Using FAO to Improve EBITDA Margins in Portfolio Companies

February 6, 2024 Theresa Rex

Woman going over business finances on her computer

Keeping EBITDA margins as wide as possible is a core element to the success of portfolio companies in the private equity (PE) model. The ability to acquire an asset and turn it from a low- to middling- performer to a profitable superstar at exit is what makes private equity the successful moneymaking powerhouse it's known as today. Which is why creating efficiencies, reducing cost and strengthening weak areas in portfolio companies have become table stakes items. Succeed at these initiatives, and managing your margins becomes a simple byproduct.

EBITDA vs. Net Income for Measuring Success at Exit

Executive team reviewing documents they prepared for exit strategy

There are hundreds of metrics you can use to measure the success of your portfolio companies. Pull in numbers from everything from operating profit to enterprise value and you can paint a pretty complete picture on paper. In the end, though, the metric that says it all is your earnings before interest, tax, depreciation and amortization (EBITDA).

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When the exit is done and the last t's have been crossed, it all comes down to this: Did you do what you set out to do? What value did you create for your investors and your firm? Nothing is as simple as a single number on a sheet of paper, but EBITDA sure comes close. You begin each deal with a sense of what you'd like that number to be and move your pieces across the board hoping to get as close to that goal as possible. To turn strategy into actuality and – finally – results, preventing the erosion of your EBITDA margins is absolutely crucial.

To get there, firms have to start with operating cost margins at the portfolio level. It's not enough to simply cut fat anymore, you absolutely have to tone muscle, and one place to see results quickly is within the value-neutral back office operations within your portfolio.

Optimizing Operating Profit in Portfolio Companies by Controlling Operating Costs

Improve ebitda margins in portfolio companies

It can be easy to get mired down and develop a sense of "analysis paralysis" around exactly what provides value and what doesn't when you're in the data room late at night, especially if an acquisition is recent. Attempting to determine where improvements can be made and what revenue or cost streams can be tweaked to keep things moving in the right direction can be underscored pretty simply, however, if you continue to ask yourself, "what makes this asset a good investment?"

Typically, you're not investing in an organization for its tax and treasury capabilities or because you were excited about the payroll arm of its finance department. Private equity requires vision. It imagines what a company is capable of, and unless it's an up-and-coming ERP software startup that's going to revolutionize the way business is done, that rarely has anything to do with general accounting or bookkeeping.

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That's part of what makes these areas such excellent places to start. Improving them tends to yield the highest result with a lower amount of effort – both from a consultancy and cash standpoint. It's a little like purchasing a classic car: PE players will invest in an organization with a fantastic chassis understanding that they'll inherit the rust and dents. This can take the form of "bookkeeping spaghetti" or messy reporting, outdated software or inflated team sizes.

It's also true that buffing out the imperfections is frequently easier said than done and presents a little bit of a conundrum. The idea is to move quickly and efficiently, and untangling spaghetti, onboarding a new software suite and rightsizing an existing team takes a lot of time and effort, putting you right back where you started: dumping focus and energy into an area of your portfolio company that simply doesn't add value.

Protect Your Profit Margins with an Efficiency-Focused FAO Partner

business owner working with FAO partner

Outsourcing provides a unique workaround, but in the era of buy-and-build, this solution can unfortunately be overlooked; the idea that outsourcing is "just" for enterprise or platform companies can throw even seasoned players off.

The truth is, private equity firms can outsource even micro-teams of accounting professionals; and that's an especially good thing as we head into the new year with a talent pool that continues to shrink as the correlating salaries continue to grow in response to that scarcity. There are solutions, it's just that dealmakers will need to expand their understanding of what outsourcing can offer.

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Finance and accounting outsourcing (FAO) partners who can work up boutique offerings of accounting teams as small as one are valuable partners to have, particularly for portfolios that hope to roll-up by adding smaller assets to their platform companies. A model that works within what already exists at the portfolio level is absolutely critical, however, and PE professionals should look for technology-agnostic partners that can provide one-to-one asset assignment and a robust knowledge sharing process.

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These partners are uniquely well-positioned for a private equity exit plan that requires a "hit the ground running" approach because they have multiple functionalities that shores up operation cost margins where they're most vulnerable and can also be applied over and over again as firms work to create high-performing roll-up companies. Once you've found a partner you can trust to understand your needs, achieving EBITDA margins that allow you to hit your goal multiples becomes well within reach for all portfolio companies from the outset of future transactions.

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