Treasury in a Private Equity Setting
In the second instalment of this TMI miniseries looking at treasury in non-corporate settings, we examine the roles and responsibilities of treasury in a private equity portfolio business.
The fundamental goal of a private equity (PE) house – an investment firm that specialises in acquiring, building, and disposing of businesses – is to use its (often institutional) investors’ funds to buy companies it considers to be of ‘improvable value’. It will then set out a broad strategy to achieve that value, with the typical aim of holding its investment for around three to five years.
Mid-cap PE houses usually assemble a portfolio of companies with turnovers in the range of around £100m to several hundred million. Portfolio companies of this size would not typically have a treasurer. The treasury function would instead be handled by a finance director or CFO and a small finance team. Larger mid-cap firms might also employ a financial controller, who could assume treasury responsibilities. Treasury functions in these companies would therefore be part of finance, without an officially designated role to execute them.
However, most mid-cap PE houses adopt a ‘buy-and-build’ strategy, notes Patrick Mina, CEO, Redbridge Debt & Treasury Advisory. This will often see them acquiring and merging other companies in a related industry. After a few years, the initial portfolio company will be expected to have grown significantly. “Additional companies may be overseas investments, contributing FX complexity to the financial mix. This, added to the expected accelerated growth of the business, suggests that it will soon need a dedicated treasury, and the earlier this role is planned for, the easier future buy-and-build integrations will be, from a financial reporting and treasury-management perspective.”
Large-cap PE houses strike deals for multibillion-dollar businesses that will almost certainly have a formal treasury function. An important focus for target companies will be generating, and having visibility over, cash. Mina comments that PE investment “raises the stakes considerably for treasury reporting” because extra debt is often put into portfolio companies – “more so than would normally be invested by the incumbent management”.
We want information
In terms of cash management, PE portfolio companies are typically highly leveraged, and the PE houses will thus be demanding frequent and comprehensive cash updates to ensure they meet their lending requirements, as well as providing regular reporting on specific financial KPIs. So, says Mina, “while an established treasury may have its own way of reporting, it will now be expected to adopt the PE house’s specific reporting format and frequency, and deliver accurate data in an extremely timely manner”.
Indeed, time is always of the essence under PE ownership. “Typically, PE firms will look to make all the key changes in year one, embed those in year one and two, and start reaping the benefits from then on in preparation for a year three or four exit,” explains Mina. “Focus on EBITDA is particularly high in years two, three and four, as the exit value is driven by EBITDA at exit, multiplied by the Price/Earnings [P/E, see below] multiple.”
Of course, this means that in year one, several key strategic initiatives will be rolled out, for which treasury must be prepared. “The PE owner of a UK firm, for example, might buy a competitor in France, and then expand into Asia by massively increasing distribution. So not only does treasury have to provide significant financial data in the format and frequency required, but it also now has to engage with those strategic projects, and provide related information,” reveals Mina. “The first year for treasury is usually intense.”
While both PE-owned and traditional corporate treasuries are compelled to strictly define and respond to the risk appetites of their key stakeholders by trying to avoid variability in returns, Mina’s colleague Dino Nicolaides, Managing Director, Head of Treasury Advisory UK & Ireland, notes an additional funding risk obligation for portfolio companies.
The funding structure is decided by the PE house as part of the capital structure decisions it makes at the outset. Because PE houses tend to substantially gear up their portfolio companies, treasury will have to monitor and adhere to all loan covenants. It will also be expected to adopt a more nuanced approach to a whole suite of other risks, in line with the appetite of the ownership.
“Interest rate risk in the current environment, for example, has induced in PE-owned firms a tendency to swap debt from floating to fixed. PE houses, knowing they are going to offload the business, must stabilise returns,” explains Nicolaides. “The same applies to FX where, in the past few years of market volatility, we’ve seen a higher proportion of hedging as PE houses seek a more stable trajectory.”
Other cash, liquidity, and counterparty risk management measures, such as cash concentration and working capital optimisation, while among the traditional core responsibilities of treasury, must fall within the explicit tolerances set by the PE house. What’s more, says Nicolaides, with funding strategy and execution generally “set in stone” immediately post-acquisition by the PE house, these are “rarely negotiable”.
