Taking Off the Blinders
PE firms must face the hard truth of their underperforming portfolio companies in order to right the ship, says Chiron Financial’s Chris Mudd
Although any private equity investor can find itself with an underachieving portfolio company, the ongoing market volatility requires that PE firms be extra vigilant about the performance of their investments.
Yet Chris Mudd, managing director at investment bank Chiron Financial, warns that investors and executives too often leave the blinders on. “The most common mistake,” he says, “is waiting too long to address a problem.”
Virtually no industry is immune to the risk of volatility, but lackluster internal controls and processes can also lead to financial mishaps. And once financials start to go south, so do the chances for raising additional funds.
Diversifying financing sources and having a competent executive leadership team in place to address underperformance are key steps. It may seem an intimidating task to put a struggling portfolio company back on the right track, but with support from external experts, Mudd says, middle-market companies and their private equity partners can have a greater chance of success.
Industries at Risk
The most common mistake is waiting too long to address a problem.
The middle-market M&A community is well aware of the major sources of volatility today: inflation, the war in Ukraine, a tight labor market and continuing effects of COVID-19, to name a few.
According to Mudd, what’s less recognized is how widespread the impact any one of these factors can be.
Drawing on his 30-plus years of experience in the petrochemicals industry, Mudd points to the ongoing conflict in Ukraine to illustrate its cascade effect across verticals. “While energy has dominated headlines and is important, the invasion will affect other sectors as well,” he says. “For instance, European sanctions have resulted in Russia—a major supplier of wood pulp—being unable to export goods.” This leads to limited supply for paper mills across the continent.
Similarly, the conflict’s impact on Russia’s natural gas exports has consequences beyond the energy industry. Natural gas isn’t only vital to power generation; it is also a critical component of synthetic fertilizers, used for crops that feed approximately half of the planet today. Natural gas also produces hydrogen, used widely in the chemicals industry, notes Mudd. “Unbeknownst to many, natural gas is also used to make fabric, glass, steel, plastics, paint, synthetic oil and other products,” he says.
This is just one example of how a single crisis can affect businesses across a broad swath of industries. Private equity firms must not turn a blind eye to the potential consequences that one volatile industry can have on another.
Righting the Ship
Vigilance about the potential impact of market volatility on a private equity firm’s portfolio is key to avoiding business interruption, and Mudd says it’s imperative for partners to identify the red flags if performance starts to slip.
Gross margins, EBITDA and net cash flow are reliable indicators that can reveal if a portfolio company is struggling. Whether those metrics fail to hit their goals or are performing erratically, once those warning signs are recognized, it’s time to act.
For middle-market companies already financed with debt, it’s likely the lender will increase its scrutiny of the business, says Mudd. “The bank almost always asks the private equity firm to inject additional capital to support the underperformer while it turns itself around, many times with the assistance of a financial (or) restructuring advisor,” he explains. “Private equity firms tend to avoid this solution, citing a variety of reasons. But the most obvious one is economic: They don’t want to throw good money after bad.”
Instead, PE firms will often seek a different lender. While voluntarily exiting an existing lending relationship may be easier than repairing an established one, finding new financing requires a strategic approach.
Mudd says middle-market companies may be reluctant to hire a financial advisor to help with a new capital raise, but it’s an important part of fostering a competitive financing opportunity and securing the best possible terms, while also ensuring a backup plan in case one lender backs out. An investment bank can also help mid-market companies and their PE partners determine whether tailored financing products, like real estate or equipment financing, are the best option.
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Beyond financing, Mudd also advises PE firms and their portfolio companies to look at the human capital side of operations. “Out of touch” or “ineffective” management teams may be at the root of underperformance, he says, adding that it’s important for business leaders to understand the most effective way to communicate with creditors.
With inflation and interest rates on the rise, it’s an opportune moment for PE firms to examine ways to strengthen their existing portfolio or quickly address any signs of underperformance. A proactive approach will support the overall health of the portfolio, and as Mudd explains, taking advantage of external expertise, like that of an investment bank, can help partners see all angles of the challenge—and all potential solutions.
“The best solution is not always apparent at the beginning of the effort,” says Mudd. “It is a great advantage to engage a financial advisor who can help with the financials, can raise debt or equity capital, can help amend or modify existing financing, and can guide you through a merger or sale.”
Carolyn Vallejo is the digital editor for ACG Media.