In PE, cash is king, but unfortunately only in the short term

By Daniel Windaus, Head of Private Equity, REL UK

Daniel-Windaus‘Cash is king’ is an oft-quoted mantra but reality is far removed from the theory as far as fast-growing companies and their working capital go. Private equity held investments arguably have the most to gain from optimising the cash conversion cycle, yet they are no better – indeed they are often worse – than the average enterprise.

REL research into some of the world’s biggest companies – PE backed or otherwise – shows working capital has oscillated in terms of its key ratios over the last five years in a way that is not strongly correlated with macro-economic drivers.

While companies reacted to the credit crunch, we see performance deteriorating since the initial wake-up call. This is often driven by inconsistent management attention, as well as focus on the low hanging fruit, rather than the more difficult structural changes required in the supply chain and customer as well as supplier management processes.

These problems are accentuated at private equity held investments, where we see three key challenges facing the equity sponsor when targeting improvement in the cash conversion cycle, each cascading into the other: too much focus on quick results, leading to overlooked and untapped potential and ultimately to the eventual loss of the gains made by those initial ‘quick wins’.

Mind over matter
Dealing with the first issue, the root cause of poor cash conversion is the mindset of portfolio companies’ management is still focussed too strongly on the need for quick results. This is partly induced by the impatience of the equity sponsor itself. As a consequence, surface changes are favoured over structural, resulting in improvements that are often not sustainable over the length of the investment cycle. Addressing the structural issues requires more energy and political buy-in, which is better promoted by the equity partner from the outset than by anyone else.

Mis-prioritisation of initiatives and limited visibility on the full working capital opportunities leaves untapped potential on the table. Particularly for secondary buy-outs, we see limited degrees of willingness to push for the next tranche of working capital improvements. This is compounded by the limited insight into ‘best possible’ performance levels that could be achieved. Dissecting fact from fiction (to establish why current working capital percentages may not be at acceptable levels) requires a depth of understanding into actual process execution at an operational level. Often we see that even in secondary buyouts where working capital has been targeted historically, 10-20% improvements are still possible.

Not only is this a huge missed opportunity, but a failure to properly address structural processes relating to working capital from the outset means that most initial gains are eventually lost, resulting in the need to run second round mid-cycle improvement initiatives. This is simply because changing behaviour and mindsets requires a dedicated initiative over a relatively long period, and equity sponsors should encourage companies to seek structural support for this extended time.

Measure…
Reducing working capital sustainably over the investment cycle is essential as it is a significant driver for value generation. To maximise performance equity sponsors need to actively promote the strategy within portfolio companies, defining the performance base lines and the desired state, installing the right management systems and ensuring action.

To discern opinion and fact on the way to making real improvements, a three-tiered level of investigation of working capital performance is required. Firstly, conduct an external benchmark of peers in the industry, as well as with companies outside the direct industry, that face the same challenges in terms of target customer markets, key supplier spend purchasing channels, and supply chain complexity.

Follow this up with an internal benchmark on variation of business units, change over time and best performance. This will question some of the status quo, as well as uncover potential hidden opportunities within specific areas of the portfolio company. This can be built on by a deep dive diagnostic of end-to-end receivables, supply chain and payables processes. The best time to identify improvement opportunities and targets that management will buy into is when evaluating internal constraints and identifying detailed pragmatic improvement.

… Manage…
Installing the right management systems is essential to carrying through any actions taken following benchmarking and investigations. This should cover a number of key elements, including process-focused KPIs, cash related incentives and standard company-wide rules of engagement.

As in all things working capital, the devil is in the detail when it comes to these top down measures. Particularly in geographically fragmented businesses we recommend clients establish rules of engagement, part of a harmonised process blueprint. In most instances achieving 80% commonality in key working capital processes across geographies is feasible.
KPIs also need to go beyond top-down balance sheet ratios like NWC/Sales, DSO, DPO, DIO. None of these will drive action and they are usually translated badly into the operational level where they need to be effected. A number of bottom-up operational KPIs based on transaction data from ERP systems better measure real process performance.

Targets are a key motivator and need to be cascaded from top management all the way to operational and clerical staff, but incentives based on reporting period-ends do not create the right focus. They should instead be run based on relative KPIs and aligned to trend movements over time. Incentives related to cash also need to make up a significant part of the remuneration scheme to take any effect. Anything under 20 per cent of the total possible for management does not tend to get the required shift in focus.

… Act!
Finally, it is of no use going to all this trouble if action isn’t taken and working capital performance is driven to a large extent by the grass roots of business. Habits often stubbornly prevail at operational level against management intentions and therefore the change management challenge requires attention beyond the typical action plan and project management office focus. Any initiative needs to have a solid operational change structure in place that must include change in operational processes, hands-on training and daily walking the floors to provide coaching. Changing operational behavior is more ‘hand-hold and support’ than ‘plug and play’. Equity sponsors need to encourage company management to put this support structure in place to achieve sustainable improvements.