When Things Go Wrong, Part II: Taking Action When Performance Slips

[00:00:00] Lloyd Metz: Get ready to peer behind the curtain of the private equity universe with each episode of best but Never Final. Hi, I'm Lloyd Metz, joined by Doug McCormick and Sean Moon. Together we'll navigate the corridors of private equity, revealing the uncommon knowledge, challenges, successes, and lessons that drive the world of private equity and business forward.

[00:00:30] Let's go.

[00:00:36] Sean Mooney: It is great to be back with Doug and Lloyd. Lloyd and Doug, how are you guys?

[00:00:41] Lloyd Metz: Hey Sean. Hey, Doug. We're great. Good to see you,

[00:00:44] Doug McCormick: buddy.

[00:00:45] Sean Mooney: All right. I think we've got another great conversation here, gentlemen. And so this is going to be the second part of a two-part conversation where we talk about everyone's least favorite topic, what to do when things go wrong.

[00:00:59] The first part we talked about was really like, how do you diagnose it and like how do you figure out something's going wrong? Today we're gonna talk a little bit more about what do you actually do when you actually have a good sense of, there's a challenge here to, to overcome. How does that sound? Guys?

[00:01:15] Lloyd Metz: Sounds great because there's. A lot of things we didn't really address. So let's get at it.

[00:01:21] Sean Mooney: And I think this is gonna be a great conversation to really lean into Lloyd and Doug on, because when I was in private equity, I never had any problems. It was all kind of up and to the right. So I'm really gonna be generally curious about this conversation here.

[00:01:35] Lloyd Metz: I thought the preceding episode, you, we were asking for friends.

[00:01:38] Sean Mooney: Oh yeah. My friends had problems, but, uh, no, the, the reality is I had problems every day and I was circled by them.

[00:01:48] One of the many reasons why the only hair I have left is gray. So I'll, I'll, I'll also be listening for a friend, but also nodding in a knowing way. So maybe as we kick this conversation off, you've kind of diagnosed that there is something that is causing your company, we'll say politely, to not reach full potential.

[00:02:11] What are some of the most common kind of operational areas that you're gonna first look to when performance is giving you some signals of things aren't right for some reason.

[00:02:21] Lloyd Metz: We talked a little bit about this diagnosis thing, and I'll throw it back at you both. I think one of the first things you need to figure out is, is what you're dealing with.

[00:02:31] Sort of a temporary external market driven phenomenon, headwind, whatever you want to call it. Maybe it's some of your inputs or, or going the wrong way against you, but do you think it's temporary versus is this something truly internal structural that you need to address? I think that's one of the first things you need to get a point of view on.

[00:02:52] I don't think you need to get it a hundred percent precisely right, but you need to figure that out first so you know what you're dealing with. I don't know, Doug, if you've had any occasions to, to wrestle with situations like that, but that's how I think about it from the start.

[00:03:10] Doug McCormick: Yeah. Listen, I, I find that there's an important level setting that happens here in terms of reconciling when you say things are not going as planned.

[00:03:19] I would argue what we're really saying is things are not going as the forecast that we underwrote would've suggested. And it's trying to understand was the forecast flawed or are we not executing, you know, IE not achievable or not executing to that forecast. And so for me, a lot of times, I'm, I'm trying to isolate, is it a market issue, like a fundamental demand in the market for that services?

[00:03:42] Is it the way we're engaging with our customer set issue? Or is the market fine? The customer's fine, but we're not generating the profit that we thought we would based on that answer. I think you get to very different action plans on how to address those.

[00:03:57] Lloyd Metz: I agree. And sometimes it's tricky to get a timely answer to the market dynamic, right?

[00:04:05] Depending on how soon this thing's not going according to plan happens to your initial investment. You can revisit your market diligence. You can revisit your customer diligence, but you need to find a way to talk to the customers or the distributors or your salespeople to figure out what's happening in the marketplace, to see what's driving that portion of your three-legged problem solving stool, Doug, that can take time.

[00:04:35] Voice of customer work can be helpful. Oftentimes it's, it's talking to your distributors and your, your salespeople that can give you a sense for at least how the customers are receiving your product or service. I don't know if you have any other tricks up your sleeve on how to figure out market dynamics, but those are ones that I know have been helpful.

[00:04:55] Doug McCormick: Yeah, and by the way, I agree with you. It doesn't seem like it should be hard to identify the source of variance, but like when you have a bunch of different variables in the business that could be influencing the outcome, it's surprisingly hard. One of the things that I have struggled with, there's this balance between, you come with a thesis and part of that thesis is an end state, and then you get into the business and you wanna drive toward that end state.

[00:05:19] In my mind, there's a tension between a, there's change when you did the deal. Now I'm gonna institute change or introduce change into the business because I intend to grow it. So I'm trying to drive this big growth objective, this very audacious goal. But if you're not careful, you are now changing other variables and it makes it harder to isolate what this new cause is, right?

