Why financial modelling in private equity matters now more than ever

As was the case during the pandemic’s early stages, private equity’s priority is to ensure investee companies can weather the storm to avoid possible insolvency. While PE firms have traditionally concentrated on creating value, now is the time to shift their focus toward preserving the value of their investments.

The need for financial modelling

Businesses need to grow profits and contain costs to continue operating. Unfortunately, given the present financial environment, the ability to thrive, or even to survive, has become more difficult. Companies must be flexible enough to respond quickly and effectively adapt to ongoing changes. Higher costs for materials, increasing interest rates, rising labour costs, supply chain interruptions, and possible foreign sanctions are just some of the hurdles they face.

If the last few years have demonstrated anything, timely action is crucial when operating in an unpredictable global financial landscape. While some industry veterans will say PE has survived a recessionary environment before, it is worth remembering Warren Buffet’s famous quote: “What we learn from history is that people don’t learn from history.”

One lesson from the pandemic is that historical results are not an accurate indicator of future performance, which is why scenario planning using financial modelling sensitivity is more essential than ever.

PE firms need timely access to critical data from each of their portfolio companies so they can quickly analyze the financial information leveraging projections that reflect a range of potential outcomes under different scenarios.

Externally, these projections are extremely valuable to PE sponsors, the portfolio company’s lenders and other stakeholders. In an uncertain economic environment exacerbated by businesses facing repayment of COVID-19-era loans, PE firms should be more active in monitoring the results of their portfolio companies. Seeing evidence of timely, reliable reporting and financial forecasting will demonstrate the business is “under control” and will provide crucial reassurance to the PE firm. It will also assist businesses in building a more compelling case for additional financing if needed.

Internally, these projections allow management to anticipate the results of different eventualities and to implement preventive measures before situations escalate. Management’s recognition that actions are required to maintain liquidity will often result in identifying redundant assets that can be sold, expenses that can be reduced, etc. Taking proactive steps will allow management to remain in charge of the company’s destiny rather than have its lenders impose demands for their financial support to continue. Projections also provide management with the information required to obtain alternative funding sources. While traditional lenders become increasingly cautious during periods of economic turbulence, private markets—including PE—have more than $3.3 trillion on the sidelines looking to be put to use.Frequent interaction between the PE firm and the portfolio company management team allows for trust-building that will be critical when actual results deviate from the plan, and corrective actions are required.

Dangers of no financial modelling

Even without external pressures, there are compelling reasons for businesses to recognize the importance of accurate and timely financial reporting and modelling. Failing to do so can result in a business faltering when economic conditions are favourable. Every accountant has stories of enterprises that fell into difficulties while seemingly thriving. Inevitably, companies that grow revenue without consideration of profitability unknowingly sell products at a loss, provide services below their cost or run into cash flow problems. Poor visibility into the entity’s finances and a lack of forecasting can result in unexpected crises. Undoubtedly, this poses a major problem for the company’s PE owner.

All that said, in an unpredictable and fast-changing environment, an increasing number of businesses will not just run unwitting risks, they will miss out on opportunities that are before them that their PE may be willing to support. The past couple of years has made both suppliers and customers question fundamental business assumptions—the increasing globalization of supply chains being one example. The opportunities associated with such changes can only be properly evaluated and exploited when a clear view of the company’s costs and requirements to take advantage of those opportunities are clearly set out.

Time to reset strategy

In the past, middle market businesses could often succeed by relying on management’s sales skills or the quality or efficiency of their manufacturing process. Some middle market businesses have even made money despite themselves. However, with today’s rapidly changing environment, this may no longer be the case.

PE firms should have confidence that management entrusted with overseeing a portfolio company considers all aspects of the business including enhancing processes for sales generation, management of supply lines, and dealing with labour shortages or other operational challenges.

Often, businesses will not have all the skills required to analyze the information properly that is produced in-house. Given current labour shortages, that is not surprising. In such cases, PE firms should turn to their trusted business advisers with subsector industry expertise to not only assess the viability of the portfolio company and minimize the PE firm’s risk, but to allow opportunities to be identified that competitors may not see.

The assumptions that historically underpinned the business strategy may have changed or no longer apply. If not updated, decisions based on outdated assumptions will likely lead to unsatisfactory results. Accordingly, a fresh set of eyes to independently assess the investee’s operations, financial results and future viability may benefit the PE firm.

The adage that short-term pain may result in long-term gain applies at times like these. PE firms should use this economic slowdown to not only assess what can be done to ensure their portfolio companies weather the storm but to position those companies to come out leaner and stronger to generate positive results when the sun comes out again.