Why fund managers need to stay focused on cost management
'Rarely a primary focus for private equity managers'
At a time of considerable economic and market uncertainty, many investors are focused on driving returns from their investments in growing businesses.
However, some private equity fund managers could be missing out on an opportunity to increase enterprise value in their portfolios by taking a more granular approach to cost management.
A study by Oxford Economics found that a flow of £4.1bn of venture capital and angel investment to sustain businesses and jobs the UK in 2015 generated GDP of £15bn.
In most cases, such investments are designed to help profit-making businesses to scale up, so they can do more of the same and generate value as they do so.
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While cost management impacts the financial performance of a business at any stage of its development, it is rarely the primary area of focus for private equity fund managers early in the investment cycle.
All about the (cost) base...
In fact, costs are usually only considered much later, if business performance starts to slip for some reason.
If growth stagnates, forecasts are missed or markets turn sour for example, fund managers may turn their attentions to the cost base in order to drive efficiencies and improve profitability.
Equally, if a fund is due to close in the near future and some assets are proving hard to shift, fund managers may look for ways to take out cost in order to enhance their value, before selling the assets and closing the fund.
While it is absolutely key to focus on costs and enhance margins should growth stagnate, focusing on the cost base to eliminate non-performing cost early in the cycle also delivers more cash to invest in growth levers.
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Cost that is not returning on the core growth proposition should be stopped or reduced, as not only is it a performance drag but the money could be invested in the proven growth levers instead.
Keeping cost management front of mind throughout the investment cycle can deliver significant results. For example, in a consumer product business, understanding true demand, or testing price elasticity and rationalising product ranges, can bring benefits in a number of ways.
Third-party cost optimisation
As well as reducing inventory to free up cash, taking such steps will increase cash velocity through the business and reduce investment in low-returning products.
A relentless focus on third-party cost optimisation through benchmarking and strategic negotiation can realise significant uplifts in both enterprise value and cash.
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Often the key to unlocking value is to analyse the corporate data. Advances in data science mean larger data sets can be combined and analysed in ways that were impractical just a few years ago.
For example, it may not be immediately apparent that a business is selling products or services at different price points into thousands of different customers or hundreds of channels, which could present an opportunity to adjust pricing and increase margins.
Along with business growth, supply volumes may have grown for certain individual parts significantly, without any attempt to leverage this increase in volume to negotiate lower unit costs.
These opportunities are relatively simple to negotiate, but they can be hidden in hundreds of millions of lines of data.
In the case of outsourced services, such as logistics, a lack of detailed knowledge about the exact volume of deliveries made to precise locations and distances travelled could be preventing the business from negotiating a contract that represents the best value for money.
Data science can analyse huge volumes of data, and when then combined with sensible supply strategies negotiated off the back of fact-based analysis, significant savings can be made.
Improving skillsets
Many private businesses already have a wealth of data at their fingertips ,but lack the capability to process it to generate sustainable value.
Some very large corporates may have access to data analysts and scientists to support them in integrating and analysing datasets and delivering insights to drive radical performance improvements.
However, smaller private equity-backed businesses are less likely to have access to this top-flight capability.
By importing such skills, private equity-backed businesses can reap the benefits and maintain competitive edge. With access to deep data science skills, they can layer up complementary datasets to deliver new insights and identify new performance levers.
For example, in many industrial markets, layering spend data (procurement and supply chain) with sales forecasting data across the bill of materials delivers margin forecasting insights.
This can be used to direct sales efforts into profitable products or channels, highlight opportunities to discount or drive volume and increase margin.
The key to realising value from data science, is having the sector or industry understanding to test the data with the right hypotheses, knowing how to implement the resulting insights and get the bottom-line impact.
Even if the business has access to specialist analytical expertise, it may lack the know-how needed to turn insights into action. This typically involves the development of bespoke algorithms, designed to help managers to secure the best financial outcomes.
In the example where supply volumes have tripled but the price paid by the business has not moved, the algorithm will find that part number and instruct the procurement team automatically to request a specific deduction and negotiate a lower price per unit.
When embedded within business processes, such smart analytics can drive performance and lock in added value for the benefit of the business, the PE fund and its investors.
Helping businesses on the road to cost base transformation is not always straightforward but is ultimately rewarding through locked-in operating profit improvement and an uplift in enterprise value.
Management teams may not be aware of the potential in their business, particularly with the demand on the skillsets in the market, but the results can be transformational in embedding sustained change and performance improvement.
Dominic Jephcott is co-founder and managing partner at consultancy Vendigital
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