[00:05:42] So I find there's this balance of we have a thesis, we have an end state. We need to invest in delivering on those initiatives, but not make so much change that we lost the secret sauce, or when things go awry, we can't identify what the new variable is that has caused that change.

[00:06:00] Lloyd Metz: The unintended consequences of your growth initiatives.

[00:06:03] Doug McCormick: Yeah, exactly.

[00:06:04] Sean Mooney: Yeah. There's ripple effects. You're doing all these things that are often meant to do the things that you normally kind of enact when something's not going right. You're trying to basically optimize those things just as a normal case. You're trying to tune up everything and then something is going wrong.

[00:06:19] Let's drill down into, if we kind of break this apart, right? You could have, let's say you primarily have a market or a revenue issue. You have an operations or a cost issue. You think it's a market or sales issue. What are some of the things that you would do to help improve sales, whether it's a market issue or it's an effectiveness, something like that.

[00:06:41] What are the kind of the levers that you pull to say, we've got a lift revenue?

[00:06:45] Doug McCormick: So first of all, let's just acknowledge that that's generally the single most important driver, right? If I've got a challenge, you can solve a lot of problems with, uh, incremental top line. And so obviously pricing can be a powerful lever, both in terms of driving your revenue, but also in terms of driving gp.

[00:07:01] And it's usually not like, Hey, just increase price or decrease price. My sense is it's usually how do I price more effectively relative to my cost or relative to customer value, but put pricing on that as a key. I find in small middle market businesses, sales is generally straightforward, and if you want more sales activity, you add more sales resource.

[00:07:23] But marketing is a huge opportunity in a world where most people are pretty unsophisticated about it. But it takes time to dial in and get effective, right? So you gotta try things. It's a lot of trial and error and optimization, but huge opportunity there as well. And then I think just overall investment in sales resource, right?

[00:07:42] So whether that's brokers, whether that's direct sales folks, all the above.

[00:07:45] Lloyd Metz: The tricky part, and I think this is, I think this conversation is fascinating, a lot of what Doug, you just mentioned, we tend to identify in diligence and build our value creation plan around. From day one, right? And so if we're adding additional salespeople, if we're investing in marketing and we're still not hitting the underwriting case or hitting budget or, or whatever the expectations are, I guess your diligence causes you to revisit the value creation plan, or at least look at it briefly to figure out, okay, that's all working.

[00:08:23] So something else must be not working right, because it's. The steps you've were talking about and described, we tend to put those into the value creation plan on a good day. You know what I mean?

[00:08:35] Sean Mooney: It's interesting, Lloyd, as you talk about then as I'm, I'm thinking about it, the number one value creator today is growth, right?

[00:08:42] There's things you can get some returns off, cost improvement, but very often, particularly with a founder owned business, I think you're right, they usually either have a sales motion or a marketing motion. Rarely both. You're gonna be coming in and, and ask that you're going to, whatever they're doing, accelerate and go faster.

[00:08:58] Whether it's organically through acquisition, through expansion of product lines, you know, the grid of existing in new customers, existing in new products, and try to bring different places to go to. On the last call we talked a little bit about is it a CEO challenge. I think particularly in sales and marketing, this gets to like, you really need to augment, do you have the right people in the right seats?

[00:09:20] Further down the line are your front level salespeople. Is your head of marketing the right person in a data-driven world? And that is, to put it bluntly, very often in these transformations, you gotta get those right people who are more in tuned about the future of the businesses going versus where it came from.

[00:09:38] And that's a really, at least to me, an unfun part of the business.

[00:09:41] Lloyd Metz: Yeah, I think you have to be mindful, and again, this is where having good relationships with the. Leadership team more broadly at your portfolio company can help. If you brought in a new head of sales or a new head of marketing, it's important to know whether that person's being accepted or not by the sales organization that's in place.

[00:10:03] Are you watching or experiencing organ rejection, so to speak? Is that person that you've brought in being effective with the sales team or the marketing team that's in place, or are they not gelling? Is the chemistry off. Sales organizations can be very chemistry dependent, has been my experience. And then trying to bring new ways of selling or new ways of sales management to the table can also elicit sort of allergic reactions that get in the way and show up in sales that are not as expected or budgeted.

[00:10:39] Doug McCormick: There's an irony here in my mind, which is we all agree. That growth in sales growth in top line is generally project one A in terms of long-term value creation. 'cause it's compounding and it's, it's really driving terminal value. But the irony for me is it's also the one that's the most elusive and the one that takes the hardest to pin down.

[00:11:01] Exactly. Cause and effect. And in many cases, customers take a period to cultivate, there's a lag there. And it's the part of the business where I don't control all the variables 'cause I've got a willing party on the other side of that transaction that's gotta do what I hope. So the challenge to me is in these environments where you're under performing, you often, and I think appropriately so migrate to the things that you can control, which is cost or doing more of the same on sales, right?

