The mid-market transition: Is your group structure adding value or just creating complexity?
Plenty of the mid-market growth companies we work with create group structures. That may be because of expansion into new territories, the separation of, say, services activities from a technology product, or through acquisitions. In one recent case, a 300-person investee already has a two tier group structure – a ‘group within a group’.
For a CEO, the creation of the group may initially be simply a way to manage multiple legal entities and handle financial consolidation, i.e. mostly an issue for the CFO and perhaps general counsel to deal with administratively. From an investor perspective, the group may be mainly a vehicle to facilitate aggregation of EBITDA and enhancement of the earnings multiple. Both of those perspectives are valid and useful – but do not cover the possibility of group structures to add value more actively than being, essentially, holding companies – or sometimes suck value out of operating businesses.
This ambiguity about the impact of groups can be illuminated by material presented at the first iteration of a course on Organisation Design and Development created by Andrew Campbell (https://www.linkedin.com/in/andrewstrategy) at Ashridge which my colleague Aly Stewart and I attended about 15 years ago. The insights still feel relevant today.
Can a group add value at all?
The 1980s and 1990s witnessed leveraged acquirers deconstructing bloated groups which had been assembled during the 1960s and 1970s. The logic of companies like Hanson and Tomkins was that individual business units would perform better with greater managerial autonomy, lower group overheads and within a robust financial framework. Groups persisted but in much leaner format than previously.
The lesson from that period is that corporate ‘parents’ need to justify the cost in time and money of governing business units with a return in terms of on-going value-add. Where that isn’t possible, parents and would be better served by disposing of subsidiaries. That attitude fed a wave of MBOs which notably fed the emergence of private equity.
Andrew Campbell’s contention is that the ability of groups to create value net of cost would likely be achieved under only a limited set of circumstances where:
Business units would perform sub-optimally without a parent’s influence, e.g. where scale was needed to achieve efficiencies in procurement. He calls this the ‘parenting opportunity’.
The parent has relevant capability or resources to exploit that opportunity, e.g. access to reliable suppliers in China – ‘parenting skills’.
The parent is wise enough to avoid destroying value by heavy-handed governance, or supposing that it knows much better than business unit leaders than it does in reality.
The key point for new groups emerging now is that they need to beware of hidden costs they may inflict on business units, whether that is excessive reporting, unhelpful interference in decisions or pushing for unrealistic strategies and returns. Consequently, deciding upon the right balance of engagement and distance is critical.
A couple of years back, we worked with a financial services business which had started as a successful single-country unit with a young and ambitious team. Their value creation plan had multiple ‘pillars’ but the main strategy pursued was an M&A one which had led to operations across six countries. The new structure pushed the management team out of their depth, created frustrated business units and essentially suppressed all organic growth. Organisational complexity had grown faster than managerial capability and suffocated value creation. Adjustments to group-unit relationships and changes in management allowed what was fundamentally a good business to re-find its balance.
In what ways can groups add value?
There are four main ways groups can bring value to their subsidiaries:
Stand-alone influence
This involves direct parent to business unit influence, e.g. through high quality governance, a powerful corporate brand, assistance creating a focused strategy or a set of useful KPIs. It assumes that there are areas where group managers know better than their business unit subordinates, perhaps due to greater experience or information.
Linkage influence
Different business units could, in principle, cooperate with each other spontaneously. Sometimes, though, they don’t have sufficient knowledge of each other’s activities and the potential synergies, or else bandwidth to gain that knowledge. If so, a parent can add value by promoting value-creating connections.
Central functions and services
Groups can provide access to specialist skills which individual businesses might not be able to create or afford as stand-alone units. That might include marketing, technical or HR skills. The question for units is whether access to those capabilities is sufficiently tailored to their requirements and budget or whether outsourcing them (or living without) would make better sense.
Corporate development
Groups can add value through adding to (or subtracting from) the number of units within the group. Benefits to other units could include enhanced capabilities to leverage horizontally or new central resources which can now be afforded. Acquisitions are always something of a gamble (most academic studies suggest a majority destroy value after considering costs of capital), so a group is hoping to beat the odds despite paying a premium. That implies unusual skills at finding the right targets, buying well and integrating competently. Campbell suggests checking not just whether an acquisition fits a strategy but also ‘are we the best buyer of the business?’ in the sense of being best placed to add value to it.
How is this relevant to private equity?
As backers of businesses which either are already groups, or may became one, considering the issues above is relevant for investor directors.
However, in addition, private equity firms can themselves be considered as a form of group structure because they:
Accumulate multiple businesses under a larger financial/legal umbrella.
Need to decide how deeply to try to influence their portfolio companies.
Are in principle no less susceptible than group executives in potentially generating unintended negative value effects as well as positive impact.
It is notable that whereas 30 years ago, investors mostly acted as holding companies with light touch governance (think of 3i which had 1000s of investees), now they have migrated towards being significantly more engaged now, often building complex capabilities to back that up: portfolio teams, value creation people with various functional skills, operating partners, as well as sophisticated reporting systems and processes. As noted elsewhere [https://www.catalysis-advisory.com/blog/value-creation-a86bg], that value creation apparatus is not only expensive but can sometimes become self-defeating.
The key point is that not all interventions and structures are likely to create net benefit (more intervention can sometimes reduce value not increase it, in the same way that more change initiatives can often slow down the pace of useful improvement), and spotting those situations requires a sceptical eye. The lack of that led to sub-optimal results for sprawling groups in the 1970s and could appear again. There isn’t a simple formula for overcoming this risk because outcomes can be unpredictable and the decisions involved are complex. But encouraging a devil’s advocate to consider why a cunning strategy might backfire is a low cost and potentially high value starting point.
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