Why formalised Value Creation can often get in the way of value creation
Value Enablement Series - Part 1
The way that formalised Value Creation has been deployed means that it is often hindering its own objective of systematically growing economic value. This article explains why
Investing successfully in growth companies has got harder – and won’t get any easier anytime soon
Since the 1990s, long term trends have all eroded average returns: more money chasing opportunities and driving up entry multiples; less use of debt; demographic and other factors lowering economic growth; less management experience amongst teams being backed. More recent issues – the impact of Brexit, Covid and supply chain problems, deteriorating public finances – may ease with time but make managing companies trickier for now. Taken together, the amount of attention which needs to be given to getting strategy right and building effective teams and organisations – as opposed to buying well and relying on multiple arbitrage – has grown significantly.
The investor response has been a shift towards more formalised approaches for specifying value creation objectives, initiatives and KPIs
The growing value creation challenge has been a topic of concern for more than a decade and has been addressed through a mixture of additional due diligence (notably commercial, operational and technical), as well as the hiring of in-house resources to define and drive value creation, such as operating partners, more activist portfolio teams and specialist experts. It is those dedicated resources, and the framework of activities they have created, often in association with external consultants I am referring to as Value Creation (capitalised).
In parallel, expectations of Chairs have grown, often to an unrealistic extent. Some have aligned themselves to Value Creation methodologies, others are more sceptical.
Value Creation is showing its limitations
My document, The Seven Sins of Post-Deal Strategy, offered a first stab at mapping some of the unintended side effects of trying to accelerate value creation without proper balance. The ‘sins’ it described have not gone away:
Not digesting due diligence
Misunderstanding the nature of strategy (focusing on objectives, forgetting the route map)
Failure to consider organisational inertia
Confusing change activity with change results
Trusting targets and incentives too much
Rushing key people decisions
Unbalanced governance (i.e. seeing it as mainly a control mechanism)
A representative example is provided below:
What hasn’t changed much in the ~20 years I have been researching private equity relationships with investee management/organisation issues are the main reasons investors give for investees producing disappointing results. Almost every relevant survey points towards a lack of adequate execution of strategies overall and management weaknesses in particular.
Apart from the emphasis on the importance of the management in either producing success or failure, it is interesting to note the similar emphasis on the quality of the value creation plan on both sides of the equation. 20 years ago, the phrasing would have been less specific, but very similar items would have dominated.
More anecdotally:
Informal discussions with veterans of the industry suggest that many are not persuaded that value creation is happening more successfully than previously. Higher returns over the last couple of years seem to have been driven more by liquidity than better handling of companies.
When Catalysis speaks during MDD exercises with management teams who have worked with investors previously, even those who have enjoyed the relationship rarely talk about value add or the quality of governance. When we talk to Chairs, they note the higher expectations of them but rarely mention the benefit they get from Value Creation.
Perhaps most tellingly, portfolio and Value Creation people are often the least happy with the clarity and reasonableness of the roles given them and seem to leave at a higher rate than deal doers.
Why isn’t Value Creation working as well as hoped?
As mentioned, investing has got harder, so almost any conceivable approach will struggle sometimes. There are also structural reasons why getting execution of strategy right is especially difficult:
As enterprise values have grown, driven by a rise in multiples - and as MBOs have faded away in favour of other types of funding - investors are increasingly dealing with smaller, entrepreneurial managed companies.
Unlike the world of finance where there is a well-established framework and vocabulary available to describe concepts and make comparisons, the same is not true for team, organisational and strategy issues, so discussions tend to be less precise.
When it comes to cross-functional issues, it is rare to have anyone in teams who have much experience or specific responsibility for building team, organisational and strategic effectiveness. Instead, they tend to be everyone’s side job.
Those points aside, when smart and motivated people appear to be getting in their own way, a good place to start understanding is to examine the assumptions which underlie behaviour. Those are often implicit in nature and based on a prevailing common sense. Espoused beliefs can often contradict those assumptions, but we can look at the allocation of time, effort and money in practice.
The main assumptions of Value Creation appear to be (in no special order):
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The reality is that lots of expensive reports by clever people have a short shelf life and the time which elapses between their production and deal completions condemns most to irrelevance or indifference. To build value, diligence ought to be designed for use post-deal.
