How to reduce costs

A challenging economic climate calls for innovative ways of producing greater savings and efficiencies within companies. Kevin Ley and Jennifer Harris explore some ways in which private equity firms, with this in mind, are interacting with their portfolios

Although deal activity has slowed across the private equity industry, GPs are not sitting on their hands. Instead they are using the time to refocus on and strengthen existing portfolios. After all, what may set apart the most successful firms in an environment like this is the degree of operational oversight and financial acumen applied to keeping businesses healthy and creditworthy.

As more private equity firms redouble their efforts in this area, it is increasingly the responsibility of the private equity sponsor's chief financing officer (CFO) or chief operating officer (COO) to monitor performance dynamics across the portfolio as well as look for opportunities to better control costs. That is why firms are employing a number of innovative strategies, from aggregating healthcare costs to utilising dashboards to getting portfolio company chief executives' buy-in for cost-cutting and/or monitoring initiatives. As the importance of monitoring and analysing the portfolio increases, such strategies are likely to become a bigger focus of the industry in the near future.

During PEI's Strategic Financial Management Conference in New York earlier this summer, several CFOs discussed the importance in the current economic environment of reducing costs and getting better rates by lever-aging the combined purchasing power of portfolio companies.

As the importance of monitoring and analysing the portfolio increases, such strategies are likely to become a bigger focus of the industry

With healthcare representing a huge burden for many companies, Blackstone Group is taking the lead in efforts to aggregate such costs across portfolios. The question is how many other firms will follow its lead?

The programme, Blackstone Equity Healthcare, leverages the collective employee base of its portfolio companies to secure discounts in healthcare insurance. It currently includes 28 portfolio companies, with 125,000 employees and a total of around 260,000 members including dependents.

The programme was designed by Dr. Alan Muney, a former executive and chief medical officer at Oxford Health Plans and United Healthcare, who was brought in in 2007 to try and address a problem that has only grown costlier for firms over the years. “With healthcare costs plaguing employers and employees across the US for quite some time, Blackstone undertook an effort to study how it might tackle the issue across its portfolio companies,” he said. “This issue came to a head when Blackstone CEO and co-founder, Stephen Schwarzman, attended a conference and listened to corporate CFOs loudly complaining about healthcare costs.”

Muney said he negotiated contracts with Aetna and Anthem Blue Cross and Blue Shield with an eye toward receiving the type of service and staffing normally received by large corporations like UPS or Bank of America. The number of employees already enrolled makes Equity Healthcare currently Aetna's fifth-largest customer and Anthem's ninth-largest customer.

“My terms were simple: we wanted the highest level of customer service and care management staffing possible and wanted staffing teams exclusively dedicated to Equity Healthcare,” he said. “Dedicated units are usually only available to a Fortune 10 national employer.” He adds that the programme will save the portfolio companies involved $50 million in 2009, and potentially up to $150 million next year.

The deal marks a major step in the institutionalisation of private equity, with Blackstone now allowing other private equity firms to join Equity Healthcare for a cost of $2.25 per employee per month, a price point which is likely to both decrease and include additional services as the purchasing pool increases.

TPG recently became the first private equity firm to put some of its portfolio into the programme, but, despite the advantages, many firms have expressed reluctance to either join Blackstone's consortium or implement a similar programme across their own portfolios. One of the main reasons for this is that healthcare is such a hot-button issue, as recent town hall protests regarding plans to overhaul the US healthcare system have shown.

Healthcare is such a hot-button issue, as recent town hall protests regarding plans to overhaul the US healthcare system have shown

“If you want to pool the purchasing on office supplies, it's not really a very emotional issue. No one really cares where they buy paper clips,” says The Riverside Company's COO Pam Hendrickson. “But people really care about their benefits. So it can be a very emotionally charged issue and I think some PE firms just don't want to get in the middle of something like that with their portfolio companies.”

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Riverside established its own group buying programme in 2004, but although it requires that companies participate unless they have a good business reason not to, the firm has sought to avoid discord by establishing a steering committee for the programme comprised of representatives from its portfolio companies.

Other problem areas can occur. For private equity firms with a geographically diverse portfolio, it can be tough to find one provider with strong network coverage in all the right regions. A private equity firm with a small portfolio, or a portfolio of small companies, would also have trouble reaping the benefits of a group buying programme due to state regulatory benefit mandates and other regulations.

