Better risk assessment, supply chain and operations optimization, and a renewed focus on ESG throughout the portfolio will drive continued PE success in 2022.
Private Equity has seen more deals and high multiples, but at the same time the PE market is beset with supply chain disruption and continuing pandemic-related challenges. Maine Pointe's Bob Brennan looks at how, in 2022, the private equity market will continue its frenetic deal pace amidst these challenges.
The 2020s may be starting out with unprecedented challenges, but as we start to see the light at the end of the pandemic tunnel, we are seeing hints of a return to a more dynamic era of prosperity.
Despite overwhelming supply chain challenges and a global pandemic, 2021 saw near-record levels of growth in the Private Equity market, surprisingly high multiples and a frenetic deal pace. That hyper-driven pace is expected to continue through 2022, with increases in deal count and value, and pressure to move quickly and take proactive steps to gain deeper visibility across the end-to-end supply chain.
Despite the rapid pace of deal-making, 2022 will also face more uncertainty -- although firms which adhere to a few specific operational strategies will enjoy the highest levels of success. As we look into 2022 with anticipation of more and better deals happening more quickly than ever, confounding factors include the fact that according to a survey by Chief Executive magazine, 48 percent of CEOs and 50 percent of CFOs expect inflation to get worse over the next 12 months. The consensus is that inflation will remain elevated for 2022, supply chain disruption will continue, and the impact of Covid-19 will continue to be felt globally.
Last year made visible the risks associated with a supply chain focused on production in China and other Asian countries, and research from Bank of America estimated that foreign firms looking to move manufacturing operations out of China would incur costs of $1 trillion or more over the next five years.
Fast pace and more deals: Too much of a good thing?
Pitchbooks' Q3 2021 Middle Market Report expects the heightened pace of deals to continue, both in terms of deal count and value. But while we always want to think that "more is better," it does put more stress on the due diligence cycle, and risk must still be assessed -- and that risk assessment cannot be shortchanged.
To accommodate the increased volume of deals while still doing proper due diligence, some PE companies are moving some operational due diligence tasks to take place post-close. Doing so without the right support and insight can be risky. The key in this environment is to, during the pre-deal period, rapidly identify all operational risks while developing a value creation theme that can be quickly implemented post-close.
Many have been shortchanging their Value Creation Plans (VCPs) in order to take care of daily firefights due to not only a lack of qualified labor, but due to ongoing and critical supply chain shortages. Meeting these post-deal challenges amidst rising inflation and supply chain disruption requires firms to bring in a sense of calmness and control in day-to-day activities, and get back on track with their VCPs.
There is no silver bullet and no single countermeasure to fix the current disruptions to the supply chain due to the existence of so many global moving parts, including demand volatility, logjams at the ports, labor shortages, non-optimized operational footprints and supply networks, and lack of visibility. But while clogged ports may demand a political solution that is beyond the purview of the PE firm itself, disruptions can be mitigated by acting swiftly and thoughtfully with countermeasures that may include increasing inventory, offering higher wages, and creating more optionality in the supply base, while leveraging digital technologies to create more visibility across the end-to-end supply chain.
ESG and the bottom line makes this a major consideration for new acquisition targets
The pressure to incorporate new and better assessments of any new acquisition candidate now includes analyzing any deal for Environmental, Social, and Governance (ESG) sensitivities. In fact, in analyzing trends in ESG assessments, it has become evident that many PE clients, as they launch new funds, are insisting on ESG risk assessments for target companies. While companies are increasingly aware of the need for an ESG policy, creating a clear strategy with measurable goals and KPIs, consistent practices, and a deep dive into the company's actual ESG risks and opportunities. In one example, we conducted ESG due diligence for a client to identify gaps, necessary mitigation, and follow-up actions. One area which became evident is the need for transparent disclosure and clear communications with internal staff, partners, and consumers and other stakeholders. And while a robust PR function is always necessary, simply reiterating that ESG is "part of our DNA" is inadequate when specific objectives, principles, goals, and accomplishments are not part of that communication.
On the supply chain front, ESG compliance may prove more difficult with an entrenched, extended supply base, and external reviews -- especially in a global supply network -- require compliance with not only local requirements but also internationally recognized criteria.
