All The Pieces Matter - Value Creation

All the pieces matter Value Creation “Y’all can’t be playing no checkers on no chess board yo!” – D’Angelo Barksdale, The Wire

April 2025

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Introduction As investors seek to maximize risk-adjusted returns in an increasingly competitive landscape, Private Equity (PE) firms are shifting focus from traditional financial engineering to comprehensive operational improvements and strategic initiatives. In the rapidly evolving private equity landscape, value creation has become a key driver for improved investment outcomes. At the heart of this transformation lies a critical question: How can PE firms consistently create and capture value in their portfolio companies?

In this joint 27four Investment Managers (“27four”) and Kleoss Capital (“Kleoss”) All the Pieces Matter article, we will explore the key strategies typically used by private equity firms to create value.

We start with a real-world example of value creation through a Kleoss portfolio company and then draw out more general observations of the kinds of value creation levers available to private equity fund managers later in this article.

Gist of Value Creation - What Is It Technically?

Private equity has become an increasingly important force in the global economy, with firms employing various strategies to create value in their portfolio companies. So what does this actually mean?

Value creation in portfolio companies is the process of turning resources (e.g. financial and human) into something of perceived worth, enhancing the value of the businesses. It’s not just about making money; it’s about crafting something that solves problems, meets needs, and exceeds expectations in a sustainable way.

Private equity firms with active investment strategies aim to enhance the value of a portfolio company delivering risk-adjusted returns through various strategic actions.

Key strategies for Private Equity value creation includes, in no particular order: multiple expansion; operational improvements; strategic growth initiatives; leverage; talent management; improved governance and risk management. We comment on these in more detail later.

Private equity investment and value creation strategies are not without their risks. Some strategies implemented, if not managed effectively, could result in value erosion and have a negative impact on portfolio companies. The risks of poor implementation could result in the following: 1.

Financial distress of the company: taking on significant levels of debt to fund an investment could place undue strain on company cash flow, and on management’s ability to deliver financial performance. If financial performance deteriorates or doesn’t grow according to plan, this could result in financial pressure to meet debt repayments.

2. Short-term perspectives: Private equity funds may expect value to be created in unreasonably short timeframes, which can lead to pressure to make quick changes that may not be sustainable 2

over the long term.

3. Potential job losses: Managers may consider reducing jobs or outsourcing labour to reduce costs and increase profits.

Private equity value creation can offer significant benefits. However, it is important to be aware of the potential risks and challenges associated with implementing value creation techniques, and to carefully evaluate the specific strategies used to create value.

Ultimately, successful private equity value creation strategies require a careful balance of short-term and long-term objectives, a deep understanding of the company’s operations and financial performance, and an ability to implement effective, sustainable changes.

The Art of Value Creation To explore this further, we turn to Kleoss, a South African private equity firm, established in 2014, that has witnessed this ever changing landscape first hand. The founding partners’ gained their individual investing experience in banks and other private equity vehicles before fully investing and now exiting their Fund I and successfully reaching first close on their Fund II, raising R750 million and back into deployment and value creation mode.

Kleoss isn’t just playing the game - they’re actively looking for ways to evolve it in order to win. And what does a win look like? Generating risk-adjusted returns for investors by targeting high-growth potential companies or strong market leaders that need that extra push (and capital) to effect that ever elusive step change within its own growth path that ultimately results in a value inflection point for all parties involved, before doing it all over again.

Kleoss’ Playbook Kleoss Capital has its own unique approach to value creation, focusing on: 1.

Strategic influence: They don’t just invest; they play an active role in shaping the direction of their portfolio companies.

2. Growth capital: Kleoss provides the fuel for companies to expand and reach full potential.

3. Resilience building: They target companies that have demonstrated resilience, especially in the face of challenges like COVID-19.

4. Job creation: In a country grappling with high unemployment, Kleoss sees job creation as a crucial aspect of value creation and broader social impact.

By focusing on these areas, Kleoss isn’t just creating value for investors; they’re contributing to the broader South African economy and society. Now that’s what we call value creation for ALL, contributing positively to the broader macro!

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Value Creation in Action (A Kleoss Case Study) Value creation - equity and pref. share structure 400,0 350,0

ZARm

300,0 250,0

(49)

200,0

185 306

85

150,0 100,0 50,0 -

121 65

29 Entry

Earnings growth HYM

Leverage

Accrued interest

Exit

Equity

Source: Kleoss Capital Management information

As part of its portfolio construction and value creation strategy, Kleoss invested an amount of R150 million in the following Investment Case Study: •

R29.5 million as Equity; and

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R120.5 million as High Yielding Mezzanine (“HYM”) instrument.

