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I've overheard many discussions where deal teams had anticipated margin growth management seems like they know what they're doing and then ebitdam reverses itself in reality that's Greg schooling he leads Bain's operational value creation team today on dry powder I'll ask Greg i'm the leading private Equity firms are doubling down on operational due diligence we think that's going to be a key Criterion for returns in the next five to ten years for private Equity we'll see how leading firms are using unique data sets and Cutting Edge tools to accurately forecast The Profit potential of a Target company we'll also see how clear and actionable value creation plans could light a fire on your management team I'm Hugh Mac Arthur chairman of Baines Global private Equity practice and this is dry powder Greg I just wanted to start by thanking you very much for stopping by the show today well Hugh it's great to see you and I appreciate the time you know operational due diligence and looking at margins in general is a really interesting topic right now as I look back over the last decade of returns in the private Equity industry about half of overall returns can be explained by multiple expansion obviously having near zero interest rates contributed mightily to that we don't actually have a zero Interfaith environment now and I'm going to make a posit that it's going to be tough for the industry to model out that half of overall returns are going to be generated by multiple expansions whatever the number is going to be it's probably going to be less than 50 percent yeah this is critical going forward one can't assume the same multiple expansion that we saw for the past five ten years for private Equity that makes a lot of sense Greg and the second big lever for returns over the last decade has been Revenue growth which has been a tremendous Boon the industry is a underwrite growthier assets in Tech and in other sectors that are really on secular penetration curves and doing quite well and it was interesting to me to note also that third on that list the three big levers of value creation for GPS has been margin Improvement I had always thought that this was one of the areas where the industry was at its best you know margin Improvement cost cutting you tend to think of that as hand in hand with private equity and what GPS partner with management to do really well but it seems to be the lagging value driver why in your view should private Equity teams be taking a harder look at operational due diligence now and how can that actually help the situation well Hugh I agree with you 100 I've looked at the same analysis and Beyond ebitda margin not being a key driver of irr in the past several years we actually found on average that ebitdot margin declined in many Investments so deal teams who were expecting a few Point expansion and actually saw a few points of declines I think the drivers of that are a few fold number one there are a lot of businesses being sold from one PE fund to another so it's harder squeezing margins on subsequent deals for future owners secondly inflation has really been a dynamic that people have had trouble getting their arms around I have one client today which is interesting half of their cost structure is declining because they're a buyer of a lot of raw materials Commodities where the other half of the cost structure is accelerating because it's skilled labor and trying to get your arms around that if you're an investor is extremely complicated the other reason for the disconnect I think is that often there is a operational advisor that may not really dig into the details to understand how margin can be grown and then often is working in a siled fashion from the other advisors meaning that the commercial diligence findings could suggest growth opportunities in New Markets requiring more sales people and the Opera operational advisors suggesting that there are cost savings and sales which obviously doesn't make sense I think you made a very powerful point that hiring lots of Industry Executives or Consultants to only look at operations or only look at commercial due diligence can actually give you answers that compete against one another I remember a famous restaurant chain example where some Consultants came in and said Gee you can actually save some protein on your sandwiches because you put a lot in there and that a pricing consultant came in and said you know you're kind of underpriced you should be really raising price on your sandwiches and then another cost consultant came in and said you've got too much labor in here and what resulted was smaller sandwiches at higher prices it took longer to get which is you can imagine your customer didn't really want yeah and I would emphasize that in a competitive bidding process often there's a natural selection of more positive or optimistic assumptions to make the numbers work and so you may find situations where deal teams hear growth opportunities on one side margin opportunities on the other and there isn't a natural function to vet whether those two assumptions can coexist or if they're actually fighting one another makes a lot of sense so really approaching this in an integrated way in order to get a realistic picture of what the business performance will actually be so when we think about the operation we'll do diligence part of the equation Greg what does good look like first of all the operational diligence support is tightly integrated with a commercial diligence the two teams need to be working very jointly it requires daily interactions I would argue they need to operate like one team secondly the profit opportunities are grounded in bottom-up analysis benchmarks are great but it's hard to build an operational plan based on benchmarks you got to get Beyond just the percent of savings against a big number you need to understand how the business will change operationally that makes those savings possible third area that I would highlight is data and insights are key here too many operational advisors rely simply on their own experience now I don't want to diminish the value of that support these individuals know their businesses and have tremendous Insight however they often don't roll up their sleeves and dig into the hard analysis and data to validate or disprove opportunities and often as individuals they don't have the same kind of tools and data sets that a more full-scale firm would have so what I've seen