Targets, templates – and treasury
From the outset, pressure on treasury comes from meeting the demands of both internal and external stakeholders. “Typically, treasury has internal operational demands on cash for business operations. But on the other side, they have PE owners that want to upstream liquidity as much and as soon as possible,” explains Alice de Lovinfosse, Director, Treasury Advisory, Deloitte. “A treasurer therefore is expected to manage that ongoing conflict within the organisation.”
Despite the demands, PE-house views of treasury are oddly divergent, she notes. “While some see it as a critical area to meet cash conversion targets, at the other end of the scale treasury can be seen as a lower-priority technical area of finance. But PE businesses are very often a lean environment, and until they reach a critical size, it’s really not uncommon to see treasury processes being managed as a side activity by finance generalists rather than dedicated treasurers.”
Of course, a PE house will have its own highly structured template within which each acquisition – and function therein – will operate. Their approach is typically driven by three core elements. The first is how the PE house can increase the P/E ratio of each portfolio company. This is driven by the expected future earnings of a company and strongly linked to its industry sector. As an example, a company with a P/E ratio of 15 would have a market value 15 times its annual earnings. If that P/E multiple can be raised to 20 by repositioning the company as a high-growth business, the market value of the company would increase by one-third (20 versus 15 times annual earnings) for the same level of annual earnings.
Repositioning a company from a low to high P/E ratio sector can significantly increase a portfolio company’s exit value. An example of this would be the repositioning of a traditional company to a software-, data- and AI-enabled company.
While treasury may not be in the spotlight here, it can be for the second PE-house focal point: increasing EBITDA. With a P/E ratio of 15, any action that helps reduce recurring costs is worth 15 times more at exit. If £1m in recurring costs can be saved, it’s going to generate an uplift of £15m in the portfolio company’s exit market value.
“PE companies don’t always fully understand that treasurers can generate substantial savings,” comments Mina. “PE firms typically default to focusing on increasing sales, pricing,and reducing procurement costs. These are quick EBITDA fixes, but there is an opportunity for treasurers to make some valuable recurring cost savings here, too, in parallel with those initiatives.”
The challenge is that treasury functions are commonly seen as cost centres, notes Nicolaides. “Their responsibilities are accorded a budget, and few therefore seek, or are expected to seek, cost efficiencies. But the proactive treasurer has an opportunity around, for example, bank, FX, and even merchant card fees, where there is a lot of embedded cost that can be shed. And actions that improve EBITDA are always music to the ears of a PE house.”
A third focus for a PE house, cash, specifically demands that treasury delivers accurate and rapid cash flow forecasting. As a rule, it’s a 13-week rolling cash flow forecast prepared each week by treasury and distributed to the shareholders and management, notes de Lovinfosse. “It is a core process but one that very often remains challenging, given the level of input needed from across the group, and the granularity of data required. It’s by no means an easy task.”
In recent years, the level of uncertainty seen in M&A markets, and the pressure around valuation, have seen an extension of the holding periods of portfolio businesses by PE houses, observes de Lovinfosse. “There is now more focus on driving operational improvements to bring value to the business. Typically, that increases the pressure on the management of these companies to perform, and so it’s essential that the treasurer is on top of FX, interest rates – and cash in particular.”
No waiting
While treasury in PE is undoubtedly pressurised, there are still ample opportunities to add value, stresses de Lovinfosse. “Increasing the level of cash centralisation will reduce funding costs, and ultimately reduce financial leverage. By streamlining the number of banking partners and bank accounts, it can also drive operational and cost efficiencies. We’ve seen the value of improving cash flow forecasting, and we are aware of more companies investing in AI-based software to help extract more reliable and insightful forecasting.”
Another opportunity de Lovinfosse notes is around financial risk management. All treasurers are expected to have an understanding of, for example, the FX profile of their business. But PE takes it further. “Preparing financial due diligence is a vital part of every buy-and-sell process, a key component of which is the ‘quality of earnings’ analysis. FX is always a key consideration here because it has a direct impact on the value of the business,” she explains. “This is why the treasurer must fully understand the currency profile of the business, where the risks are, how these should be managed, and even how the firm’s P&L is split by currency.”
