Location Economics as an Emerging Driver of Private Equity Decisions
As they evaluate where to expand and which operations to relocate, private equity groups are increasingly evaluating location-specific factors.
While some private equity (PE) groups focus on buying distressed assets and instituting extreme cost-cutting measures, more PE firms are looking to grow companies through capital infusions that enable them to pursue market opportunities. Their goal is to use the acquired company as a starting point for capital injections that will create additional value. While increasing efficiencies may be an objective, the ultimate goal is to increase value through growth. The newly acquired portfolio company is a launch point from which to expand sales and profits. These growth-focused PE firms often follow acquisition with expansion in the form of capital investment and headcount increases. Whether the PE group’s strategy is to own the company in the short or long term, the motivation is the same — grow the operation to increase earnings before interest, taxes, depreciation, and amortization (EBITDA) and enterprise value (EV).
Using Location Economics to Drive Strategy, Decision-Making
Location economics can be a significant value driver for businesses. For private equity, this involves understanding the advantages and disadvantages of specific locations on EBITDA, EV, and the sustainability of the business’s operating strategy. Location-specific cost factors are familiar metrics in the real estate and economic development ecosystems, including real estate/occupancy, labor, utilities, supply chain/distribution, taxes and incentives. With red-hot competition in equity markets and multiples increasing, forward-looking PE groups are increasingly focusing on these areas — using location economics to drive strategy and decision-making as they evaluate where to expand and which operations to relocate.
PE firms are looking to grow companies through capital infusions that enable them to pursue market opportunities. “The investment objective of our firm is to identify and capitalize on market distress, disruption, and growth. Many of our portfolio investments are in a period of transition and may require significant additional capital post-acquisition. Increasingly, when evaluating opportunities for growth or improvement, the physical location of the operations has stood out. Access to abundant labor, a desirable location to recruit talent, and a friendly business environment can unlock significant value,” said Jeff Holland, a director with Innovatus Capital Partners. “We are in the process of relocating a significant portfolio company after determining that free cash flow was being negatively impacted by the company’s location. What we have learned during this process has us thinking deeper and earlier about the strategic value of location across the portfolio and when underwriting new opportunities.”
Proactively Assessing the Effects of Location
Throughout the PE life cycle — from pre-acquisition due diligence to long-term hold/disposition — more focus is being placed on location economics. PE buyers historically scrutinize business fundamentals and future opportunities before making a purchase. Increasingly, the analyses are now looking much more critically at the effects of location economics. Astute PE buyers are applying resources to understand whether the location of the facility is helping or hurting financial performance. Specifically, they are looking for optimized supply chains, sufficient cost-effective labor, and an attractive tax and incentive environment.
Astute PE buyers are applying resources to understand whether the location of the facility is helping or hurting financial performance. PE firms can create significant value by proactively assessing the effect of location on EBITDA, EV, and sustainability earlier in the process. While most PE firms will eventually recognize when location is hurting operations once they are settled in, leading PE groups seek to gain an understanding of this before they close on an acquisition target or make post-transaction capital infusions. When a location is hampering growth and profitability, it may hold hidden bargains that others are overlooking. What if a target company with EBITDA of $10 million could achieve $12 million in EBITDA if relocated to a community that better aligns with its specific needs? When location effects can be evaluated during due diligence, PE groups can often avoid land mines or even find opportunities.
While much can be done to evaluate location economics prior to acquisition, the post-acquisition period always provides new revelations. PE buyers generally develop a good picture of what they are buying through due diligence activities, but the first six months or so of ownership is when the buyer truly begins to understand the purchase. At this point, PE ownership’s strategy, vision, and outcome targets begin to crystalize, and it becomes natural to question whether the current facility or facilities align with the new vision. Location economics begin to play a large role in what happens next.
While much can be done to evaluate location economics prior to acquisition, the post-acquisition period always provides new revelations. Even when buyers do not have relocation plans during the pre-acquisition period, relocation is often evaluated seriously during the first year or two under PE ownership. This has little to do with a failure by the community or state but rather is a result of the PE owners determining the ideal strategy to create additional value by optimizing location economics and aligning operations with that strategy. This decision-making process by the PE group will likely be quite different than that of previous ownership.
While closely held and family-owned businesses may be resistant to location discussions — their propensity to relocate is lower than average — PE-owned operations are typically much more amenable to relocating. With exposure to multiple markets and investments spread across wide geographies, PE groups will drive decisions based on expected financial performance, including location economics factors such as logistical efficiency, utility and tax environments, and labor markets.
A detailed location assessment (before or after transaction) can help uncover hidden value just waiting to be unlocked by an investor with the vision and resources necessary to effectively utilize location as a true driver of value.
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