part V - Experience the Bolt-on Ride as now available.
Continue to Part V
[1] https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/a-long-term-look-at-roic
[2] https://www.hbs.edu/faculty/Publication%20Files/15-081_9baffe73-8ec2-404f-9d62-ee0d825ca5b5.pdf
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