Such considerations mean that private equity firms looking to cut costs through a programme like this need to be aware that there are more factors to consider than just the bottom line.

Many private equity firms continue to leave portfolio company monitoring in the hands of the deal partner or an operating partner responsible for the company. Some firms, however, are moving beyond this approach and becoming more systematic in the way they track the companies in their portfolios, including requesting periodic and standardised reports from the management teams.

In these reports are metrics that GPs track on a regular basis, which serve as an indicator of the health of the company. Key metrics include the portfolio company's leverage ratio, fixed charge coverage ratio and interest coverage ratio. What GPs really want from management and financial reports are numbers that tell them, among other things, how likely it is that the companies are going to get into trouble with their lenders.

In order to centralise this tracking function, such firms are using sophisticated, customised systems, sometimes called “dashboards.”

For instance, financial services provider State Street recently added private equity data into its State Street Investment Analytics DashboardSM. According to the company, the system provides performance and analytical information, including look-through capabilities to the underlying assets, and captures partnership-level data for more than 2,500 private equity investments. For each asset type, relevant performance data is provided, including long-term internal rates of return for private equity and time-weighted returns.

Customers can choose from performance calculations over multiple frequencies and valuation options, such as monthly (cash-adjusted values), quarterly (general partner values) or a customised option. Historical data can also be integrated into the dash-board, enabling trend analysis for key metrics such as internal rates of return, contributions and distributions. The dashboard also aggregates performance and exposure information across each customer's entire plan, including public and private holdings for returns and exposures.

In addition to its healthcare programme, Blackstone is also an early adopter of the dashboard concept. It revealed several years ago that it has an automated web-based reporting system which all its portfolio companies use, while the information entered into the system is then analysed centrally. In 2005, the firm hired James Quella, senior managing director and senior operating partner in its corporate private equity group, to monitor the strategy and operational performance of the firm's portfolio companies.

Although the concept of a centralised monitoring “dashboard” has not been adopted on a large scale, private equity firms are beginning to move in that direction. However, a GP at a buyout firm that had previously considered building a financial dash-board to monitor the performance of its portfolio companies said he had two concerns. One, that the portfolio companies will not use the system to input relevant metrics on a timely basis, and, two, that the partner currently responsible for the company will feel as though the firm is stepping on its toes.

But even firms that don't utilise a dashboard can still move away from the usual model of placing responsibility for monitoring on the partner who executed the deal – and instead spread the responsibility among a number of in-house operating partners.

Creating portfolio wide cost-cutting programmes can make a big impact on returns. But first you'll need to get buy-in from your portfolio company CEOs

Many private equity firms are reporting impressive savings from group buying programmes for everything from raw materials to healthcare insurance. But in order to reap these benefits, most if not all of your portfolio companies need to buy in. Below are three tips for ensuring that your CEOs support cost-cutting initiatives.

1. Involve your ceos in the planning process
If CEOs are involved in the creation of the programme, they're less likely to resist implementing it. For The Riverside Company's healthcare purchasing programme, the firm set up steering committees composed of employees from portfolio companies. “That really helps us to design these programmes and make sure we're avoiding landmines,” says Pam Hendrickson, Riverside's chief operating officer. “The companies themselves – because they know there are these steering committees – are a little more willing to listen to their peers.”

2. Clearly define the circumstances under which it is acceptable to opt out
Both Kohlberg & Company and Riverside say their group buying programmes are voluntary, but those who want to opt out must present a convincing business reason for that decision. “They get to elect whether to participate or not based on an analytical response, not just because they don't have time or they're not interested, or they don't think it's the firm's responsibility to be involved in this area. Those excuses don't work,” says Shant Mardirossian, a partner at Kohlberg.

3. Provide the resources to help the ceos implement the programme
Don't just throw a set of procedures and changes at your CEOs without any guidance. Kohlberg and Riverside both send third-party consultants to help the portfolio companies set up and run the programmes. “They work hand-in-hand to implement it,” Mardirossian says. “Because of that we don't monitor the day-to-day implementation and get the results once both the consultant and the management team have jointly agreed on what they are. And then they're presented to us for our evaluation.”