Cashing in: Why working capital is too important for private equity dealmakers to ignore
October 25, 2019
Working capital often finds itself side-lined in the scramble to boost earnings. But if optimising working capital can significantly lift return on invested capital, can you afford to ignore it?
It’s a generally held truth that if the earnings before interest, tax, depreciation and amortisation (EBITDA) are looking good, then the deal is on track to deliver.
Among the ways that this narrow focus on EBITDA can manifest itself is a desire to keep customers happy and order books full at all costs, even if this means maintaining excessively large inventories and generous payment terms.
At the margins
By comparison, working capital often gets neglected. The people who manage the cash tend to be one stage removed from key operational decisions. There is also limited visibility and few incentives among operational teams to make working capital a priority. Of the 100 private equity (PE) dealmakers who took part in our Creating value beyond the deal: Private Equity research, barely half (53%) said they realised value through working capital.
Missing a trick?
Are PE buyers missing a trick by not focusing enough on working capital? The more cash you can release, the less capital you need to deploy to deliver the return, and the higher the return on invested capital (ROIC) created by the deal. Moreover, the more cash you have in hand, the more debt you can repay and the more capital you have to deploy in new investments.
The reverse is also of course true – the more capital you need to tie up through excess working capital demands, the lower the return. Our analysis and work with clients show that businesses could reduce the cash they need to run the business by as much as 20%. Addressing these excess working capital demands would lift overall ROIC by up to 30bps (basis points) across different industries, though most acquirers tend to underestimate the potential. And in some sectors such as retail, engineering and construction, the boost could be over 50 bps. With acquisition prices high and target returns difficult to realise, this significant, but still largely untapped, value lever could make the difference.
The next lever of value creation
How then can you realise the working capital uplift? While much depends on the type of business and how it operates, four key drivers are common to all in our experience:
1. Create a cash culture
Ensure working capital is on operational teams’ agenda through targets, performance measures and incentives. The underlying priority is a cash culture that’s embedded within the business and its governance.
2. Improve processes day-by-day
There is no magic wand. Working capital optimisation is the sum of many different parts and many different teams in areas ranging from safe but not surplus stock levels to timely follow up of overdue payments.
3. Make it everybody’s business
Everyone from production managers to sales teams has an impact on working capital. It’s therefore vital that they understand their influence and how to manage it in the most effective way.
4. Make sure the data is acted on
There is a huge amount of operational data and key performance indicators (KPIs) that can help to manage working capital more effectively. It’s important that this data and its implications are prominent within both management dashboards and ground level operations. Training can help teams to understand what the data is telling them and develop the insights needed to intervene and optimise. By setting targets and regularly engaging with management on performance against them, PE teams can help to ensure that KPIs are properly analysed and acted upon.
Binding capital and operational efficiency
Earnings growth doesn’t add value in itself. Capital efficiency does. And working capital optimisation can deliver at both ends of the pipe – more available funds to put in and more return at the end. While it can be tempting to put working capital in the ‘too difficult’ pile, especially when other operational priorities are pressing for attention, it is the key bridge between capital and operational efficiency and hence should be right at the top of the PE agenda.