Extreme volatility creates challenges for portfolio companies, but also opportunities for the most agile and resilient to build market share. A group of investors and political risk experts discuss how PE can support value creation through one of the most tumultuous periods in recent history.

Speakers:

Florian Otto and Jean Devlin, Control Risks
James Markham, Graphite Capital
Richard Pearce, ECI Partners
David Kirby, Livingbridge
Tracy Bownes, LDC
Kerim Turkmen, MidEuropa
George Swirski, Abris Capital Partners
Moderated by: Amy Carroll, Real Deals 

What are the macro challenges that are causing you and your CEOs most concern right now? What keeps you up at night?

James Markham: As a long-term asset class, private equity has always had to contend with macroeconomic and geopolitical risk. But there is no doubt that the list of challenges we face is long right now and I would put inflation, and particularly pay inflation, at the top. There is a real war for talent.

Tracy Bownes: I would agree. Grappling with inflation is definitely the biggest challenge facing businesses today. Our response has been to support businesses in formulating confident pricing strategies. But there is an employee welfare side to this as well. People are facing a cost-of-living squeeze and it is important that they feel adequately supported. As employers, we have expectations on us that just didn’t exist last time we were in an inflationary environment.

Richard Pearce: Supporting employees is definitely more important now than ever, not just because it is the right thing to do, but because there is real commercial value in retaining staff and maintaining the integrity of your culture. This is a drum that we are banging as loudly as we can right across the portfolio.

Kerim Turkmen: As well as having a direct impact on profit margins, inflation is also impacting demand because disposable income is contracting. Meanwhile, inflation is driving interest rate rises, which means a higher cost of capital. Private equity has benefited from loose monetary policy and expanding valuations for a long time, but this is not something we will be able to rely on in the near future, which is why we have invested significantly in our operations team to ensure we are highly focused on creating value through operational measures.

George Swirski: A lifetime’s worth of events has taken place over the past 12 to 18 months. It all started with Covid, which presented huge challenges in terms of preserving operations, while looking after staff. Then just when it looked as though the worst might be behind us, we suddenly had all these geopolitical events to contend with, which has now led to inflation and spiralling energy costs.

But while inflation is undoubtedly a big issue, we are constantly surprised by just how well some companies are performing this year. Why? Because they have been able to negotiate price increases offsetting rising costs. It is by no means all doom and gloom by any stretch of the imagination.

David Kirby: The risk, however, is that all this volatility creates an increasingly short-term focus around the board table. We have companies with graduate recruitment models where the attrition rate has been as high as 40% to 45%. That places enormous operational strain on a company, especially a company that is growing.

Meanwhile, although our investee businesses don’t tend to have complicated supply chains or macro exposure, their customers often do. For example, I am on the board of a company where Chelsea Football Club is a major customer. They stopped spending overnight when Russia invaded Ukraine. When you are constantly dealing with issues like that, it can be hard to stay focused on the strategic levers you need to pull such as pricing or M&A. Most management teams have never traded through a period with this level of volatility. Our role is to help them do so, without losing sight of longer-term value creation.

Florian Otto: Companies are being pushed to the limit of what they can handle, given the confluence of challenges they are facing with the worst geopolitical crisis in decades, coming hot on the heels of a global pandemic.

Having experienced this massive dislocation in their personal lives, employees are now having to absorb this next shock, which they fear will threaten their standard of living. This all means that maintaining a culture in which employees feel looked after becomes paramount.

That focus on people led to better retention through the pandemic, which in turn enabled businesses to bounce back strongly and actually gain market share. Investing in organisational resilience, not only helps businesses mitigate risk, but also seize opportunity.

How should private equity investors be supporting their portfolio companies to ensure they are resilient and well positioned to take advantage of growth?

Kirby: Many businesses surprised themselves with how well they dealt with Covid. It helps to remind them of that and to reassure them they can deal with this latest crisis as well. They just need to get back on that war footing.

Turkmen: I think we have had a lifetime of learning over the past few years, so that should make us more resilient.

Jean Devlin: Organisational resilience involves situational awareness of what is coming and the response, in the moment. But then businesses need to recover and adapt. Private equity owners and management teams need to acknowledge that recovery piece. That is true of a cyberattack. But it is also true of a period of extremely high attrition in the workforce, for example. There is a discipline to going through a ‘lessons learned’ exercise and then adapting that is extremely valuable.

And what lessons can be taken from Covid when it comes to this critical issue of retaining talent?

