Funds need to squeeze more free cash flow from companies in order to generate an adequate return from vintage 2019-2022 investments. More sales growth and/or higher profitability is needed to make-up for the valuation headwind from higher interest rates. One of the best ways to achieve lower cost, greater market responsiveness and top-line growth is to work-off “organizational debt” accumulated during the ’19-’22 land-grab days when companies were acquired and not properly integrated.
Buy-and-build was a popular value growth strategy when debt was cheap. However, this came at the expense of integration to capture both top and bottom-line synergies. This off-balance sheet “organizational debt” has become apparent in the current market where it is no longer possible to exit to another private equity buyer with lots of cash deploy. There is no longer a willingness to turn a blind-eye to org debt in due diligence. It must now be worked-off in order to sell and generate a reasonable return.
Its a big problem across an industry that went on a buying binge. Bain estimates a record backlog of 28k buy-outs to be sold. And pressure to work-off org debt is further exacerbated by record high leverage ratios with +80% of deals having EBITDA/cash ratios of less than 3x. The pressure to generate sustainable EBITDA has never been greater.
Working-off org debt starts with the portfolio company management designing a new operating model on a blank sheet of paper. There is often an reluctance to integrating the broader management in this discussion due to the (unfounded) fear of losing key talent or gaming decisions based on self-interest. But this is wrong. Current managers are the subject-matter-experts to judge the pro’s and con’s of different operating model and structure alternatives.
Like with product development, it’s crucial to first get agreement on the requirements that a new operating model must fulfil before diving into the design. Consensus on requirements also anchors a “case-for-change” that facilitates implementation at all levels thereafter. As there are many trade-offs and options for a new operating model, it’s just as important to have consensus agreement on what the future operating model will NOT be as what it WILL be and the rationale.
The real work begins after basic agreement on a target operating model that fulfils the value growth requirements. That is, implementation. Implementation requires carefully working through all the important details of the new set-up including the design of sub-structures, new/changed roles, management processes and finally, the appointment of qualified managers to new roles. Its this detailed work, which is done before going live, that clarifies efficiency improvements and works-off the debt of unintegrated acquisitions to enable synergy realization.
Implementation is also where qualified external support can add high value. By providing objective 3rd party expert facilitation, management teams can work through the issues at pace and get to consensus agreement on pragmatic solutions much faster. Humatica’s proven 7-step playbook for working-off org debt enables design an implementation of a more efficient operating model in three months and typically results in a 15-20% improvement in EBITDA margin.
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