On September 9, 2024, Accordion’s CEO & Founder Nick Leopard appeared in Forbes to discuss the valuation disconnect between dry powder that needs to be deployed and logjam of companies that need to be sold.
Here’s what we know:
- Private equity (PE) firms have historically large amounts of cash to burn ($4 trillion in dry powder).
- Hold times are unprecedently high. The average hold time will reach about seven years by the end of 2024.
- Firms are eager to do deals so they can return money to limited partners (LPs). Funds are sitting on approximately 28,000 unsold companies, with 46% of those assets having been held for over four years. Many assets plus long holds equals minimal investor returns.
- The quantifiably good assets—the “diamonds”—are trading (see 10 recent megadeals).
- As for the rest of their portfolio, general partners (GPs) are being aggressive when valuing their underperforming assets. A recent report exposed the negative correlation between valuation multiples and earnings growth in PE-backed companies.
So, there’s a ton of dry powder that needs to be deployed, there’s a logjam of companies that need to be sold, but there’s still a valuation disconnect.
The Conundrum
How can buyers get comfortable paying up for non-diamond assets in a competitive market? (A critical question given that in this game of valuation chicken, sellers are unlikely to come down too far on price.)
The answer is finding a better way for buyers to distinguish between assets that are diamonds-in-the-rough and those that are just in rough shape. That better way must extend well beyond traditional due diligence. Buyers need a plan for which value creation levers can be pulled to increase profitability—and they’ll need the confidence to know pulling those levers will work.
Making it real
Take, for example, a company with $500 million in revenue and an enterprise value of $1 billion, stemming from a 10X enterprise value (EV) multiple. If, during bidding, a buyer can achieve a high level of confidence that by pulling often-overlooked operational value creation levers, they can realize $20 million in EBITDA (earnings before interest, taxes, depreciation and amortization) improvements, they can increase their offer by approximately 3%-5% and still see a meaningful equity value bump.
The good news is that this better way exists. Future value diligence provides buyers with a way to achieve confidence and end the cycle of valuation chicken. This type of diligence tells the potential buyer, “If these specific levers are pulled, there is a 90% certainty you can realize X amount of EBITDA accretion within Y period of time.” Think of it like a “value scope.”
The five-step playbook
There are five areas/levers that should rise to the top of the buyer’s list trying to find future value:
1. The value creation plan
This seems like the obvious first step: revisiting the seller’s original value creation plan (VCP) to identify the “dids” and “did nots.” And while that’s always a smart idea, much of the VCP is centered around a broader strategic vision that will take years to realize. For future value diligence, the question becomes, what are the go-to “did nots” that can drive EBITDA now? And just how much value can be realized by executing them?
2. Postponed integrations
Given the sponsor’s recent prioritization of revenue growth over value creation, many portfolio companies haven’t yet done the hard work of integrating acquisitions, leaving a ton of value on the sidelines.
A future value diligence assessment can help quantify any yet-to-be-realized synergies from postponed integrations and lay out a comprehensive path to realization—whether through process uniformity/standardization, back-office integration, supply chain/network consolidation, labor redundancies/automation, SKU rationalization, or commercial excellence. Levers can be prioritized based on expected impact, time-to-value versus time-to-exit and required one-time costs.
3. The tech stack
The tech stack can be optimized as a value driver as well. Companies that have been acquirers (and especially serial acquirers) are likely operating under multiple enterprise resource planning (ERP) softwares. This environment isn’t ideal, but for those on a near-term path toward exit, overhauling the ERP doesn’t quite make the agenda.
That’s why buyers must understand the type of value that can be created by either centralizing the system or by optimizing a disparate data environment with more cheap and cheerful initiatives. (The latter may include leveraging nimble business analytics solutions, better centralizing data governance with master data management systems, and/or investing in extract, transform and load/extract, load and transform (ETL/ELT) platforms that automate data flows quickly and cost effectively.)
4. Working capital/cash optimization
This is the sweet spot of future value and the kind of lever that can make a target worthy of purchase. (A recent report by the Hackett Group found that working capital presents a $1.76 trillion opportunity in untapped sources of additional liquidity.)
As it relates to how a future value assessment can identify working capital/cash optimization opportunities per target companies, we’re talking about whether there’s meaningful return on investment (ROI) to be had in maturing the operating model for scale, increasing visibility into data, automating processes to reduce labor spend and revenue leakage and/or finding high-impact working capital opportunities in billing and collections to contribute to run-rate savings.
5. Industry-specific levers
This is where an expertise of industry nuances can reap real benefits (or conversely, show that an asset is overpriced). Future value diligence will mine for those industry-specific levers that have not yet been pulled to drive value. For example, if the target asset is in the consumer packaged goods sector, has it instituted any alternative strategies to deescalate costs around current sourcing issues?
If the company is in the healthcare sector, has it implemented strategies to address labor shortages, like investments in workforce management solutions to enhance staffing efficiency, revenue cycle management (RCM) optimization to reduce labor spend, or AI-related tools for a near-term impact on billing, support, enrollment, claims processing and coding?
The secret to making this type of assessment successful (and well-embraced) is for it to be fast. Future value diligence must take no more than a couple of weeks to complete.
This new paradigm for diligence (if executed properly) increases a PE sponsor’s ability to win deals, ensures they can effectively deploy capital in assets with real potential and enables a go-forward plan to capture value far outweighing entry valuation.