Finally, ESG best practices calls for stakeholder engagement that includes source suppliers, as well as the broader community to make sure every interested party is represented.
Who's going to do the work: Labor shortages in 2022
2022 will be a very good time to be in the job market. More companies will be offering higher pay, both to keep up with expected inflation and to attract top talent which is in demand more than ever. Data from Indeed Hiring Lab showed the number of job openings could reach 11 million by the end of October 2021. But if you are on the other side of the desk and trying to attract and retain top talent in this job market, you are being challenged, especially in food services and manufacturing.
We saw this challenge amplified while working with a client to address labor shortages from both a restricted labor market and a reduction in force on a weekly basis due to Covid. There are multiple mitigation actions that can be used to address these issues to drive enhancements in productivity, for example, implementing initiatives such as cross functional working groups and capturing the skills of your people who, if needed, can be re-deployed to ensure critical aspects of production continue.
Getting the goods when you need them: Supply chain and network optimization
Before the pandemic firms often settled into an unproductive "if it's not broke, don't fix it" mentality which avoided re-examining sourcing strategies to find greater efficiencies. The pandemic, if nothing else, has caused us to re-evaluate this approach, and for the first time, implement a strategic sourcing process and avoid less productive and more risky methods such as single-company or single-region sourcing. Sourcing has also relied too heavily on historical patterns of demand, which almost always results in the all-too-predictable result of too much of the wrong kind of inventory, and not enough of the right kind.
In another example, our client, an automotive materials company, recognized the immaturity of their supply chain, having relied too much on tribal knowledge and a small number of suppliers. We rolled out a new S&OP process to create more optionality in the supplier base, resulting in an increase in EBITDA by 11 percent. In another example of client success, a semiconductor company planned three new plants and implemented a 10-year demand forecast with capacity requirements across multiple geographic markets. This effectively reduced the risks that would otherwise come from subsequent supply chain disruptions.
Post-deal, production bottlenecks still reveal winners and losers
The disruptions we continue to see in the supply chain are laying bare the winners and losers. While those on the losing end of the balance sheet tend to be those who lacked resiliency in the supply base and are paying the price now, the winners had planned ahead with better inventory positions, a more resilient supply base, with labor and production practices that encouraged loyalty and attracted top talent.
Building in that resilience can be done at any time, even amidst uncertainty. Doing so begins with establishing a more complete visibility of the current state of business and identifying weaknesses, and then leveraging that insight to build in greater supplier optionality to limit exposure to both current and future risks. Building resilience may also involve taking a hard look at supply and production and rebalancing onshore, nearshore and offshore footprints, and analyzing disruptions in transportation and shifting towards decentralized warehousing and stock keeping, and finally, exploring alternative supply, manufacturing, storage, and distribution routes.
Those bottlenecks on the supply side are more obvious as companies faced shortages in raw materials, but demand side challenges continue to exist as well, with a recent Forbes survey noting that manufacturers are seeing a dramatic surge in demand, some of which can be attributed to the release of sudden pent-up demand and a shift in consumer preference. Responding to an increase in demand, while simultaneously attending to continuing supply-side bottlenecks, is perhaps the biggest, if not the most obvious problem companies will face in 2022. Some companies are addressing this imbalance with optimization of existing manufacturing processes, a focus on Overall Equipment Effectiveness (OEE), and strategies such as rebalancing work content and work cell redesign to improve flow.
Better forecasts and multiple-region sourcing will improve the situation, but none of this can be accomplished without more modern technology. Legacy technology, still frequently relied on by even the largest corporations, still leave companies with low visibility, a lack of supply chain integration, and no way to predict, anticipate, and mitigate future problems. It's not that the tech does not exist to solve these problems, it does. We were able to provide a solution for our client, an agricultural company, by rolling out new decision support tools to gain more insights into how to position inventory across the business, optimize margin, and gain a competitive advantage. The result was improved EBITDA, and better efficiency and accuracy through data visualization and spatial analytics.
The challenges of the pandemic need not spell disaster for companies, and those which come out ahead will be those who have aggressively re-examined their end-to-end supply chain operations, created resiliency, expanded optionality and leveraged technology.
If you would like to discuss any of the points raised in this article, please email rbrennan@mainepointe.com.