[00:11:27] So in some ways, like I know if I have a certain sales program and I just force the team to operate at a higher ops tempo, I should get better results, right? More throughput. And then cost management is something that you can control totally within the four walls of the business. And so that often becomes almost an interim fix to buy yourself time to figure out the longer term problems.

[00:11:52] And some of this conversation, I think then you gotta talk about it's balance sheet driven. How quickly am I forced to manage my cost aggressively, in some ways is a reflection of. What the long term opportunity is and what the balance sheet looks like.

[00:12:07] Lloyd Metz: Absolutely. In some cases, and I'm sure you've experienced this too, Doug, with getting your internal costs and your internal processes, right, that gives you lower costs overall.

[00:12:20] You can use some of those cost advantages to give you a better position in the marketplace to sell, right? So. If you've taken some costs out of your product, your unit costs outta your product or your service, you can now be more flexible in your pricing and therefore more competitive with your pricing, which leads to more revenue.

[00:12:41] That's part of the diagnosis too, where when you talk to the customers, when you understand what's happening in the market, both competitive dynamics as well as customer need dynamics that can inform how you think about your cost structure. Right in terms of what you need to skinny down or slim down to be more competitive in the marketplace.

[00:13:02] That connection is a nice one if you can find it, but I agree with you a hundred percent. Focus on what you can control, and that is often your internal cost structure.

[00:13:12] Sean Mooney: And what I would say is part of the challenge on sales and products is they're all interconnected, right? You're playing three dimensional chess, not only internally in your organization.

[00:13:21] One thing impacts the other between sales and operations. But then also you have competitors who are doing things that are playing with their own sales. They're pricing their operations. And maybe just from a tactical advice perspective, if you're a, a business builder out there and you think you have a sales issue, you know where it is, there's some groups that you can bring in to help, right?

[00:13:39] That Doug and LO are acquainted with. And the broader P firms are, if you want to use this toolbox. You can bring in pricing strategists who can help you get it right. You can bring in Salesforce effectiveness groups to say, are your motions on your sales team or your marketing team working and working well together?

[00:13:55] People who are focused on sales team hiring, who know what good is to help you get the right people in the seats if you have to. So there's help out there if you need it. And the kind of the PE way is whether you have the internal expertise or external. You're not alone. You can get help on that.

[00:14:12] Lloyd Metz: This episode is brought to you by HCI Equity Partners, a lower middle market private equity firm, focused on partnering with family and founder owned manufacturing service and distribution companies, ICV partners.

[00:14:27] An innovative private equity firm supporting management teams of leading companies at the lower end of the middle market and BluWave, the Business Builders Network connecting the most proactive business builders in the world with the best of the best service providers for critical variable, on point, and on time due diligence and value creation needs.

[00:14:50] Now back to the episode

[00:14:55] Sean Mooney: now. What are the types of things you can do to improve kind of your cost and your operational efficiency? If you think that's an area that also has to be tuned, and then maybe after that we can talk about how sales and operations are kind of intertwined, whether it's a business or a service, to make it even more complicated.

[00:15:11] Lloyd Metz: Can I just go back to something that you just said in terms of asking for help or getting help, I find that one of the biggest mistakes teams make. And I think to be fair on both the portfolio company management team side, as well as the private equity side is when things start to go off plan. One of the biggest mistakes is not thinking that you have a problem being in denial, whether it's wishful thinking and hope as a strategy or sticking your head in the sand like the proverbial ostrich.

[00:15:45] Both of those are big mistakes that can lead to really bad outcomes. A lot of times that shows up, at least in my experiences, people who are unwilling to acknowledge that they need help accepting help or asking for help. That's a real killer.

[00:16:02] Sean Mooney: I mean, it's very well said, right? It's so many people, particularly when there's a tectonic shift in an industry, you just deny, deny, deny, and next thing you know, you're selling records in the age of streaming.

[00:16:13] I think that's incredibly important. Some things are transitional, some things are just fundamental. The world has changed, and if you don't. Ask help. And if you don't get ahead of it, you're gonna get left behind.

[00:16:23] Lloyd Metz: That's right. So back to your question on operational changes. Sorry to hijack the conversation.

[00:16:30] Sean Mooney: No, no. I think, but it was a really important point, right? And it's dead joke, alert denial's. Not just a river. Right? There we go. Alright, transition back. How do you like that? Let's go back to costs. What are some of the levers you use? You say, okay, we think our costs are not where they should be or could be.

[00:16:48] What are some of the levers you can pull if you figure it out that to, to kind of start improving?

[00:16:53] Lloyd Metz: Yeah. One of the key areas I, I find is many organizations do carry a lot of costs in some of the processes that they just follow in producing or delivering their product or service. And there isn't enough attention been paid over time to figure out, Hey, why do we still.

