PE/VC firms have a simple goal: create added value. Straightaway acquire a strong target with respect to growth potential, increase its value in the market, and sell generating profitable returns for stakeholders. The challenges appear quite simple as well; generate value by improving business performance. Yet inexplicably, the single most significant contributor to enterprise value has largely been ignored. However, things have changed.
Let’s back up a step to help explain.
- Crunching The Numbers
Historically, value creation for private equity focused on picking attractive acquisitions with growth potential over the hold period and leverage financial engineering to drive increased revenue and a higher level of earnings and EBITDA. For decades now, the private equity sector has mainly focused on this tactic to enhance the value of its portfolio companies, and it served them adequately well when there were plenty of under-valued and attractively priced targets in the market.
As competition for desirable acquisitions increased, and cost multiples grew, financial engineering could no longer drive the incremental value and provide the returns demanded by stakeholders. Financial engineering alone was not enough to justify skyrocketing acquisition prices and increasing multiples. The choice was to increase risk in acquisition choices, meaning investing in less desirable targets, or find new ways to drive value creation.
“In the early days of private equity, the industry was able to make good returns through financial engineering alone,” says Matthew Kearney, an Operating Partner at Rockbridge Growth Equity. “As prices and competition increased, funds have had to provide more active support to drive cost efficiencies across the portfolio to achieve sufficient investment performance.”
- The Advent Of The Operational Role
Over the last decade or so, ever since the days of cheap capital, the dot-com crash, and the great recession, private equity (mirrored by the growth of venture capital), recognized the need find additional methods of value creation. Focus expanded to operations. The strategy was to grow value through improving the underlying business through a wide range of operational improvements from merger integrations, to improving sales force effectiveness, to overhead reduction, to logistical streamlining, to offshore supply chains, to optimizing financial reporting and management information systems, among a myriad of other things.
This period saw the rise of the Operating Partner role to provide vertical market expertise and capabilities that add value to the investments beyond the traditional formula of leverage, low-cost capital, and financial engineering. The operating partner role, along with the rise of digital services, has grown to develop shared services and functional expertise in areas of operational leverage such as spend analytics, logistics efficiencies, shared IT services, customer analytics, digital transformation, zero-based budgeting, and more, all depending on the nature and needs of the business.
This growing dependence on operational value creation moved PE/VC firms to expand their skillsets and offerings. Traditionally, PE/VC professionals came from investment banking or financial roles. With the adoption of operational value creation, most firms today have in-house teams of operational specialists. Their singular focus is to leverage professionals who typically come from an aligned industry or strategic and operations-focused consulting firms.
Until recently, financial engineering and operational improvements were the primary paths to value creation. These days, the market dynamics that fueled the advent of operational improvement has changed how value is created once again.
- The Missing Piece, And Where The Real Value Is
Today, competition for acquisition has never been stiffer. Billions in dry powder is sitting on the sidelines. Multiples are higher than ever before making it even harder to achieve the growth and value creation that can deliver the desired return on investment. The third and most critical method of value creation is now finding its own: Brand Optimization. Here’s the truth: strong brands drive predictable future cash flows, higher margins and create options to quickly and cost-effectively expand into new markets, channels, and products. Brands powers the market, they empower employees, they build preference and loyalty, and they are the single most important factor predictor of future success. Together with financial engineering, and operational improvements, brand optimization is the golden triad of value creation.
“…brand in a company represents the lion share of value. If you understand brands are IP, you stand to make an outsized return while minimizing downside risk. The key to identifying, valuing, and leveraging the latent value and potential of the brand in a company is to separate the IP from the operations”, says Bill Sweedler, Tengram’s Founder. “If you only owned the operations without the IP, what would the company be worth?”
Forbes research shows that brand and marketing assets can contribute over 50% of enterprise value. For example, according to brand valuation standards recently proposed by International Organization for Standardization (ISO) — brand value alone contributes 19.5% of enterprise value on average based on an analysis by the Marketing Accountability Standards Board (MASB). For consumer and luxury brands, that number can make up the majority of shareholder value.
So how in the world did brand equity get left behind in the quest for value creation? The answer is simple: it is tough to quantify. There are no clear standards, rules, or agreed-upon methodologies for measuring intangibles and applying them to the balance sheet. And yet “Financial statements cannot fairly represent the value of an enterprise if they don’t systematically include key intangibles like the brand or customer relationship values,” says Neil Bendle, Associate Professor of Marketing at the Ivey School of Business. Sadly, very little, if any, of intangible assets are captured in financial accounts.
In addition to vast amounts of empirical data, it is easy to see the power of brand to contribute to enterprise value when looking at the public markets where book value can be measured against cap value:
PE/VC firms are catching on. More and more, they are working with brand strategists to build brand equity as a core practice in their value creation strategy to generate outsized returns. According to academic research, most of a firm’s value is intangible, and the majority of intangible assets are brand and marketing related. The struggle has been that brands are significant assets that are poorly priced and misunderstood by financial analysts and CFOs. Brands can make up over half of a firm’s value but are subject to arbitrage because of the general lack of information, reporting standards, and marketing acumen in the investment industry. Those who get it will win.
Additionally, many firms are beginning to integrate brand strategists in their due diligence processes and as a competitive advantage in pitch teams. They are focusing on building brand equity as a standard operating principle — from the beginning of the acquisition. These firms know that, regardless of the difficulty in quantification, brand investments are now considered a primary driver of value in a world where intangible assets such as brand awareness, brand purpose, customer loyalty, preference, and advocacy represent much or most of enterprise value. Firms that focus on building and maximizing the return on brand equity will get higher values on exits. Brand is at the ultimate multiple modifier.
Building brand equity is a consistency-over-time equation that it is best deployed as a philosophy, a way of doing business, a standard best-practice. And an ongoing focus from due diligence to exit. In today’s highly competitive environment, the most successful firms understand these synergies and will seamlessly integrate financial engineering, operational improvement, and brand optimization in their value creation strategy.
Executed in concert, they will generate the highest investment outcomes possible.
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