Managing procurement spend can substantially improve EBITDA for private equity (PE) partners.
When PE firms add a company to their portfolio they generally formulate a rapid action plan to make positive changes when employees are most receptive. Procurement should not be overlooked.
The math is very simple. Once the level of external spend at the business is more than one third of the revenues, the procurement profit improvement lever can be quite substantial.
We have historically seen suppliers benefit in many industries from inflation-led growth. But the customer/portfolio company should actually be benefitting from price improvements in the underlying source material or process (lower production costs, lower technology and telecoms cost, alternative distribution models, etc.).
And as inflation and consumption growth has fallen in recent years in many developed markets, procurement savings have a relatively more important profit potential improvement impact for a company than was the case in a higher-growth environment.
Individual companies may require a slightly different approach, but fulfilling procurement potential is always a five-stage process.
1. The plan:
Identification of procurement opportunities by private equity (PE) and portfolio company management.
This opportunity will typically form part of the 100-day plan or annual budget improvement plan. You need to have a clear savings target and between 6-18 months to deliver it.
Management and the PE firm will often work with an external provider to help assess the potential improvement opportunity and, if necessary, use external support to implement the required changes/improvements
Management and the PE firm will often work with an external provider to help assess the potential improvement opportunity.
2. The people:
Getting the PE team and operations team (CEO, CFO, COO, and CPO) on board.
Without management buy-in, improvement projects can lose momentum or revert to the norm, which can result in failure. Eliminating any potential obstacles upfront is a shared responsibility for both the PE firm and management team.
As the relationship between the PE firm and company management is often particularly focused on key initiatives and KPIs, there is usually great buy-in and cooperation on procurement-related initiatives. Every top manager understands that there is always a better way of doing things, but that a lack of buy-in will often prevent a superior solution from being delivered.
3. The procurement diagnostic:
Assessment of potential improvements in processes and people, quantification of savings, alongside timing for implementation (often with external support).
This should be a focused, four- to six-week ‘Opportunity Assessment’. The aim is for a granular roadmap for savings delivery, which presents an attractive project ROI based on realistic savings targets.
This can be done internally or with expert external assistance. Either way you must ensure that the scope is comprehensive and that the key improvement potential levers are tested.
For the diagnostic to be reliable and robust, sit-down meetings with the entire management team, key budget holders and influencers are essential.
Digging into the detail of spend buckets is important as there can be big variance in spending – even within categories. Without a clear picture of all the underlying spend components, the diagnostic will be flawed.
For example, within a business that has €100 million of turnover and €10 million of profit, Marketing spend of €5 million may at first appear low. If, on closer review, you see that €1 million is being spent on conferences for the wrong audience, this can be cut to zero for an immediate 10% profit improvement, or the money can be reinvested elsewhere to grow the business.
Balance savings against commitments, keeping in mind that savings should ideally be locked in one or two years before exit. Quick wins are generally better than future performance improvements. If you are still making procurement improvements three to six months before a sale, it may be too late: buyers usually will not be willing to pay up for this.
External eyes are often better at picking up potential improvement opportunities. Using a best-practice process, which is adapted to individual client needs, can generate a very good understanding of what can actually be delivered.
Once completed, management should sign off on the roadmap to aid implementation.
4. The implementation:
‘Best of breed’ solutions and ensuring they stick; building buy-in at all levels of the organization (internal delivery and external support options).
Implementing the identified improvements is not always as easy as it sounds. Blockages are usually removed speedily under PE management. However, sometimes difficulties do arise, perhaps with staff not wanting to ‘rock the boat’ and jeopardize existing supplier relationships.
Explain why activities are being undertaken. Over time, most businesses become complacent. The message should be that changes (sometimes seen as cuts) will make the business stronger and fitter, not weaker.
Careful consideration of how staff is incentivized can also pay off. It can be beneficial for PE firms to provide equity ownership to all employees in a business. Having an ownership stake is important – employees in companies like John Lewis are clearly motivated to succeed, given that they all receive a percentage of annual profits.
Quick wins are generally better than future performance improvements. If you are still making procurement improvements three to six months before a sale, it may be too late: buyers usually will not be willing to pay up for this.
5. The results:
The EBITDA uplift, with a multiplier effect on the equity.
Project implementation should bring clear results – process improvements, cash savings, an EBITDA uplift, greater equity value and therefore increased value to all stakeholders.
Certain PE groups have strong awareness of the value-creation potential from improvements in the Procurement function, particularly in lower-growth western markets.
If you take the example of a business that is growing revenues and costs by 2% per annum, with 50% of revenues in procurement, over a five year period profit growth is a benign 8%. However, if procurement spend is managed effectively, profit growth will be a much more compelling 22% and 36%, respectively, where procurement spend growth is controlled at 1% per annum or is held constant.
Using the examples shown, let’s assume the business was acquired for 10x EBITDA or €150m with €75m of debt funding and €75m of equity funding.
In example 1, on exit we assume that the outstanding debt is €50m due to repayments over the four years, and if the business is sold again at 10x EBITDA or €162m, the return on equity is a pedestrian 1.49x (162-50/75).
In example 3, however, the business is sold for €204m, which is a return on equity of 2.05x (204-50/50) which is the typical return sought by a private equity fund.
Clearly, private equity type returns can be created by any company that appears to be low growth but where a procurement opportunity exists and access to an appropriate level of debt is achievable.