[00:17:18] Process things the way we do well 'cause we've always done it this way. We've done it for the last umpteen years. Let's take a look at what do we actually need to do to reduce steps in our process to reduce touches in our process, to reduce the amount of people who need to manage or oversee or supervise our process.

[00:17:40] That's one of the first areas that there's a lot of opportunity to find. The other is in, particularly in manufacturing, and Doug, jump in if you've seen something different, but you'd be surprised how often the speeds at which different manufacturing or machines are running is not even close to the stated speed or capacity of that machine just on the name plate and certainly not near sort of max speed or max capacity that that.

[00:18:15] Machine can perform and that can happen over time where just speeds slowly dwindle down to where people are comfortable taking a fresh look at that can often uncover some, some opportunity.

[00:18:30] Doug McCormick: I'm gonna come at it a a little bit differently just to kind of frame it and talk about gross profit management and I wanna talk about it in terms of speed to realize versus long term.

[00:18:41] And so. When I start having businesses underperforming, I first think about, okay, what cost can I take out rapidly? And I think purchasing jumps right to the the front. What am I buying and should I be taking some of those costs out with the vendor base? And my sense is there's always opportunity there, right?

[00:18:57] Even if you've done it recently, the market's always dynamic. And with a discipline process, you can generally realize cost take out there pretty well. The other one that people come and look at is g and a, right? Are all the investments in my g and a kind of part of the income statement. Prudent, given the circumstances.

[00:19:17] And then this one I'm, it's a little bit of a cheat, but I think you throw pricing back in there in the context of GP management, gross profit management, and we talk about growing sales, but it's also pricing in the context of cost. Because if you can focus on the items that are not making money. That's a pretty good bet that you're gonna be able to keep that business if you raise the price because others are presumably rational.

[00:19:41] And so I think those are like the three levers that you can action pretty quickly. Then I think you move up the income statement into things that can be real opportunities, but they take longer efficiencies. Generally, I'm thinking about like a shop floor or manufacturing business where you've got some combination of labor and and materials where you can drive efficiency and take out labor and material.

[00:20:04] The second one is a trade between labor and capital. What can I automate? What kind of investments can I make to take out labor, which can be a good ROI over time? The third is lean systems and processes to take out wasted activity and often wasted inventory. And then the fourth I would focus on is quality, and those are all very tangible and often result in really good long-term results.

[00:20:30] But I, I highlight they're often longer term opportunities. It takes a while to achieve some of those benefits.

[00:20:36] Lloyd Metz: I'll add onto it. 'cause in the short term, it can lead to some savings. If you can figure out customer account profitability. So are all of your customers profitable on an account basis?

[00:20:51] Oftentimes there's a tail, a little stub that may not be profitable. Are all of your product lines or service lines profitable? And are all of your assignments, engagements, or jobs profitable? So in a profitable account, you may find there are matters or projects or jobs, whatever your business model is that aren't profitable.

[00:21:14] And sometimes you can restore profitability to the overall enterprise by just repricing or not accepting certain projects or certain jobs. That aren't profitable, so you cut off that unprofitable tail and lift the remaining business's profitability by a meaningful amount. Those are three areas that you can always look at to begin with, and I'm always surprised at how much opportunity there is with unprofitable accounts, unprofitable jobs, and unprofitable service lines.

[00:21:51] Sean Mooney: What I think is great about what each of you, Lloyd and Doug are mentioning is like these are all in the, what I call the free money categories. These are the things that, like in any company, whether you're thriving or surviving, this is the money that's there If you have the audacity and the know-how to go get it.

[00:22:08] Lloyd Metz: That's right.

[00:22:09] Sean Mooney: And it's just so often just not either prioritized because it maybe shouldn't be sometimes or it's just not known that you can get it. And so for our listeners. Once again, if you need the H word help, there are groups called Lean Six Sigma groups that you can Google that are really good at the process part.

[00:22:28] The other thing I'd recommend is like anyone who's interested in this, read this book called The Goal by Eli Goldratt, and you'll understand no Lloyd is nodding. It's like, it is like standard canon. I think that was passed out like earlier, but it'll just teach you how, like the theory of constraints and how all processes work.

[00:22:45] It'll change the way you think about whether you're a service business, a software business, or a manufacturer. It'll think about how you consider optimizing a system. But you can bring in folks who do this Lean Six Sigma stuff. And to Doug's point, it's usually very high ROI, but it takes a long time and it takes more money to go get it.

[00:23:04] And so it's something that you're gonna use kind of like when you're making, like, let's fix it versus bandaid it and then let's, let's use it as a weapon. Because then if you're able to improve your system and take out costs and reduce working capital, then you can price it aggressively and take share once you configure a whole system.

[00:23:22] The other thing that I'd say people can get for help is there's a whole ecosystem of direct spend takeout groups. So if you are a manufacturing something, there are groups that specialize in things like buying metals better, buying plastic, better, buying food ingredients, better buying boxes, and corrugated.

