Our research also identified a trend that is increasingly shaping the industry and that we believe will be central to its future evolution—irrespective of the specific operating model that a private-equity firm chooses. That trend is increasing standardization.
By “standardization,” we mean the development of explicit, easily replicable proprietary processes for creating operational value. Driven by the maturing of the private-equity industry, standardization is taking place both along the private-equity value chain—that is, the general process by which private-equity firms identify, acquire, improve, and then exit their portfolio companies—and within the specific initiatives that private-equity firms deploy to create operational value at those companies.
When it comes to the deal process, standardization is taking place in three areas: postclose planning, performance monitoring during the holding period, and professional development of the portfolio company management team. While nearly all the firms we analyzed are standardizing these three processes to some extent, there is broad variation in the degree of standardization and its overall robustness.
We identified three standardized approaches to postclose planning:
The postclose strategy day, in which the private-equity firm’s deal team and (if present) operations team meet with company management to reach agreement on the company’s general strategic direction and identify a limited set of critical strategic initiatives (without going too deeply into how those initiatives will be implemented).
The 100-day program, in which the private-equity firm and company management develop a detailed action plan for operational improvements to be implemented in the first three months after the deal closes (sometimes with the help of an external consulting company).
The value creation road map, which is a comprehensive long-term action plan for realizing the company’s strategic agenda—complete with critical milestones, a timeline, designated responsibilities, key performance indicators (KPIs), and links to the company’s budget and business plan.
In our experience, most private-equity firms use at least one of these three mechanisms for postclose planning. But, of course, these approaches are not mutually exclusive. Each has a different time horizon and each tends to go progressively deeper into the nuts and bolts of operational value creation in the portfolio company. One key trend in the standardization of postclose planning will be to integrate each of these approaches into a more comprehensive planning process. In this integrated approach, the strategy day focuses on aligning the key players around the long-term strategic direction, the 100-day program focuses as much (or more) on figuring out how to implement the initiatives necessary to execute the strategy as it does on achieving quick savings, and the value creation road map guides the company’s activities throughout the holding period.
In today’s highly volatile economic environment, however, firms need to be prepared for the fact that portfolio companies may have to adapt their strategy multiple times throughout the holding period. As a result, postclose planning will increasingly extend until exit, with the value creation road map being revisited at multiple points as changing business conditions require. This iterative planning process will conclude with the ever more important task of exit preparation—that is, reviewing the business plan and key value drivers 12 to 18 months prior to a planned exit in order to test whether the company is attractively positioned for likely buyers.
When it comes to performance monitoring, we also found a range of standardized approaches. While nearly every firm we looked at has some standardized approach to tracking KPIs at their portfolio companies, the comprehensiveness of those KPIs varies greatly. Most firms track financial reporting, a process that in some cases has become completely automated. But only some regularly track operational KPIs (for instance, operating income or industry-specific indicators such as same-store sales in retail), which are absolutely critical for monitoring ongoing operational value creation. Finally, relatively few firms have taken the additional step of systematically tracking leading indicators that would allow them to identify problems in the business before those problems start showing up in downward-trending operational KPIs. Leading indicators might include macroeconomic factors (such as inflation rates) or industry-specific factors (such as order intake and stock levels in the automotive industry). In the future, we expect to see comprehensive standardized monitoring of portfolio companies, including automated monthly reporting, standardized cross-portfolio metrics, and company-specific leading indicators.
The professional development of the management cadre at a private-equity firm’s portfolio companies is probably the area in which there is the least amount of standardization today. Most firms do an initial assessment of management during the due diligence process or, if they choose to go outside for management, before they hire a new team. Many complement this initial assessment with ongoing performance reviews of the CEO. But relatively few have instituted standard reviews of C-suite employees across all their portfolio companies.
As operational value creation becomes more central, private-equity firms will need to take a much more active approach to encouraging the professional development not only of the top teams at portfolio companies but also of the broader management ranks. That will be a big challenge because private equity has had something of a blind spot when it comes to talent management. When value mainly came through leverage and holding periods were relatively short, the development of talent seemed like an investment that firms could safely avoid.
