Margin expansion in PE: what works and why it’s hard

In the private equity investment landscape, margin expansion stands out as a critical lever for value creation. Whilst better multiples and revenue growth often capture headlines, my experience shows that enhancing a portfolio company's profit margins will yield substantial returns. However, achieving sustainable margin improvement is fraught with challenges. In this article we are focusing on the essence of margin expansion, its key drivers, showcasing key examples, the inherent difficulties in realising it, and strategic recommendations for PE practitioners.

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1. What is margin expansion in private equity?

Margin expansion refers to the increase in a company's profit margins over time, indicating improved efficiency and profitability. In the PE context, this involves enhancing operational performance to boost earnings before interest, taxes, depreciation, and amortisation (EBITDA) margins. By reducing costs (or controlling cost during growth), optimising processes or improving productivity, a company retains more profit from each revenue pound/dollar, thereby increasing its enterprise value.

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2. What are the drivers of margin expansion?

Several strategies can drive margin expansion:

• Operational efficiency: Streamlining processes, adopting automation, and eliminating waste can significantly reduce operating expenses. For instance, integrating advanced technologies (cloud-based operations, or AI-enabled front end) can lead to rapid margin improvements.
• Strategic pricing: Implementing dynamic pricing models and value-based pricing can further enhance profit margins. A McKinsey Report highlights that pricing transformations can directly and swiftly impact margin expansion. And interim pricing expertise can bring immediate value through embedding best practices and leveraging game-changing experiences.
• Cost management: Regularly reviewing and renegotiating supplier contracts, optimising supply chains, and reducing overhead costs contribute to better margins. Procurement-led cost containment strategies and Zero Based Budgeting (ZBB) can be the tools called upon to achieve cost management discipline.
• Product portfolio optimisation: Focusing on high-margin products or services and discontinuing underperforming portfolios can improve overall profitability. Activity-based costing and portfolio prioritisation techniques can be useful tools to help drive lasting margin impact.

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3. Why is it difficult to expand margins in private equity?

Achieving margin expansion is challenging due to several factors:

• Market saturation: In highly competitive industries, distinguishing oneself to command premium pricing is difficult, limiting margin growth. Product innovation and new product launches can overcome these limiting factors to permit enhanced profitability and growth.
• Rising operational costs: Inflation and increasing costs for labour and materials can erode profit margins, making cost control an ongoing battle. Effective procurement value-add from the CPO function and Target Operating Model design can be called to mitigate this factor.
• Short-term focus: PE firms often operate on short investment horizons, sometimes prioritising immediate financial engineering over sustainable operational improvements. With portfolio holding periods extending in Europe and US, the longer-term view on value creation may yield stronger, stickier results.

Case in point: The acquisition of Chrysler by Cerberus Capital Management serves as a cautionary tale. Despite intentions to revitalise the automaker, Cerberus faced significant challenges, including high operational costs and a declining market, leading to substantial financial losses. (Source: southerncalifornialawreview.com)

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4. Recommendations for PE practitioners to expand margins with a focus on value creation

To effectively drive margin expansion, consider the following strategies:

Case study: We have recently completed a 12-months margin expansion engagement with a PE-backed portfolio company. The business benefited from our robust approach to deployment of procurement-led vendor consolidation and negotiation strategies, ZBB implementation rigour and alignment at the CxO level with the paramount objectives of cost-conscious ways of working. Our engagement brought about multimillion pound P&L savings which have been redirected for investments into front-end augmentation, back-office tech-enabled transformation and M&A programs.

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In conclusion, margin expansion is a vital yet challenging aspect of value creation in private equity. By focusing on strategic, sustainable improvements and addressing inherent challenges head-on, PE practitioners can enhance profitability and achieve superior returns. Interim resources could be a strong way to move the needle substantially while achieving a remarkable performance boost for your portfolio companies.

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If you need help with embedding value creation techniques in your organisation, please reach out for a confidential chat