[00:23:41] Anything that you make, and they see billions of dollars of transactions and they're gonna be able to come into you right away and say, here's the free money you're buying at this, at these volumes. Everyone else is buying at this lower number, and we're gonna give you a savings. They'll ask for part of that savings as their payment, but it's usually gonna be like at least a three to one ROI on your spend.

[00:24:01] And so once again, any of these savings, don't just think about the dollar savings, put your exit multiple on that. If you're 10 times at EBITDA, exit multiple and you saved a million bucks, you didn't just save a million bucks, you created $10 million of value on top of that million bucks. Then there's this all other category called indirect spend, your wifi and your telco and your travel and your hotels and all these other miscellaneous things.

[00:24:25] What you spend on your, on your CRM system, there are groups that will give you free money and these are like a lot easier to get. Your savings aren't as big. The one category I put out there that has big savings that no one thinks about is in your insurance spend. Recently, we had a group come in, they saved north of $500,000.

[00:24:44] It was a 30% of their spend on just insurance that they came. It was just free money. They didn't change the benefits at all. They didn't change the coverage levels, they just took the slack outta the rope in kind of that ecosystem that naturally exists. And so those are gonna be kind of like the three areas.

[00:24:58] And then the last one, that's the most complicated. We see a lot of companies that get into trouble because they have a sales and operations problem. Sales is like selling the company out. They don't tell operations and then operations is caught flatfooted, and then they spin up the whole plant. And by the way, this is, think about a service as like a, a process and a widget as well.

[00:25:19] It's the same thing. It goes like in this whipsaw from sales outselling operations, trying to keep up sales, stop selling, and then they gotta refill the pipeline. And so there's a another way that's also harder to get at. You're gonna be built to win more when you put in systems where sales and operations work together and level load each other, and there's groups that will help you do that, does that resonate with you guys?

[00:25:40] Lloyd Metz: Absolutely. It's a lot of what Doug was talking about earlier when he said the concept of balance. Sometimes that's actually what can drive variability and profitability, is that you have this whipsaw effect of volumes and orders and not able to level load your system, whether, like you said, whether it's manufacturing or service.

[00:25:59] Sean Mooney: And if you want help, help exists there. But candidly, you can also self-teach yourself a lot of this stuff.

[00:26:04] Doug McCormick: I'm generally in agreement with you and, and I think it resonates. I think consultants get a bad rap. I would argue some of these consultants. The more tangible the activity is, the more predictable the ROI is, not necessarily the higher the ROI, but the more predictable.

[00:26:19] It's like singles and doubles, you know, it's a good return on investment and a word of caution. A lot of them will put skin in the game, like we're only gonna get paid if we deliver return. But what I've seen in some of these cases is they're still executing in a world with a lot of variables. And so sometimes it's still hard to pin down what value did they create versus did the market move in your way, right?

[00:26:44] And so you gotta like really work to make sure that the program is structured effectively and and accomplishes the desired objective. Then the last thing, just to reinforce what you're saying about this tension between sales and ops, this is a game of there's always gonna be a constraint in the business.

[00:26:59] And as soon as you create capacity in one function, you've created the constraint in the other. And so that acknowledgement that we're gonna grow one part of the business's organizational capabilities, and by definition that's gonna put the other one at a sold out capacity or a disadvantage, and then the goal is to increase capacity in that functional area, and you kind of go back and forth and that's healthy.

[00:27:20] Sean Mooney: I think spot on and a great point on consultants, if you're gonna use them, you have to think of them as if they're full-time employees and give them very detailed direction and manage them as if they were on your team. And then I think the best advice you point out as well is like make it ROI driven and pay them when they show you the money.

[00:27:40] Yeah.

[00:27:40] Doug McCormick: And a lot of 'em will sign up for that. They're comfortable.

[00:27:43] Lloyd Metz: Yeah. Doug, you bring up an interesting point and you also brought up the idea of that there's multiple factors and multiple variables. When a company's performance starts to go off plan, it's rarely been my experience that it's one factor or one thing that led it to this place.

[00:28:00] So there's always multiple factors. And so finding this consultant who's willing to find you a million dollars, like you said, Sean and Teya capitalize it. It's enterprise exit value. You just gotta make sure you've also caught the other factors that are leading to your underperformance, so you can isolate it a hundred percent.

[00:28:21] Sean Mooney: Let's talk about one other topic here, kind of related to this. And so when you're starting to maybe fly blind and or moving from underperformance towards duress, one of the most important things then becomes cash. So Doug, how do you think about. The value of cash flow and liquidity and having fuel in the tank during these periods.

[00:28:45] And what are some of the easier things you can do to start creating cash flow or maximizing the cash you have on hand to kind of weather a storm?