in the past few years is that private Equity Funds are increasingly hiring full-scale firms to do operational diligence Rich data sets from outside of the company across the industry are key and then lastly you need to get Management's buy-in on what is possible I have seen some disconnects where there is a value creation plan put together by an advisor Management's not on board with it and it leads to a lot of tension and frankly a poor execution of the plan so at some point during the deal process getting Management's buy-in is critical when should a team actually start doing the operational due diligence and how long does it take to do a good one yeah very good question because a lot of operational advisors will tell you it doesn't make sense to hire us until there's a data room and access to management and we think that approach is actually wrong perhaps the most valuable time to get an operational advisor going is early in the process we are finding that with a couple of weeks of outside in research you can obtain high quality insights that will improve your view of the deal so when a commercial advisor is hired an operational advisor should be hired as well we typically then Hugo pencils down then at some point when access to data and management does open up we will do a phase two you know three four weeks in length that really validates the findings or disproves the findings from phase one and also starts building that management buy-in that we talked about earlier that makes a lot of sense Greg what I hear you saying are three big takeaways and tell me if I go wrong here is that number one you can't just rely on the data room you have to actually have data from outside that is credible that is benchmarkable that actually tells you where you can go by cost item by cost pocket whatever you want to describe it but that's not enough you can't just talk or talk and look at benchmarks you have to be able to walk the walk and really think through no kidding how are we going to operationally change this business so that these aren't just numbers on a page but I can imagine actually operating differently at a lower cost and therefore a higher margin structure in order to Delight the customers and provide the service levels that they're going to come to expect and then thirdly my big takeaway is but if I'm not co-creating this in partnership with management and they're not Believers hey they run the business they're not going to actually just change the company overnight in a way that they don't think is sensible so it really is that partnership that's grounded in the reality of we all believe we could operate in a different way buttressed by the facts that we will believe saying that we can achieve certain levels of performance if we all do that together they really make this work exactly I think it's fascinating the kind of unique data sets and tools that can get you out of the blocks quickly are there other sector based and even capability-based data sets that you utilize frequently and assessing at the outset whether or not substantial margin Improvement is possible yeah well this is one of the wonderful things about being at a firm like Bain where we invest so much time and money in developing proprietary tools and data sets like the aura tool which allows us to build censuses of any company you can imagine private or public using publicly available data and that allows us to understand whether the SG a is lean whether sgna is heavy and for on a functional basis where we think there could be cost savings opportunities and that can be done quickly with very little cost the other one that I would highlight is a data set of over 800 software and tech services companies and it collects dozens of operating metrics on these businesses such that we can very quickly and accurately investigate the cost structure of growth software businesses to understand where they're lean where they're not where they may need to invest more and where they may be fat well Greg I've learned a tremendous amount today I thought we were going to be talking about what they call Harvey balls of those circles around different opportunities and whether it's a quarter filled in or a half filled in the three-quarters filled in but you described to me that there's a really rigorous high-tech database way to ensure that any margin Improvement you're underwriting is actually there and that there's actually a process that you can follow to make sure that you actually get it in partnership with management once you close the deal so I wanted to end by saying do you have an example in mind of where actually everything went right and you really exceeded expectations or met very high expectations of where margin Improvement was a huge factor in making a deal winner yeah so let me give you an example Hue of a private Equity investment where the thesis was we're bringing a couple of companies together and they tried to integrate didn't work my client was ready to write a check to be part of this but it was all based on a turnaround we went in and we quickly realized that it was a distribution business the Distribution Center footprint was way too big for the scale of the business that there were opportunities in procurement to Source the products better and that SG a had gotten bloated and the last piece of the puzzle was the sales force wasn't as productive as it should be and we were working with management over a six-month period we're able to take the business from two three percent negative ebit dot margin to high single digit ebitda margin which made the deal a home run management was very happy to be leading a healthy business a year later I guess tremendous learning experience both for me and I'm sure a lot of our listeners out there if there's one area where I think GPS need to get much better it is underwriting cost down margin of improvement in operational due diligence and being much more rigorous about it and so going back to the old school way of saying let's take an integrated view of the asset let us talk about the operational Improvement levers go right through the cost bar how they tie to what we're trying to achieve on the revenue side and why that knits together that's what we need to get back to as an industry and I wanted to thank you again for coming by the show today it was very informative well thank you Hugh it's been a pleasure and I look forward to talking again in the future thank you I'm Hugh Mac Arthur thank you for listening [Music] foreign