But as top-line growth becomes more important and holding periods grow longer, building a strong management bench even down into the middle ranks of portfolio companies will be core to successful value creation. Systematic professional development will help to ensure that firms are getting the most out of the people at their portfolio companies. What’s more, we believe that standardized approaches to people development will eventually cover all employees at portfolio companies. (See “Bridging the Talent Gap.”) For example, one large private-equity firm we studied has a proprietary professional-development process that includes an employee-training program and online surveys to gauge employee satisfaction at portfolio companies, the results of which are integrated into the firm’s reporting system.
Private-equity firms need to think more seriously about how they develop a strong bench of talent at their portfolio companies. Consider the demographics. Talent is already in short supply for many positions. In a 2010 BCG worldwide survey, 56 percent of responding companies cited a critical talent gap for senior managers’ successors—in part because their internal talent pools were too shallow.
Despite slow economic growth in the developed nations, most companies are hard-pressed to find high-performing, high-potential individuals who will serve as tomorrow’s middle managers and senior leaders. In high-growth emerging nations, the challenge is to find sufficient numbers of skilled workers. The shortage of skilled people will worsen over the next decade, making it more difficult for organizations to penetrate new markets and compete effectively in volatile markets.
The new reality is that companies face a seller’s labor market, with highly talented individuals having more job choices than ever before and desperate companies engaging in “talent wars” that only bid up the price of talent, often far beyond an individual’s capabilities. In such an environment, it is more sustainable to build talent internally. Doing so preempts the need to expand expensive and time-consuming recruiting processes, and it reinforces the company’s value proposition to employees and potential recruits. On the basis of our survey, high-performing companies (as defined by revenue growth and profitability) fill 60 percent of senior-manager positions internally, as compared with 13 percent at low-performing companies. High performers have realized the need to have a holistic talent strategy in place to leverage this most valuable asset.
For a fuller treatment of this subject, see “Make Talent, Not War: From Serendipity to Strategy,” BCG article, December 2011.
The other area in which standardization is taking place is in the range of initiatives that can create operational value at a private-equity firm’s portfolio companies. Exhibit 1 presents a typology of 25 ways that a company can create operational value. Some involve optimizing the company’s financial structure—for example, its working-capital productivity, capital expenditures, or policies for the use of surplus cash. Others focus on creating efficiencies that improve the company’s bottom line—reducing overhead costs, delayering the organization chart, or reengineering key functions such as sourcing, logistics, and procurement. Still others focus on improving the top line—whether by fine-tuning the core business or by expanding into new channels, regions, or whole new businesses.
We asked the private-equity executives whom we interviewed which of these initiatives they regularly use at their portfolio companies. Their answers are portrayed in Exhibit 2. In an environment in which operational value will increasingly come from improving the top line, the good news is that nearly all of the firms are using at least some of the top-line initiatives. More than 80 percent of respondents said that their firms systematically focus on two: M&A and geographic expansion. And more than 70 percent said that their firms also focus on sales force effectiveness and pricing. The bad news, however, is that despite these exceptions, the majority of top-line initiatives bring up the bottom of the list. For example, less than 30 percent of the firms systematically focus on product bundling and cross-selling, less than 20 percent consider account management, and none focus on channel management.
Of course, just because a firm says that it uses any one of these mechanisms does not necessarily mean that it has developed a robust, replicable, standardized capability. In our experience, the areas in which firms are using fully standardized approaches the most are financial optimization and bottom-line improvements. Relatively few have developed standardized approaches to the top-line initiatives increasingly critical to creating operational value. “We’ve become good at taking cost out and standardizing our approach,” said one operating partner. “We are less experienced with the revenue growth levers.” Although it is true that some top-line areas seem inherently difficult to standardize—business model development, for instance, or brand strategy—we believe that best-practice models do exist for many of them. (See “A Standardized Process for Pricing Improvement” and “A Standardized Aproach to Product Innovation.”)
A standardized process for pricing improvement focuses on two clear goals: improving a company’s pricing model through better policies on how prices are set and improving the pricing platform used to implement those policies throughout the organization.
There are three ways to improve a company’s pricing model. The easiest is through quick, no-risk fixes for pricing policies and anomalies—for instance, tightening the terms of payment, setting strict guardrails (such as minimum profitability levels), increasing prices on products or product features that have low visibility, and monetizing giveaways. Such initiatives can be decided upon quickly and rolled out for immediate impact.
Other changes are more strategic—for example, shifting price levels on key items by changing list prices or redefining the terms of trade promotion. Such moves are not to be taken lightly. It is critical to analyze carefully how both customers and competitors are likely to react to the changes. Exploring the impact of such changes takes some time, but once a decision is made, implementation is fast—and so are results.