[00:28:55] Doug McCormick: To me, it dramatically depends on the type of business, right? And so is it a technical services business, a labor based business, or is it a manufacturing or distribution business?

[00:29:08] Those are the the three kind of businesses we spend time on. In a manufacturing distribution business, you've got a lot of assets. And so in many cases, like if you're managing cash flow, it's more about managing, working capital, managing kind of inventory levels and capital investments. The reverse of that is in technician based services business, you really don't have a lot of inventory, and so if you're managing cash, you're really managing the p and l, and obviously you gotta do both.

[00:29:34] And the old saying, especially in a leveraged situation, the name of the game is Do it soon. 'cause like it's hard to take out costs and it takes a period of time. You gotta do 'em early to take advantage of 'em in, in the context of really impacting your liquidity. So I find many cases you wait too long and then you're in a liquidity constraint as opposed to doing it early enough to avoid the liquidity constraint.

[00:29:59] Sean Mooney: And I guess in terms of actually managing the working capital, and really any good company should do this anytime. If you think about receivables, payables, those type of things, what do you start doing to create more cash?

[00:30:12] Lloyd Metz: Don't forget inventory too.

[00:30:13] Sean Mooney: Exactly.

[00:30:15] Doug McCormick: Just to go down the list. I mean, it's kind of pretty straightforward on receivables.

[00:30:20] It's just a maniacal focus on people that are outside of terms and possibly revisiting the terms. In some cases, a business has a collateral base that sets itself up well for factoring. So on a short term basis, you can generate liquidity outta your receivables by factoring. Banks often have certain constraints on that, but it's still a viable option as you go down the balance sheet.

[00:30:42] Inventory, obviously big opportunity potentially, and my only comment on inventory is I guess two things. One, it's not helpful to look at inventory in a homogeneous fashion, and so a lot of times what we'll see is. Aggregate inventory in a business is turning at, let's just say five or six times. Okay, that's interesting, but it doesn't tell me where the opportunity is.

[00:31:05] But when you break it down by product category, you'll find like some inventory is turning at one times and some inventory is turning at 12, and so it's kind of focusing on those outliers. And then payables is essentially trade financing. And so how do you lean on the trade in a way that creates liquidity but also preserves?

[00:31:25] The relationship because they're obviously looking at you as a customer and evaluating not only the profit of their service to you, but the capital investment required to support that service. That is an opportunity, but it comes with its own set of risks as well. The last one is, is you think about like they're all asset related decisions.

[00:31:44] I think there's always an asset related decision around do I invest CapEx that I had planned and do I ever consider selling? Either non-core assets or assets that are good leased assets. And so a lot of times we'll look at doing sell leasebacks on real estate or leasing capital equipment that we don't wanna purchase upfront.

[00:32:06] All those decisions can be part of a comprehensive plan and arguably pretty attractive cost of capital.

[00:32:13] Lloyd Metz: I wanna underscore your mention of inventory that long tail I talked about. With respect to accounts not necessarily being profitable or jobs or product lines not being profitable. Same thing with inventory that you mentioned.

[00:32:29] Like what are the slow moving SKUs or the slow moving customer related products, focusing on those and then adjusting your production schedule accordingly, right? Or your sales offering. Maybe you stop. Carrying or offering that SKU that turns once a year, maybe discontinue it right and flush it out of the system and and streamline your operations that way.

[00:32:57] But looking at the slow moving and fast moving inventory absolutely can improve how you think about your operations.

[00:33:05] Sean Mooney: Those are spot on points, right? Your working capital, you have free money. If you can make your receivables systematically lower, it creates cash. If you stretch out your payables systematically, it creates cash.

[00:33:17] If you keep your inventories at lower levels, it creates cash and the extent you can actually maintain those afterwards, you've given yourself free money that never existed before. So I think one of the lessons I always had when I was in your shoes was like, let's remember these lessons after we go through this kind of storm here.

[00:33:34] 'cause then we've just fundamentally given ourselves free money. That's right.

[00:33:39] Doug McCormick: Yeah. And Sean, I wanna offer a dose of realism as we talk about this topic, 'cause I think it's all true and accurate. And then I want to provide a tone of caution here as you think about the opportunities, because I find there are real risks and there are real world constraints to some of these choices.

[00:33:57] So for example, the real risk is often you end up compromising service levels when you take out too much inventory and. Distribution businesses, for example, exist because supply chains don't work perfectly. And so part of your job is to be a buffer for the unexpected. And so like you just gotta make sure you're balancing how much investment I need for buffer versus a capital efficiency.

[00:34:22] And then I also find there are a number of real world constraints. And I'll give you like two examples. One is a lot of times in distribution businesses you have. Minimum order quantities. And so you see your inventories only turning at like three times, but you realize that you've gotta purchase a minimum of a thousand units, and the only way you get the thousand units is have it turn in slowly until you grow the business.

