While COVID-19 has certainly been a disruption to the private equity landscape, the primary goal of PE firms remains the same: Strive for smart investments that deliver outstanding returns.
The days are behind us when PE investors could rely solely on financial engineering and cost cutting to drive outperforming returns to LPs. In today’s unprecedented market, purchase price valuations in many industries remain high, which in turn, requires greater amounts of value creation during the hold periods of portfolio companies to ensure outperforming IRRs are achieved. One of the many “levers” that can be pulled is revenue growth, which is one of the most effective options when executed successfully.
Despite the economy’s roller-coaster ride in 2020, PE professionals need to hold their operating company managers accountable to organic revenue growth goals. (It is important to distinguish between organic growth and inorganic growth, of which, the former will be the focus of this discussion.) To facilitate realistic revenue growth goals, metrics must be calculated, tracked and reported to help drive behavior and accountability throughout the organization. But how do managers or owners know what metrics to focus on when so many are out there?
It is important to know the magnitude of effect that each metric has against the revenue growth of the business. At Baker Tilly, we refer to this degree of effect as the “magnitude ratio” of that particular metric. The magnitude ratio calculates the amount of incremental revenue that results from every 1% improvement for the metric being analyzed, and then dividing the incremental revenue amount by the total existing revenue. The resulting percentage is the “magnitude ratio” of that KPI. For example, if you have a $100 million revenue business, and a 1% improvement in a particular KPI will drive incremental revenue by $3.5 million, then the magnitude ratio of that metric is 3.5%.
Once metrics are analyzed in this fashion, it quickly becomes clear which metrics an organization should prioritize for integration. Just as importantly, it clarifies which metrics should be ignored. For example, a product warranty business with large call-center operations was tracking sales personnel productivity and salesforce employee turnover as their primary KPIs to support their organic growth goals. After a detailed magnitude ratio analysis, these two metrics had ratios of 1.3% and 0.3%, respectively. Further analysis showed that the renewal rate of existing contracts, with a magnitude ratio of 2.3%, would be a more effective metric to focus on. The company began tracking this metric and installed an incentive plan for managers and sales reps around renewal rate improvements.
Another example involves a home inspection business. Before conducting a detailed magnitude ratio analysis, the PE owners and management had focused on two KPIs – inspector productivity and the number of gross new hires for inspectors. These KPIs had magnitude ratios of 1.1% and 0.2%, respectively, in this particular business. After a deeper analysis, the company found the more impactful metric to install was inspector turnover, with a magnitude ratio of 5.7%. In order to improve this metric, managers at this company raised employee morale by improving internal communications and sponsoring fun employee events.
In both of these examples, the focus on magnitude ratios resulted in strong organic growth. It’s important to not underestimate the need for the data analytics to be done correctly, thoroughly, and with reliable datasets. If the data is corrupt, not focused on the proper areas, or not analyzed correctly, then the output of a magnitude ratio evaluation will be misleading and can result in companies making misinformed decisions. Naturally, this can lead to missed opportunities for revenue growth at best, and value destruction within the portfolio company at worst. If done correctly, on the other hand, the magnitude ratio approach can be a foundational starting point to drive significant value through the identification and installation of the most powerful KPIs to help drive organic revenue growth.