Because portfolio companies will be operating in a lean environment, every process needs to be as friction-free as possible. The role technology has to play can be significant. Most treasurers understand that implementing new systems and processes should enable them to better collect, collate, analyse, and report essential data. But, notes Nicolaides, in PE it’s about treasury playing a much more proactive role, helping internal and external stakeholders to understand that a small investment in optimisation in the early stages of PE ownership will lead to vastly improved cash information. It will also reveal potential recurring revenue savings that could have a major impact on exit value.
Unfortunately, most treasurers also know that additional budget is hard to extract in any company. From de Lovinfosse’s observations, in a PE setting it will be a matter of quickly presenting the case for a few specialised solutions, not a full TMS, to drive value. “A single banking platform capable of connecting different banking partners may be sufficient to provide visibility over a significant portion of your cash balance. There are also dedicated technologies capable of automating and building better cash flow forecasting.”
Indeed, with cash visibility and forecasting always focal points for PE houses, these solutions represent a smaller investment in terms of getting up to speed. But in the PE world, pushing for budget, and being heard at the right level, requires treasurers not only to create a smart and compelling business case for investment but also to become more vocal than usual in communicating their ideas.
“PE houses often don’t have depth in their understanding of reporting challenges in their portfolio businesses to meet current and anticipated PE-firm reporting requirements,” Mina notes. “Treasury, therefore, has an opportunity to clearly articulate these challenges, explaining how simply hiring more people means data acquisition will always be a struggle – especially in buy-and-build – but investment in automation and process optimisation can deliver accurate, scalable reporting, in the formats and frequencies demanded.”
Taking it to the top
The key to PE treasury success rests in making the right approach. An understanding of the structure of PE houses is essential. A decade or so ago, Mina says, large PE houses would rely heavily on professional consultancies to help execute their portfolio company value creation plans. “When they realised how much they were spending, they started directly hiring specialists into their businesses, referring to them as ‘operating partners’.”
As previously noted, Mina says that their initial remedial focus was on sales, pricing, and procurement, “because these presented the quickest wins”. But in the past few years, he has witnessed more PE houses hiring finance operating partners – often CFOs lured away from successful companies in the same industry in which the PE house is investing, or otherwise finance transformation or debt capital market specialists.
In a public company, treasury typically reports to the CFO. In a PE firm, the portfolio company’s own CFO, and now the PE house’s own financial operating partner are both now in the line of command.
Although the portfolio company CFO is usually appointed as the main contact point for treasury, there is much to gain when the treasurer takes a more proactive stance in reaching out to the finance operating partner (with the CFO’s blessing, to avoid treading on toes) at the earliest opportunity. The reason, says Mina, is that operating partners will almost certainly be interested in hearing about any EBITDA or management reporting improvements that treasury can deliver.
Nicolaides adds: “Data accuracy and timeliness is vital at a day-to-day level. If the portfolio companies are struggling to extract cash flow forecasting data, they cannot create credible cash flow forecast. It then becomes almost impossible for the PE house to control risk, especially across a diverse and international portfolio. This is perhaps why I have seen more appetite for investment in technology, especially in the early ownership years, because that’s the time when they’re building infrastructure and turning the business around.”
Set for change
The shift from corporate to PE treasury will reveal many similarities around scope, notes de Lovinfosse, “but there is a different pace to it, and this can be more challenging”. For the PE newcomer, it is therefore primarily a matter of acclimatising to the speed and intensity of focus on cash-related reporting and cash forecasting, and what Mina refers to as “a much lower tolerance for data inaccuracies or lateness”.
While there is no need for specialised training to make the transition to PE treasury, Nicolaides believes that every treasurer heading in this direction must fully understand and embrace their PE house’s philosophy. He reiterates the PE reality that “time is always of the essence” and urges treasurers “not to expect to move at their own pace”.
Treasurers should, however, be respectfully vocal from the outset. “Ask about plans and targets, and identify how treasury can contribute to achieving them,” suggests Mina. “Be insistent about any opportunities for improvement that you see, especially those addressing the recurring cost base, and ensure these are understood and pushed forwards quickly.”
Success in this setting, suggests de Lovinfosse, requires “a dynamic character, someone who works well under pressure, is a team player but who also has an entrepreneurial spirit and can think beyond treasury”. Indeed, in the rapidly evolving world of the portfolio business, the treasurer has an opportunity to suggest a number of courses of action that can deliver real value. All this, she concludes, establishes proactive treasurers as valuable long-term partners for any PE house.