[00:34:45] So you have constraints like that, or you have constraints around is the inventory at the right warehouse or am I shipping from the most effective place now because I don't have the inventory at the right location? So it is a complicated kind of mosaic of choices that you gotta make.

[00:35:02] Lloyd Metz: Wow. You just gave me a flashback to my classes in operations research.

[00:35:07] 'cause that's the kind of stuff you deal with, warehouse location and optimizing and replenishment quantities and replenishment frequencies. But that, that's all true. And, and I think Doug, even with those constraints, I think at least you're explicit about the purpose. We're carrying this amount because it's supply chain insurance and that's just an insurance cost and you've gotta think about it that way as opposed to just having, having that amount of inventory and you're not sure why you have it, at least it makes you think about it explicitly, which is always a good thing, I think.

[00:35:46] Doug McCormick: Totally agree.

[00:35:47] Sean Mooney: Yeah, I think it was totally spot on points and, and you know, these are good tools at the margins, but you really not need to know your business about what you need. Don't overly constrain it. Unless you have to. So you've diagnosed a problem, you've pulled these levers, you've done some things at the edges to create more cash flow, and at the end of the day, sometimes that's not enough.

[00:36:08] How do you all think about if and when more capital is warranted to support the business kind of managing through a period in time?

[00:36:18] Lloyd Metz: That's a heavy question. It's gonna be driven by your point of view as to whether this is a temporary. Departure from the underwriting plan, or do you think it's gonna take some time?

[00:36:33] And again, it's months and quarters is what you're trying to decide. If you think this is gonna be a situation that lasts a year or more and putting in capital addresses, liquidity needs, putting in capital, perhaps pays down some debt and provides debt relief. But usually it's gonna be driven by liquidity needs.

[00:36:54] You should put the money in. And how much is part science? It's part art, but you want to think about how long might this take to get the business back on track? What investments or what additional investments do you need to make? Whether it's CapEx, you talked about labor versus capital. How long will it take to streamline inventory?

[00:37:18] Do better on your collections with receivables. It's gonna be a function of those multiple work streams that informs ultimate timing, and then you wanna make sure you have enough runway to execute. So that all goes into the calculus of figuring out whether to put money in and how much

[00:37:38] Doug McCormick: I generally agree with Lloyd.

[00:37:39] I think about it with kind of three different talk tracks or three different lines of reasoning. The first is, you know, we try to get a sense of like, how much conviction do we have in the end state? Is this a bump in the road, but we still feel like we're gonna get to the promised land? Or are we questioning the business model or the market?

[00:37:57] The second is like, do we really feel like we understand the problem? We talked about this earlier of it's kind. Sometimes it's hard to identify the problem. Exactly, and it's a very different underwriting question. If you're saying, I have an inventory shortfall, the problem is a $2 million problem, and I believe with 2 million I fixed the problem.

[00:38:15] That's one set of underwriting versus. I have a $2 million problem with my bank, and I don't know if that $2 million problem is adequate liquidity to solve the operational issue at hand. So we try to get clarity there and then for me, it's all in the context of the current capital structure. And so what's the existing balance sheet?

[00:38:37] What's the quantum of capital required relative to what I got in it? How much time does this capital buy me? And how do I think about enterprise value of the business versus debt today? In some cases, is my new money going in relatively toward the top of the cap structure or do I have to believe a decent outcome to start being in the equity?

[00:38:56] And so we kind of think about all three of those issues in the context of a re-up

[00:39:02] Lloyd Metz: that last part in terms of where do you come in into the capital structure, what security you come in. So the how you put the new money in, that's one where you have to. As Doug, you were alluding to look at the investment with a fresh set of eyes, you almost have to put to the side your existing investment and say, okay, for this business as it is today with the outlook and prospects for it today, and the capital structure that it has today, if I were to put this amount of money in, how would I put in my money?

[00:39:37] How would I invest those dollars? You sort of have to look at it. With a clean set of eyes and a clean sheet of paper.

[00:39:45] Sean Mooney: And how do you think about it? I mean, sometimes the world has unexpectedly changed so much that money doesn't, it can't even matter. How do you think about that? Like, sometimes there's just like, there's so many problems that we see in our broader society where we throw lots and lots of money as a nation into things, but it doesn't, more money doesn't solve the problem.

[00:40:03] How do you think about that? You can pick your political philosophy and I'm, I'm sure, think five of 'em in each of our heads.

[00:40:09] Lloyd Metz: You're making me think of a guy mentor. I, I respect a lot who said, we're in the business of solving puzzles, not mysteries. So part of what you're framing sounds like a mystery, right?

[00:40:22] Where. It's unclear whether money's gonna solve the problem. And so if you don't know, as Doug said, what the problem is you're trying to address and how long ballpark it may take to solve it, if it's solvable, then you probably don't put the money up. That's a hard decision. I don't say that lightly, that that's super hard.