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There appears to be an increasing trend for investors, and their buy-side corporate finance advisers, to want to collate key conclusions and recommendations into big spreadsheets for management to then digest in a 100-day post-deal period. That has the apparent advantage of completeness, and may be a necessary task for legal and financial to-do lists. However, in other areas it risks atomising and drowning insights.
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The best example of this concerns multi-dimensional team and organisational issues which are often squeezed into a box called ‘people’ or ‘management’. The problem comes when actions are set related to that box: in practice, the focus on individual managers is much greater than on the submerged iceberg of management in the form of teams, structures, functions which tend in reality to drive scalability and performance.
A desire for tidiness over grappling with complexity can also lead to an excessive focus on role titles and organisational reporting lines over broader team and organisational effectiveness.
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It makes sense that tasks which can be delegated to junior staff or consultants, and inserted into templates should be. However, their risk is that leads it to genuine complexities not receiving the judgement, debate and skilled synthesis they deserve.
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The maxim that ‘if you can’t measure it, you can’t manage it’ has led to a proliferation of KPIs. Taken to extremes you can end up with 80-page operational reports going to a board each month, as happened in one company Catalysis worked with recently. The problem is the apparent assumption that, if only desired outcomes/effects can be measured precisely and completely, then the inputs/causes will look after themselves.
This is reminiscent of the old joke about the drunk who is looking under a lamppost for a key that he has lost on the other side of the street - because that’s where the light is. Things in the shadow can get ignored in companies.
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Granted, creating economic value is the main purpose of investment. Acknowledged, that some companies under stress need to be very careful about cash. But money is a scorecard for value creation rather than its main cause. In practice, other resource gaps are more likely to limit growth.
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OK, that might be overstating things, but how often does work on strategy create executable roadmaps for management teams to follow? Instead, exciting goals about what to do tends to crowd out consideration of how they might be achieved.
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Those of us with analytical tendencies can find it hard to let go of information which might be relevant in some conceivable circumstance. We may also lack patience with managers who are better at taking action than formal articulation. That’s how we end up with managers who were in the room when the strategy or VCP was being discussed, and who have nominally signed their names to a plan, but then admit that they never really believed in its viability.
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This might seem like a strange criticism. After all, the investment thesis and financial model both needed to persuade investment committee of returns over a five-year period. And it can be helpful to show managers who think in yearly increments what they might achieve through change initiatives over several years. The risk, though, is that too much time is spent working through the detail of changes which won’t happen for a while and may never happen at all as the environment evolves. That can create a sort of parallel - and over-theoretical - future stealing time from activities which are more certain deliverers of value.
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Too strong a claim? Possibly, but we still have memories of a team struggling under the impossible expectations created by a 120-page Value Creation plan created by a consultancy which had not been revisited for two years to understand why it was failing. Or the CEO pushed by his Chair to write a 15,000-word ‘strategic business plan’ while his business fell into operational chaos because he was distracted. Those may be extreme cases but plenty of managers think their VCPs are more burdensome than helpful.
Consequences
The assumptions above, and the processes which flow from them, can have three types of unhappy consequence:
Insights into strategy and execution which are insufficiently broad so that they lead to flawed decision-making.
A strategic and operational focus which is sufficiently loose - and reflects insufficient alignment - such that management bandwidth is dissipated. More change initiatives fail to generate greater change results; teams become tired and under-performing.
Apart from the effect of the previous two points, the possibility of accelerating growth and improvement is missed because bottlenecks are left unaddressed, or key capabilities remain undeveloped.
Put together, these three problems generated by Value Creation assumptions can lead to increases in challenge and complexity (see the vertical axis in the diagram to the right) faster than management horsepower, creating risk and slowing progress towards stated goals.
This is how Value Creation reflecting some or all of the assumptions above can undermine its own objectives. The benefits of greater formality has had the advantage of making the various value drivers more explicit but there is a risk of making this endeavour too much like painting by numbers: easier to execute but creating results of questionable quality.
The point is not that analysis, process, KPIs etc are inherently unhelpful. Instead, we need to beware of narrow over-reliance on them in the messy world most growth companies inhabit. Consequently, we require countervailing ways of thinking. That’s where value enablement comes in.
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