The third, and most comprehensive, way to improve a company’s pricing model is by creatively rethinking its overall pricing structure. For example, a company could decide to overhaul its product lineup or completely rebuild its discount structure. It might also consider innovations such as pricing for performance, subscription pricing, or dynamic pricing (which is pegged to an external variable, such as time of day). These types of changes require managers to carefully segment their customers and opportunities. Piloting and testing are crucial before pricing schemes are rolled out; therefore, implementation takes longer than for other, less complex moves.
Improving the pricing platform is a more cyclical effort in which the company reviews its progress and redesigns its processes when necessary. The process includes redefining the roles and responsibilities of key stakeholders; establishing a clear process for collecting, analyzing, and interpreting market data; integrating pricing into key business processes; investing in tools and technology to support stakeholders in pricing; and designing incentives for general managers and sales teams that incorporate explicit price-realization targets.
Given the complexity of pricing improvement, it is best for these initiatives to be implemented in phases. Start by sizing the prize and developing a road map for pricing improvements. Then optimize price levels in the pricing model and redesign processes in order to improve the pricing platform. In the final two phases, return to the pricing model to reshape the pricing structure (a new product lineup and new pricing schemes, for example) and hardwire the new pricing platform.
For additional information on pricing improvement, see “Pricing Fluency: A Program for Pricing Excellence,” BCG article, December 2009.
After years of focusing on cost, quality, and productivity, private-equity firms are increasingly concerned with generating growth. As a result, they want more innovation from their portfolio companies. But they often admit that they don’t know how to put an innovation agenda into practice.
A starting point is to realize that innovation is an act, not an idea. Successful innovation—which is to say profitable innovation—depends on the entire set of actions that are required to turn an idea into cash returns. Combined, these actions are what we call the innovation-to-cash process. Because this process cuts across organizational boundaries and presents many difficult choices, it must be explicitly and thoughtfully managed. In particular, companies need a way to evaluate and manage the inherent tradeoffs—consistently and across a whole portfolio of different innovation efforts.
Despite the many uncertainties of innovation, it is possible to assess, at the outset, the likely impact of different approaches to managing the full innovation-to-cash process. This is accomplished by examining a particular innovation’s “cash curve.” A cash curve depicts the cumulative cash investments and returns for an innovation over time. It runs from the very beginning of development until the point at which the product or service is removed from the market. (See the exhibit below.)
By carefully modeling the impact of different choices on the cash curve of an innovation, managers have insight into the relative impact of key drivers of value. This approach also provides a mechanism for raising important questions about risks and for discussing possible interventions to reduce the risk of failure.
The financial analysis of innovations, which is fairly common, combined with a dynamic view of the cash curve, which is relatively rare, blends strategy and execution. It can make the difference between developing another inconsequential product or service and winning big—because it gives the top management team a language for and an appreciation of interrelated financial, market, and technology risks. In the end, executives have common ground to make better tradeoffs and break current compromises.
For a fuller treatment of this subject, see “Making Innovation Pay,” BCG article, May 2004.
How do the various operating models differ in their use of standardized approaches to operational value creation? On the basis of our research, firms that use external advisors show no consistent pattern. In fact, the initiatives they employ seem largely dependent on the experience of the particular advisor. Firms with generalist operating partners typically have a balanced mix between bottom-line and top-line initiatives, although they tend not to be as comprehensive in addressing bottom-line opportunities—owing mainly to lack of time. Firms with functional partners have a clear focus on standardized approaches to bottom-line improvement, but to the degree that they do address top-line levers (which is rare), they often take a relatively unsophisticated “plain vanilla” approach. The profile of firms with operating teams is similar to that of firms with functional partners, although the teams, of course, are significantly more involved in the actual implementation. (See Exhibit 3.)
The trend toward increased standardization in private equity presents the industry with a paradox. The more the industry embraces standardization—both in the deal process and across the spectrum of ways to create operational value—the less likely it is that either arena will become a source of differentiation. However, those firms that push standardization furthest and fastest will free up their senior people to focus on activities that potentially can confer a long-term competitive advantage—specifically, activities that do not lend themselves to standardized approaches and that require a complex mix of strategic and operational skills (for example, top-line expansion levers such as channel strategy, brand strategy, and business model development).