[00:40:42] Sean Mooney: I'll think about, A couple things that I remember came across our desk is like looking for like rescue capital. One of them was a manufacturer of compact discs. And another one was a newspaper printing company. And they were all saying, no, no, we're gonna invest in more and more of these faster printing presses and we're gonna be the last one standing on the compact disc.

[00:41:03] Like there was one company in Nashville that still persists today, and that was the winner and the vinyl record game, they're the only one that exists. But everyone else failed. And so one was just saying, no, we're gonna be faster and people are still gonna use paper. Kind of going back to. We talked earlier about, you know, just the world changes and are you open and honest about it?

[00:41:19] The other one was saying, we're gonna be the last survivor. And at the end of the day, we just couldn't get conviction on, at least on this new investment, that the money's not gonna matter. There's not enough of it in the world when you're fighting a tide and when you have that as an, I've had those similar things in portfolio companies.

[00:41:35] It's probably the biggest personal failures I've ever felt. The most like sour my stomach has ever felt when you just realize like we had tried and tried and tried and usually put money and money and money in, and it just, you couldn't fix it.

[00:41:47] Doug McCormick: Yeah. It's really helpful for me to think about liquidity need versus terminal value.

[00:41:54] Is this challenge presenting itself because there's a real question of terminal value, or is it presented itself because we have a liquidity need? How do they relate? I think in sometimes being so close to it can be a liability. 'cause you know what you need to fix and you're not asking the more fundamental question of should it be fixed?

[00:42:11] Lloyd Metz: That's right. If you're facing those kind of questions in your investment, you can't help but force yourself to step back and rethink your diligence initially because there was something in that diligence for that compact disc maker or whatever where you didn't see or didn't appreciate that it was going to go away or that it was.

[00:42:34] Highly unlikely that you'd be the last standing CD manufacturer. Something didn't go right in your diligence is ultimately what you have to confront.

[00:42:44] Sean Mooney: Yeah. Unfortunately, in this point, it went right in our diligence. It didn't go right in the other sponsor's diligence just because we didn't, we didn't fund either of those, but two other groups did.

[00:42:56] But I've been on the other side of that coin where you're right, just something changes or you missed it, or the world changed. And fortunately that's life, right? It just happens.

[00:43:05] Lloyd Metz: But part of our job is to anticipate how the world might change. There's knowable unknowns, and so you're, you're supposed to at least consider what happens if one of the knowable unknowns comes to pass

[00:43:21] Sean Mooney: certain P firms.

[00:43:21] You'll hear like they pride themselves and they've never lost money. I've talked to 'em about that and they'll go, well, we actually get some guff from our LP saying, well, are you taking enough risk that you've never lost any money in your entire career? And that's, it's a delicate balance. 'cause on one hand I can say, you know, that's really good that you've never lost money.

[00:43:37] Like holy mackerel, the other one, it's like you're also in the game of balancing risk and return. And so it just shows why, like, I think this conversation's a perfect example of why Doug and Lloyd, your business is a fascinating and terribly interesting, but also really, really hard.

[00:43:53] Lloyd Metz: Don't remind me.

[00:43:54] Humbling. Humbling, for sure.

[00:43:58] Sean Mooney: All right, gentlemen. Well, I think this is another really good kind of canon in the annals of private equity of like not only the good, but some of the hard things that you all have to work through. And I appreciate you kind of pulling back the curtain and saying here's some practical ways to kind of address them.

[00:44:13] Lloyd Metz: Yeah. Thanks a lot, Sean. Thanks, Doug. Thanks

[00:44:15] Doug McCormick: man.

[00:44:18] A special thanks to HCI Equity Partners, a lower middle market private equity firm focused on driving transformational growth through consolidation strategies by partnering with family and founder owned manufacturing services and distribution companies. Learn more@hciequity.com.

[00:44:37] ICV Partners an innovative lower middle market private equity firm, supporting management teams of leading companies at the lower end of the middle market. Learn more about ICV @icvpartners.com.

[00:44:50] And finally, BluWave the Business Builders Network connecting the most proactive business builders in the world with the best of the best service providers for their critical, variable, on point and on time due diligence and value creation needs. Learn more about BluWave@BluWave.net for further information on HCI, ICV, and BluWave and relevant topics to discussed here during the episode, please see the episode notes for links.

[00:45:19] Sean Mooney: The views and opinions expressed in this program are those of the individuals presenting and do not necessarily reflect the views or positions of any other persons or entities, including those referenced herein.

[00:45:30] No representations, warranties, financial, legal, tax, or other advice are made herein. Consult your advisors regarding any topics discussed during this episode.

Join Doug McCormick from Oridian Capital Partners, Lloyd Metz from ICV Partners, and Sean Mooney from BluWave as they explore timely private equity topics and offer their seasoned perspectives on crucial areas of focus within the industry. Gain valuable insights from these industry experts in this engaging podcast tailored for PE professionals.