Commingled savings

Supply chain commingling is the latest frontier for private equity firms striving to add across-the-board value to their portfolios via operational improvements. By Judy Kuan

Today's farsighted GPs of the private equity industry are scouring the income statements of existing and potential investments for line items with room for operational improvements and cost savings. As firms push beyond performing simply so-called financial engineering, so too are they appointing operations talent to their advisory and investment teams. The aim? To improve operational efficiency – including supply chain management – at portfolio companies.

Now, a new trend has started up in the last 12 months or so, with private equity firms beginning to express an interest in finding ways to streamline supply chains at a portfolio level, rather than solely on a company-by-company basis.

The goods and services with such ?supply chain commingling? potential can typically be categorized into three categories, says Michael Sarlitto, president of Chicago-based operations due diligence advisor SummitPoint Management.

At one level are commodities consumed on the tactical front such as printing, postage and supplies. Level two consists of services utilized in executing operational processes, including legal, marketing, sales, consulting and information technology services. The third level takes place on more of a strategic plane in which the relationship between the GP and the company management begins to exhibit characteristics of a classical governance model, as if the portfolio were a grouping of strategic business units, describes Sarlitto.

While cost efficiencies in these areas have always been pursued by GPs on an intra-company level, it is only recently that GPs have started to formally adopt an inter-company framework for adding operational value to their investments, notes Sarlitto.

Scale and synergy
One of the early adopters of supply chain commingling is The Blackstone Group. As an initial step, the New York-headquartered mega-buyout firm hired senior managing director James Quella as a senior operating partner in 2004. Prior to joining Blackstone, Quella was a managing director and senior operating partner with Credit Suisse's private equity direct investment division, DLJ Merchant Banking Partners.

?I joined the firm in response to Blackstone's recognition that they had a growing portfolio and that, collectively, the size of their investments was equivalent to a Fortune 15 company,? says Quella, who previously served as a senior consultant to CEOs and senior management teams during his pre-private equity days at Mercer Management Consulting. ?Therefore, there is not only value in and need to monitor that set of investments in a direct way, but also to put resources into finding ways to leverage the scale and buying power of that collective group of investments.?

At Blackstone, Quella's role has been to provide the processes and some of the infrastructure to help the firm realize the value from its scale and buying power. One of Blackstone's first steps was to recruit Greg Beutler, formerly an executive at GE and now a principal at Blackstone, to leverage his supply chain management experience. Beutler's role is to coordinate the purchasing of ?indirect? products and services for Blackstone's portfolio companies, says Quella. These services include utilities, telecommunications and commercial insurance (including D&O, property/casualty, excess liability). Under a subheading of ?indirect goods and services,? Blackstone has a portfolio of contracts dealing with the firm's IT hardware, office supplies, overnight express package delivery, copiers and other business products and services.

At press time, Blackstone was in the process of developing a capability in the healthcare/employee benefits arena, with pharmacy benefits management being considered as a portal for the firm to buy pharmaceutical drugs for its portfolio companies.

?We haven't gone [into employee benefits] because what we tried to do, at least initially, is not change the quality or the level of employee benefit or employee perceived value,? says Quella. ?This is more in the category of, ?Let's continue to consume the same things, but at a better rate,? and does not run into the issue of asking people to change their behavior.?

Sun Capital Partners, a Boca Raton, Florida-headquartered buyout firm, has also recently begun to get its portfolio company procurement program off the ground. Leading the charge is Charles Megan, who joined Sun in January 2006 as a vice president and full time employee of the firm, after having previously served as the chief executive officer of a Sun-backed portfolio company.

In his current position, Megan is tasked with examining opportunities for collective procurement and cost reduction of services in a wide spectrum of goods and services, including print, paper, healthcare, food sourcing and other categories of indirect and direct spend across Sun's 56 portfolio companies.

?Overall, we are not looking cost reduction opportunities by sector, but by function,? says Megan. ?Therefore, many unrelated portfolio companies may participate in a purchasing program.?

An adjunct to its various supply chain management strategies, Sun Capital opened a product sourcing office in Shenzhen, China in January 2006. ?It's another free service for our portfolio companies,? says Megan. ?Since we acquire only small and mid-sized companies, there may not be a lot of experience in offshore outsourcing. Sun Capital will work with affiliates in creating an outsourcing program and accelerate the timeline for implementation.?

Megan echoes the sentiment that having the critical mass in order to make collective procurement a ?meaningful? endeavor was a key point in Sun's decision to explore its options in this area. ?We've grown very strongly in the last four years, and it has only been within the last two years that we have had the critical size that would make this function work,? adds Megan.

Shopping strategies
Having the right talent and pointpeople in place for these operations is crucial to their success. Finding a senior operating executive like Blackstone's Quella and Sun Capital's Megan to lead such an effort is crucial. Having the necessary executive skills and the experience in managing companies – including an understanding of how the purchasing process works – are essential characteristics of service commingling pros.

One way of building up talent is by working with a specialized operations consulting group, building up a relationship and then potentially bringing that relationship in-house, given the customized needs of private equity firms.

