Even the slightest perceived dip in financial performance against goals sets off alarm bells for financial sponsors.
July 29, 2016
No company is immune to financial challenges arising from marketplace or internal factors — shrinking markets, altered competitive landscapes, cash flow and forecasting difficulties, broken covenants with lenders — which to one degree or another fall on the shoulders of a CFO.
However, the expectations of CFOs increase even more dramatically when companies come under private equity ownership. For PE-backed CFOs, in-depth, regular reporting to a concerned sponsor in an environment of flat or declining performance requires far greater depth of insight.
After having spent their limited partners’ capital on an acquisition, financial sponsors come in with a single objective: increase investment value. Therefore, even the slightest perceived dip in financial performance against goals sets off alarm bells. Lack of progress toward value-creation initiatives, continued performance headwinds, overlooked or inadequately addressed market challenges, or deterioration in financial results invite swift and intense sponsor scrutiny and intervention even before the onset of true financial distress.
As a CFO of a sponsor-backed company, it’s critical to ask the right questions and have data-driven answers that demonstrate understanding of root causes and options to address them. By putting early warning systems in place, embracing preventative measures, and acting quickly at the first signs of a problem, a CFO can effectively get ahead of operational challenges, get business and investment plans back on-track, and ultimately avoid liquidity pressures, solvency risks, management changes, and the disruption of a chief restructuring officer appointment.
The incubation period from early detection of a problem to a full-blown crisis can be vanishingly small and may go unnoticed given all the other responsibilities of a CFO. Whether you work with internal teams or bring in a firm to help you, there are steps you can take to prepare for, understand, and deal with challenges successfully even before they emerge.
Step 1: The Journey of Self-Diagnosis
This is the research and discovery phase. Be honest and ask yourself whether you recognize any negative operational or financial symptoms that trend to show up in declining or more troubled businesses. Some of the questions to ask include the following:
Are volumes, revenues, or margins declining? Are particular cost categories persistently rising as a percentage of sales? Are there areas that continually underperform budget expectations? Are patterns emerging that won’t allow the company to raise prices? Are there challenges to cash-flow conversion or working capital management? Are forecasting misses becoming more frequent or more significant? Are sales cycle times creeping up?
Is the business losing customers month-over-month or quarter-over-quarter? What is the cause? Is it due to declining market share? Customer share of wallet? A declining market overall? Are specific geographic markets suffering?
To answer these questions, you will need to examine operating performance metrics, sales and marketing performance data, contracts and policy documents, detailed expense category breakdowns, and working capital data.
Developing a strong internal analytical backbone and marrying it with a dashboard to monitor the business will help you answer the often-simple questions that reveal whether your company is experiencing just a hiccup or is trending towards something more severe, and whether such issues are attributable to macro, market, or intra-company issues, or a combination.
Step 2: Identifying the Problem
There needs to be a sophisticated analysis of the root causes of the symptoms uncovered. Think about the “why” behind the issues you’re detecting:
If revenues are falling, are your prices too competitive or is there a customer service issue? If your liquidity forecasts are consistently coming up short, is the problem on the balance sheet or the P&L? If the former, are contract terms being enforced or are they being extended in an effort to capture more sales? Are the changes coming from the left or right side of the ledger? If the latter, are misses coming at the top of the funnel or deeper in operations?
During this phase, you should be performing an in-depth analysis of your product/service line profitability, spend effectiveness, cost variability by timeframe, cost allocation methodology, contract enforcement opportunities, and merger and acquisition costs.
By pinpointing where the major inefficiencies lie, and the root causes of each, you’ll be able to better address problems before they grow unwieldy, and also address the nature of resources needed to fix them.
Step 3: Develop Your Strategy: Identify Opportunities to Solve Each Problem
Once you’ve isolated the issues and causes of each problem, it’s time to analyze the opportunities for cost optimization and enhancing return on investment in meeting the goals laid out in your revised business plan. Think about the levers you can pull when you are experiencing sideways or negative growth.
Identify a granular, capital-weighted view of growth and profitability by customer/channel/product or service offering — including product development, customer acquisition, and account management costs. Explore strategies to turn loss leaders into profit centers and drive customer loyalty, such as bundling, longer-term customer relationship arrangements, or quantity thresholds for pricing. Revisit long-held beliefs about core markets and the benefits of being in lower-margin or lower-growth segments.
Drive dialogue across the organization about how current brand or market positioning can be leveraged into higher margins. Cast a wide net in exploring both acquisition and divestiture opportunities. Bring tools like zero-based budgeting to determine the resources required across all departments to support the business as it stands currently.
Be thorough in your analysis of the return on investment for each segment of your plan, including opportunity costs, timeframes, how complex the project will be, and the potential for internal disruption. Come up with an air-tight plan.
Step 4: Act on Your Strategy
You have a strategy now, and it is time for implementation. Be disciplined and methodical in your process: build work plans with detailed goals; establish timelines and accountability; redesign processes to eliminate waste; define roles and responsibilities; enforce deadlines; and regularly track progress.
Whether you are just starting to see the warning signs on the horizon or your company is already headed in the direction of a restructuring, stay in front of the private equity sponsor, offering answers and solutions before the questions get asked.
The effort that you put into devising and acting on a strategic improvement plan will pay off if you are able to avert issues that, left unaddressed, could lead to outright distress. Stay on top of the implementation process and keep your teams accountable for the success of the program.
Hal Polley is Managing Director and Head of Strategic Finance at Accordion Partners. Accordion is a financial consulting firm focused on executing value-creation initiatives for private equity firms at their portfolio companies, particularly within strategic finance, performance improvement, and financial accounting and advisory services.