4 post-close pitfalls to avoid for private equity firms

In an uncertain deals market, private equity firms need to maintain consistent approaches to integration to avoid post-close pitfalls.

In the midst of supply chain challenges, recruiting talent in a tight labor market, increasing borrowing costs, and a rising inflationary environment, business owners and their management teams must navigate myriad issues to maintain profitability and cash flow.

Research shows that private equity-backed companies fared better during the Great Recession than those not backed by private equity, because private equity-backed companies had access to more financial resources and were able to be more resilient to economic shifts.¹ Some of the keys to success for many companies that survived that period were scenario planning for a variety of outcomes, reducing the company’s cost structure, and preserving cash to maintain profitability and cash flow as revenues declined. During the Great Recession, many private equity firms worked with their portfolio company management teams to implement cost reduction and cash flow management plans months before experiencing revenue declines associated with the downturn in business activity. By lowering their cost bases and preserving cash, many private equity-owned businesses avoided breaching covenants and debt payment defaults that might otherwise have resulted in bankruptcy.

Investors in private equity firms expect their partners to seek attractive risk/reward investments in both good and bad economic environments. In more challenging economic environments, it is critical that new business owners implement certain steps in the first several months of a new investment to increase the probability of realizing a successful investment later.

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The mergers and acquisitions market is highly competitive. Today, private equity firms have limited time to evaluate the target business, complete confirmatory due diligence, arrange the capital structure, and document the transaction. The compressed time available to close transactions can make it difficult for the acquiring private equity firm to get to know the management team, develop detailed near-term goals, and prepare a long-term strategic plan.

Getting off to a good start in the first 12 months of an investment increases the probability of achieving success. Challenges that are not addressed early in an investment can limit the ability for management to invest in the growth and performance improvement initiatives that drive long-term value creation. To address these challenges, our private equity advisory team has identified four common new-investment pitfalls, with observations on how to overcome, or altogether avoid, them.

Getting off to a good start in the first 12 months of an investment increases the probability of achieving success.

Pitfall 1: Not developing good working relationships to align goals

Recommendation: Investing sufficient time to build relationships post-close

In many competitive sale transaction processes, representatives of the buyer might meet only a few times with the senior management team of the target business prior to the closing date. In fact, during the COVID-19 pandemic, our team observed that some private equity clients never met with their management teams prior to closing the transaction. This limited access during the transaction process means that buyers have to build working relationships with management after the closing date. While it is tempting for private equity buyers to jump right into significant growth and performance improvement initiatives, it’s critical to understand how management teams like to work, investigate strengths and weaknesses, identify any gaps that need to be filled, and get a sense of how the team responds to suggestions and new ideas before initiating major changes.

While it is tempting for private equity buyers to jump right into significant growth and performance improvement initiatives, it’s critical to understand management teams before initiating major changes.

Management teams, particularly those that haven’t had an institutional equity partner before, might become frustrated or discouraged when they feel they are being told what to do by their new investment partner before a good working relationship has developed. In the first year of a new investment, many private equity buyers schedule additional in-person meetings with management – monthly, for example, instead of quarterly – to build working relationships with management, better understand the details of the business, and develop an enhanced perspective of what happens day-to-day at the company. In addition, the extra in-person interaction early in the investment period conveys to management the importance of partnership with the private equity team, which is there to assist, provide resource support, and be a sounding board for key decisions and new initiatives. Some of our private equity clients tell us they have greater success when they avoid initiating major strategic growth initiatives until they have developed a better understanding of the business and management team capabilities.

Pitfall 2: Pursuing too many initiatives, too fast

Recommendation: Aligning priorities on strategic initiatives

After the deal closes, the management team likely is excited about getting to work on accelerating growth and implementing performance improvement initiatives. However, in many cases, management might not have the capacity to pursue multiple strategic initiatives while managing the day-to-day operations of the business. Asking management to tackle multiple new projects might overwhelm the team, which can result in poor execution of both the new initiatives and day-to-day management.

Many of our clients tell us they take a measured approach to introducing new strategic initiatives, leading to better long-term execution and results. In the first year of an investment, private equity firms would benefit from scheduling working sessions with management to identify key opportunities and risks, with a goal to narrow the list to a handful or less of strategic priorities so that each member of senior management and the private equity firm are in alignment. While unplanned opportunities and challenges inevitably arise during the year, the private equity firm and management can assess the importance of those items relative to the small number of strategic priorities for the company.

A measured approach to introducing new strategic initiatives might lead to better long-term execution and results.