That's what Bear Stearns Merchant Banking did when pursuing common vendor contracts for its portfolio companies, as the firm's chief operating officer Gwyneth Ketterer told PEM earlier this year. In 2004, BSMB brought on board talent in the form of operating partner David Knoch, formerly a senior managing director and chief administrative officer of Alaris Consulting, a Chicago-based boutique offering services in renegotiating master contracts for private equity firms – and a consultant that BSMB had tapped for help in renegotiating contracts across its portfolio.

Blackstone's case is similar, with the in-house infrastructure for portfolio-wide supply chain management built up by working alongside CoreTrust Purchasing Group. At the commencement of its relationship with Blackstone, CoreTrust was already in the business of buying goods and services for hospital chains as a division of Brentwood, Tennessee-based HealthTrust Purchasing Group.

?We worked with CoreTrust to tailor their programs and processes to our portfolio companies,? says Quella, adding that Beutler facilitates the relationship between Blackstone and CoreTrust. ?When we buy companies, Greg works with those companies and helps evaluate the opportunity and the size of cost savings, and then he helps engage the portfolio company with CoreTrust to save money.?

One clear sign of Blackstone's commitment to focusing on supply chain management – both at individual investments and also across the portfolio – is Blackstone's intention to continue growing its in-house operational talent. ?It's likely that we'll continue to add people to fill out both our industry capabilities on the operational side, as well as our functional capabilities on the operating side,? says Quella. ?This is all designed to be integrated with our deal teams.?

Some firms are taking a less formal approach to supply and service management for portfolio companies, such as at 3i, a UK-headquartered publicly listed private equity firm. According to Patrick Dunne, 3i's group communications director, the firm does not engage so much in consolidated purchasing as in getting preferential discounts for portfolio companies. The areas where 3i focuses its attention are insurance, public relations and human resources. Regarding insurance, 3i has arrangements with insurance provider Aon to allow 3i portfolio companies access to preferential rates and services. On the PR front, 3i leverages the relationships that it has developed with agencies around the world, and in the realm of human resources, the firm has preferred supply relationships with certain search firms, which can be leveraged across the portfolio.

At firms with institutionalized portfolio SCM strategies in their biggest market, a less structured approach for smaller or newer markets is also a useful alternative.

For example, Blackstone's primary focus for supply chain commingling has initially been on the US, its largest market by far. Now, the firm is expanding its service and purchasing consolidation strategy into Europe, where the firm has found that such consolidation works better within a specific geography than across geographies. However, the scale of Blackstone's presence within a particular European country is incomparable to its presence in the US. Therefore, the buyout firm applies a modified approach for its supply chain consolidation endeavors in Europe and elsewhere outside of the US.

?On the overseas front, what is more typical is that it turns out to be more like best practices,? says Quella. For example, a Blackstone portfolio company in the UK might have a contract with a waste management company that is dramatically more favorable than contracts held by other Blackstone UK portfolio companies and their waste management providers. Blackstone might then recommend that its other UK portfolio companies switch to the lower-cost waste management service provider, but the firm might not necessarily negotiate a single lower-cost contract with the waste management company to be applied to all of Blackstone's UK investments.

Self-sustaining savings
Foremost on GPs' mind when deciding whether and how to engage in supply chain commingling is striking the balance between returns and the effort required to achieve them. ?It's a very ?follow the cash? sort of environment,? says SummitPoint's Sarlitto.

At Sun Capital, ?In order for an activity to become meaningful, we need to save eight to 30 percent,? says Megan.

?Within the relevant categories, when we attack a category, we need to find 10 to 15 percent savings,? says Quella, who estimates that the realized savings from supply chain commingling is approaching $100 million across Blackstone's portfolio. He adds: ?The advantage in private equity-land is that you get to put an 8x multiple on that, so it is like gaining $800 million in value.?

For Blackstone, supply chain commingling is unquestionably becoming an increasing part of the value equation, says Quella. ?And it allows us to be more competitive when we buy companies, because on the margin we know there are benefits we can add – without a lot of disruption to the core business – on a going-forward basis.?

The timeframe and effort involved for consolidating the purchase of a particular service varies depending on the complexity of the service being launched, says Megan. ?For example, in small package freight, there are only a handful of providers, so it is relatively simple to get off the ground,? he says. ?Utilities are more difficult, and healthcare is the most difficult – you're talking about months, if not years, to get a collective purchasing group together and off the ground.?

Once a contract has been renegotiated or a service consolidated, the key then is to make sure that the arrangement is self-sustaining, say Quella and Megan. ?That's one of the advantages of having the capability outside of the walls of Blackstone,? adds Quella.

As BSMB' Ketterer told PEM earlier this year, this is the toughest part of supply chain management: figuring out how to make the contracts portable. When the day comes for the firm's portfolio companies to leave the Bear Stearns fold, the participation in the contract, the value that has been created – and the savings that are to be generated – must be structured so that they are able to continue uninterrupted.

The marketplace is increasingly responding to the needs of private equity, with service providers keen on developing new products to entice new clients. Combine this with the strategies and best practices developed by early pioneers like Blackstone and Bear Stearns, and it is likely that GPs interested in pursuing portfolio supply chain consolidation in the near future will have a fairly clear path to follow.

Says Quella: ?Increasingly as a trend, the larger funds – Blackstone being one of them – are going to increasingly invest in these kinds of operating capabilities and start to selectively leverage their scale, and bring the benefits of centralization to bear in helping and assisting their portfolio companies.?