Turkmen: You need to think about your employee proposition in the same way that you think about your customer or shareholder proposition.

Pearce: The employee turnover we are seeing isn’t at a senior level or even middle management. It is in the junior ranks. One way to deal with that is to help managers learn how to manage. In fast growing SMEs, people often find themselves reaching senior positions without having learnt those vital skills.

Markham: It isn’t just about retaining talent, though. It is also about preserving culture. People are changing careers post-Covid and over 400,000 people in the UK have disappeared from the labour market altogether. That level of volatility creates real challenges and I suspect that the imperative of having a cohesive and resilient culture will start to eat into the working-from-home trend.

To what extent are you pooling resources and learnings from across the portfolio as you tackle the challenges we are currently experiencing?

Kirby: The importance of recognising when many of our portfolio companies are dealing with the same challenge is something that took hold during Covid but has stuck. That is the point at which we can add most value as a sponsor. For example, a common challenge that businesses face today is producing a believable forecast. If we can provide some basic planning assumptions – a house view – it can save management teams a lot of time. These SMEs don’t typically have access to resources for predicting the future. They are focused on themselves and their competitors rather than the wider world. We can help them to make that jump.

Markham: Covid certainly opened the door to broader cooperation across the portfolio.

Does that extend to procurement?

Bownes: Our value creation team includes a procurement expert and we choose preferred suppliers, encouraging and sometimes requiring their use. They ensure that topics that may be unfamiliar to management teams become engrained in the fabric of their business.

One example of this is cybersecurity. Small businesses may not even have a head of IT. And yet a third of UK SMEs will suffer a significant attack in the average year. We deliver training to all employees to mitigate phishing risk. We also carry out regular penetration testing and we are relentless about following through on those reports. There is always a balance to be struck in terms of letting businesses form their own strategy and being more directive. This is one area where we can step in and show management teams what needs to be done, so they can focus on the operations of the business.

Pearce: Cybersecurity is becoming hugely important when it comes to exit, particularly if there is any sort of digital proposition.

Devlin: We see cyber due diligence becoming mainstream, even with smaller targets. In particular, buyers are looking to understand what the benchmarks are.

Risk management is obviously front and centre right now. But what value creation techniques are coming to the fore in this period of volatility?

Pearce: The two aren’t necessarily mutually exclusive. There are different ways to create value. One involves growing the business – making whatever Ebitda number you are multiplying larger. The other is to improve the way the business is perceived to grow the multiple. That means ensuring you understand any objections as well as opportunities. Culture and engagement, cybersecurity, ESG - these are going to be major components of due diligence going forward and there is a lot of value to be created by getting these things right.

Swirski: We look to create value by expanding through acquisition and then overlaying that with best practice in ESG, cybersecurity, carbon neutrality commitment, people management and all those great things. The combination of doing everything better, while also getting bigger, represents the most exciting opportunity right now.

Markham: We buy businesses making £7m to £8m with a view to taking that to north of £20m. Many management teams may not have been on that journey before and won’t know what’s coming. We try and take our experience of guiding multiple businesses down this road, and combine it with their specific market expertise, in order to ensure the thesis we have invested behind is delivered.

Bownes: Execution is always different, but the common thread in our value creation is the identification of gaps in skills, resources or processes and using our wealth of experience to fill them.

Kirby: There is inevitably the need for additional capabilities as you look to double or treble the size of a business. Interestingly, 18 months ago, the most frequent skillset we were targeting was go-to-market – CROs and CMOs. Right now, the focus is more strategic. We are looking for chiefs of staff, transformation leads and project management officers. It is more about the guts of the business, rather than facing outward.

Turkmen: I would add that sector expertise is very important. We invest in four core verticals and that level of industry know-how helps us identify the right platforms, the right add-ons and position the business well. Value is created by increasing revenue and margins, but also by positioning the business in such a way that it becomes more attractive on exit.

What role does data play in your value creation strategies?

Kirby: The most frequent value creation activity we undertake, particularly in the first year, is around data. In times of uncertainty, you need to understand your customers in order to make pricing choices. You need to understand your supply chain and your people. All of that requires timely and accessible data.

Markham: Better quality management information leads to better decision making. Some SMEs tend to do things based on a hunch, so helping professionalise decision-making is a key focus for us.

And do you use data analytics within your value creation function, in order to identify risks and opportunities?