The HYM instrument was considered appropriate for the transaction to mitigate for specific risks associated with investing in the business at its current lifecycle and expected forecast growth ambitions.

The manager exited at a times money multiple (TMM) of 2.5x and an IRR commensurate with the risk appetite for the specific investment.

We analyse the Value Creation for this investment on the next page.

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Leverage / Financial engineering • • •

To optimise its capital structure, the business modestly leveraged its balance sheet to facilitate an acquisition utilising bank debt and the R150 million investment by Kleoss.

Kleoss invested R120.5 million of the R150 million as a HYM instrument with security in the underlying core division to mitigate risk.

The HYM instrument provided protection during COVID-19 as the rate was fixed and reflected equity like returns in the high teens. This accrued during COVID-19 notwithstanding the weak economy with security in the underlying businesses.

Talent management • • •

The HYM instrument was also used to incentivise management by not diluting them by a large amount.

The business was not of a sufficient scale at the time of investment and thus would have significantly diluted management resulting in non-alignment.

The management team was also complemented by the recruitment of critical senior members such as the Head of Franchising and key staff in finance. This was all to facilitate a smooth growth trajectory.

Strategic initiatives •

•

Kleoss’ capital of R150 million was utilised to acquire a complementary business that was a well-known brand. This bolt-on acquisition (which diversified the earnings of the business) proved itself to be resilient during COVID – 19.

Management also introduced strategic alliances with large stakeholders and collaborated to introduce loyalty programmes.

Earnings enhancement • •

The bolt-on acquisition and the growth of the business resulted in earnings growing 4x over a seven-year period. This growth offset the leverage of R46 million as at date of exit.

Purely on the equity invested of R29.5 million, the exit value was R65.1 million. This was a TMM of 2.2x.

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Role of technology •

•

Management also implemented smart technologies such as applications for smart phones to allow for loyalty reward programmes which were a great success and enhanced revenue materially.

Online delivery of orders was also introduced which enhanced revenue.

Job creation •

To support the growth achieved in the business over 600 jobs were created almost double that supported by the business at initial investment.

An Array of Different Options Available Private equity has become an increasingly important force in the global economy, with firms employing various strategies to create value in their portfolio companies.

The private equity industry has undergone a significant shift in recent years, moving away from traditional methods of value creation such as financial engineering and leverage. We consider some of the traditional and new value creation strategies implemented by private equity firms in their portfolio companies.

Value creation strategies

Multiple expansion Observation Impacted by other value creation activities implemented by private equity firms.

Can also be achieved through timing the market for exit and targeting strategic buyers through a competitive sales process.

Common pitfalls to look out for • PE Firms should consider modelling their exit of a business based on the same multiple they acquired a business for and perform sensitivities to test their returns based on lower multiples by at least a 1x and 2x negative turn on the initial multiple.

• Markets can turn against a PE Firm or value erosion in earnings can have a ripple effect of negatively impacting the exit multiple.

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Leverage / Financial engineering Observation Financial engineering remains an important aspect of value creation in private equity. This involves improving capital structure, working capital management, and cash flow generation.

Examples • Restructuring debt.

• Optimising the capital structure of the portfolio company.

• Investing through a debt instrument such as a hybrid mezzanine instrument can also mitigate downside risk of an investment where the debt instrument ranks senior to the equity shareholders.

• Improving working capital management.

Common pitfalls to look out for • Caution that too much leverage to enhance returns is not a great strategy.

• Where a business does not perform in line with expectations, having too much leverage can place significant strain on management and business performance.

• Fortunately, in South Africa, leverage multiples remain reasonable.

Companies can choke on too much debt, with devastating consequences for growth and reinvestment opportunities to sustain the business.

Examples • Entering new markets.

• Launching new products / services for new customers or within the same customer base.

• Divesting non-core businesses.

• Pursuing mergers and acquisitions.

• Enhancing the value proposition of their portfolio companies through customer-centric value add activities, such as improving customer experience, and leveraging digital transformation to better understand and meet customer needs.

Common pitfalls to look out for • Strategic initiatives are often times the most difficult to implement successfully.

• They truly require an exceptional management team. However, if they are implemented successfully, they result often times in multiple expansion on exit coupled by increased diversified earnings further mitigating against investment performance risk.

Strategic initiatives Observation These focus on positioning a portfolio company for longterm success.

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Optimisation of operations Observation Operational improvements require a deep understanding of a portfolio company’s operations, its market and growth potential. PE firms typically work close with management to identify these opportunities and to implement initiatives that strengthen the portfolio company’s position.