Once alignment on strategic priorities is achieved, scorecards should be developed to track progress. Scorecards are used in a regular weekly, monthly, or quarterly cadence of update discussions with management. While business activity is dynamic and there will be times when it’s necessary for management to deviate from strategic initiatives or put them on hold, scorecards are useful for creating accountability for progress on strategic initiatives.

The process of identifying and aligning on strategic priorities with management should be repeated each year, typically during the annual budgeting process. As part of the overall planning process, teams should identify current resources, locate any knowledge gaps, and proceed accordingly.

Pitfall 3: Underestimating the importance of periodic financial reporting and KPIs

Recommendation: Understanding reporting requirements and KPIs and how to align management with the private equity group

Many portfolio company management teams, particularly those with no prior experience with an institutional equity owner, often are not prepared for the expectations private equity firms have regarding periodic financial reporting, focus on financial and operating key performance indicators (KPIs), and use of metrics in decision-making. In addition, management teams often are unfamiliar with the enhanced reporting requirements in banking relationships concerning financial performance and covenants measurement. Management teams that rely on gut instinct for key decisions often struggle to keep up with the pace of change in private equity transactions, particularly as the business grows in size and complexity. Consequently, it’s critical for private equity firms to work with management to develop improved financial reporting and KPI measurements and encourage a more metrics-driven approach to decision-making.

It's critical for private equity firms to work with management to encourage a more metrics-driven approach to decision-making.

Even if companies don’t have any obvious gaps in financial statement reporting, they might not have any relevant KPIs or useful scorecards in place to keep a pulse on the business. The timeliness and quality of financial reporting and KPIs are especially important in leveraged buyout transactions, in which the company has less room for error in terms of performance cushion.

In addition, a strong correlation exists between the quality of financial reporting and a company’s IT systems. If good IT systems are not in place, it might be difficult to develop the detailed financial metrics and KPI reporting needed to track the performance of the business. IT systems that are antiquated, not flexible, or not scalable likely will affect the ability of the management team to execute an investment management plan focused on accelerating organic acquisition growth.

Pitfall 4: Not adjusting rapidly to changing market dynamics

Recommendation: Anticipating and aligning on changing environments

The years since 2020 have been a challenging period for businesses. A pandemic transformed the global business environment virtually overnight. Many businesses were forced to shut down, and business owners and management teams scrambled to determine whether they were permitted to operate the business, how to keep employees safe, and how to maintain various commitments to customers, suppliers, lenders, and regulatory parties. Business owners were forced to develop contingency plans on the fly.

Business owners have dealt with major supply chain disruptions, tight labor markets, and – more recently – accelerating inflation and interest-rate costs. Given the relative stability in inflation and the low-interest-rate environment that businesses enjoyed for the prior 15 years, the sudden inflation and interest-rate increases have forced business owners to develop contingency plans quickly. Companies have had to figure out how to manage the environment to benefit their business, including how to price products and services in response to inflation. Supply chains continue to be a challenge, and, in response, many companies have made incremental investments of working capital to meet customer demand. Recruiting talent remains a challenge, particularly as businesses have returned, or are returning, to pre-pandemic levels of revenue volume.

Lessons learned by business owners in recent years include preparing multiple contingency plans to address rapid changes in the business and the economic environment. Management teams need to be nimble and adjust both to business and economic threats and to unexpected opportunities for growth. Teams are better equipped to react when they have gone through a thorough planning process to address such contingencies. This is especially true in private equity-owned businesses that have capital structures with less flexibility given commitments made to debt capital providers.

Preparing multiple contingency plans can help business owners address rapid changes in the business and the economic environment.

Moving forward

Private equity firms are expected to evaluate risk/reward opportunities and new investments in both good and bad market conditions. Deliberate planning to avoid these four common pitfalls helps private equity investors navigate the current market challenges and realize superior returns for their investors.

¹ John Pavlus, “Private Equity Helped Firms Weather the Great Recession,” Kellogg Insight from the Kellogg School of Management, Jan. 4, 2018, https://insight.kellogg.northwestern.edu/article/private-equity-helped-firms-weather-the-great-recession

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If you’re looking for ways to help your private equity firm navigate these pitfalls pre- or post-close, our team is here to help. Contact our private equity specialists today to see how we can help your company thrive through an M&A.

Simon J. Little

Office Managing Partner, Dallas and Plano

+1 214 777 5235

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Douglas J. Knoch

Corporate Development Leader

+1 630 990 4495

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