Bownes: We collate company information across the portfolio and our value creation team uses the information to identify gaps in processes or skills. Data for data’s sake is utterly useless, of course, but we are starting to see some early results.

Turkmen: We can’t tell our portfolio companies that they have to digitally transform, if we are still working on spreadsheets ourselves. We have integrated portfolio reporting and upgraded our own CRM system, which gives us better visibility. It is a continuum though. You can always improve.

Swirski: It is a question of quality, not quantity, when it comes to data. Each business is unique and it can be dangerous to correlate across different sectors.

Kirby: The metadata can sometimes be more valuable than the data itself. Those companies that submit on time, providing accurate information are typically the best performing.

Markham: Back in 2004, I devised an Excel-based template that I sent to CFOs. The value was less in the data collected and more about judging the quality of the finance function and how the CEO dealt with the management information. It can provide great insight into how a business is run.

Inflation and talent shortages are clearly dominating portfolio company agendas. But are the big geopolitical events of the day, such as the war in Ukraine, having any sort of impact?

Kirby: We have a portfolio company with a large team in Ukraine and that is the first time I have ever talked about war in a board meeting.

Swirski: We have had whip rounds in the office to buy equipment. We recently contributed to buying winter boots for women soldiers, who represent 20% of the Ukrainian forces. That’s how real this situation is. At the same time, all the supply chain issues that have emerged since Covid, amplified by events in Ukraine, means that nearshoring is becoming a hot topic, which is definitely benefiting our companies in Central and Eastern Europe. The war will also end at some point and the recovery budget will be multiples of the size of the Marshall Plan in real dollar terms – somewhere between $400bn and $700bn. Being next door to this huge construction site will very much impact our part of the world. The war is a terrible tragedy, undoubtedly. But it will open up an era of opportunity.

Turkmen: The importance of Central Europe, as a region, is certainly poised to grow as part of this major shift in geopolitical balances.

What about the role of China and tensions with the US?

Otto: Germany is one of the largest FDI investors in China and it is interesting to see how perceptions have changed there. There was already a sense that this idea that Europe, China and the US were converging economically was not going to plan. But Russia’s invasion of Ukraine really kickstarted a cognitive change. Suddenly we are seeing nearshoring discussions gather pace at breakneck speed. We are even hearing talk of China business units being carved out from the general organisational structure because the risk is increasingly considered too high to handle.

What we are trying to relay to clients, however, is don’t just look at what others are doing. There may still be opportunities for you in China, depending on the sector and business model. Avoid knee-jerk reactions.

Is there a sense that companies are being forced to choose sides?

Otto: Tech or data related businesses are certainly facing localisation pressures in China to comply with regulatory changes. But then key US customers are asking for written confirmation that they are not using Chinese technology in any of their IT infrastructure. So, yes, companies are increasingly being forced to pick sides or think carefully about whether globally harmonised organisations and value chains are still fit for purpose.

Markham: Expanding into the US has always seemed like the easiest and most obvious route for a UK SME to go to us. China and India sound great, but the reality is that their working practices are fundamentally different and there is always the question of whether you are really in control of your operations and IP.

We started our discussion focused on the biggest threats facing portfolio companies. Perhaps we could finish with the biggest opportunities. What is giving you cause for optimism?

Turkmen: It is a great time to be buying because companies need a safe harbour and that is exactly what private equity offers. We have the capital, the resources and the knowhow. If I was a CEO, I would want to be backed by a strong private equity player right now.

Kirby: History tells us that returns are highest during times of volatility, and I think all the experience we have gained through Covid will stand us in good stead.

Bownes: I often talk to portfolio companies about great businesses that were founded out of adversity. Airbnb changed strategy in 2009 when people weren’t travelling as much. Netflix used to be a DVD home delivery business with a cost competitiveness problem. Look where they are now. It is important to encourage management teams to believe in themselves, and to communicate that belief to their staff. Positive energy can make all the difference.

Pearce: The first world war gave us trade unions and the women’s vote. The second world war gave us the welfare state and Covid gave us a realignment around work/life balance. I think the latest crisis will lead to an acceleration of the move away from fossil fuels, given their implications for reliance on autocratic governments. So, while there will be pain along the way, there will be positive outcomes.

Otto: I agree. The current situation provides motivation to rectify some of the big structural challenges facing the European economic model, including reliance on imported fossil fuels. This opportunity is now also getting the popular backing it needs to take off. There are tumultuous times to come, but there is a lot of potential for positive change as well.