Examples • Optimisation and driving efficiencies either through automating manual tasks, improving inventory management, negotiating improved supplier/ service contract terms, and adopting new technologies to reduce overheads.

Common pitfalls to look out for • In an effort to contain costs and create efficiencies, firms must ensure that they do not cut too many job functions and that they retain necessary operational skills in the business. “Cut fat, not muscle!”

• Attractive businesses are those that are able to scale up and down its operational requirements and costs in line with demand for their products and/or services.

Examples • Think of a world of when there was no desktops and the ability to work from anywhere?

• Think of a world where physical meetings were the only option and the inefficiency thereto?

• Recently the introduction of AI is enhancing business operations and reducing cost and time.

Common pitfalls to look out for • Some CEO’s and management teams’ are resistant to change or embracing technology.

There is a lot to be said for sticking with what works and “not fixing what’s not broken” but being able to identify how technology can improve a business and embracing that is equally important.

Role of technology Observation Digitalisation can streamline processes, reduce costs and redirect resources toward more value-add activities.

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Talent management Observation Effective talent management is crucial for successful value creation.

The right leadership and skills are required to execute other value creation initiatives that are considered.

Examples • Aligning management performance to company performance incentivises value creation.

• Having management invest alongside the PE firm aligns interest and motivates performance and creates a culture of excellence and accountability.

• Replacing underperforming executives.

Common pitfalls to look out for • This can cause disruption to a business. Thus, it must be carefully thought through.

• Furthermore, PE firms have only ideally one chance to alter a portion of the management team. Too many repetitive changes of the CEO or CFO (or both worst case) several times, will cause disruption to a business and delay potential exit.

Examples • Appoint experienced directors with relevant industry knowledge and a track record of value creation.

• Increase board diversity to broaden perspective so as to enhance decision-making and risk management.

• Implementing robust reporting systems to track KPIs and to identify areas for improvement.

• Implementing strong internal controls to mitigate risks and ensure compliance.

• Conducting frequent risk assessment to address any proactively.

Common pitfalls to look out for • Improved governance should not be to the detriment of stifling the company’s ability to be nimble and efficient with decision making.

• There is a fine balance between good governance and unnecessary bureaucracy.

Improved governance Observation Initiatives are typically designed to enhance oversight, improve decision-making, and to align the interests between management and shareholders.

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Exit preparation Observation Exit starts when the business is acquired by the PE firm.

Examples • Identifying potential buyers (strategic and financial) and regularly engaging with them to provide updates on the performance of the business can accelerate an exit when the time comes.

Common pitfalls to look out for • Strategic and financial buyers gain insight into business and sector performance that may benefit their existing operations or portfolio companies.

Environmental and Social (“E&S”) considerations Observation

Examples

E&S integration has become an increasingly important value creation strategy in private equity. This approach focuses on incorporating environmental and social factors into investment decisions and portfolio management processes.

Common pitfalls to look out

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for • Greenwashing: Ensure that E&S initiatives are genuine and impactful, rather than superficial marketing efforts.

• Balancing short-term costs with long- term benefits: Some E&S initiatives may require upfront investments, which need to be carefully weighed against potential future returns.

• Measuring impact: Developing appropriate metrics to quantify the

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Implementing energy efficient technologies to reduce operational costs and environmental impact.

Developing sustainable supply chain practices to mitigate risks and improve brand reputation.

Creating diversity and inclusion programs to attract and retain top talent.

value created through E&S initiatives can be challenging but is crucial for demonstrating success.

The initiatives can work in isolation or a combination to unlock the full potential of portfolio companies.

If implemented correctly, this can also lead to multiple expansion and greater value creation for investors.

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Challenges and Considerations Although value creation strategies have evolved over time, challenges still remain with increased competition, external factors such as market volatility, political stability, regulatory considerations (e.g. exchange control / competition commission) and the status of the economy can hinder the achievement of desired outcomes.

Ultimately, private equity firms have to consider risk and reward in their investment decision-making and be deliberate and consistent in how they source, due diligence and execute on transactions that form part of their portfolio construction. Selection of portfolio companies is the most critical component of creating value for investors. Choosing the right asset, implementing the value creation strategies available and timing is critical to the success of any private equity investment.

Conclusions Just as The Wire explored the interconnected nature of various institutions in Baltimore, the world of private equity is equally complex and interconnected.

Value creation in private equity has shifted from generating risk-adjusted returns for investors to also delivering broad social impact outcomes for a variety of stakeholders.

It has shifted from financial engineering to a more holistic approach focused on operational improvements, strategic initiatives, financial optimization, ESG, and talent management.

As the industry continues to evolve, PE firms that can effectively implement these strategies while adapting to changing market conditions will be best positioned for success.

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