Q&A: Going above the benchmark

What does benchmarking tell you? 

Benchmarking should tell you whether the target company is in the top or lower performance quartiles of its peer group. It will tell you the size of the gap compared to the top quartile performers and so the size of the improvement opportunity if those gaps are relevant and are closed.

Richard Ramsey

You are being given questions. You are not being given answers. It does not, for example, tell you whether the gaps can be closed, the ability of the management team, whether “you are comparing dwarfs in a land of giants” (i.e., the whole sector could do better) or whether the whole sector is about to suffer from, for example, technology innovations.

You will have to ask whether the peer group comparisons are relevant and why the gaps exist. This interpretation is where the value of benchmarking is created. You will only then determine the real gaps and the operational, product and profit improvement opportunities that actually exist. 

An issue for many private equity fund professionals using benchmarking reports is how to interpret reports and find the answers to the questions they throw up. I came across a report last year comparing a Dutch service company with one in South Korea, which had been presented to the Dutch board and given to the management operating team for discussion. This did not tell the private equity fund anything. But it told the target company a lot about the private equity fund and gave the impression they did not know the target company.  

What are some common questions or challenges that pop up during a benchmarking exercise?

They vary hugely, although they do tend to be very numbers-based; for example it may say “target grew by 3 percent while the top quartile grew by 8 percent; the target gross margin is 35 percent while the top quartile is 38 percent”; it will not tell you why! Some reports will look at key operational indicators but these can be less relevant as each company will be structurally very different and the information made public can be minimal. So you will be given a series of differentials and you then need to find out why they exist and whether and how the gap can be closed. 

Some real examples I have seen are questions like: “why are their sales growing 3 percent less per annum than the competition” – the answer we found was because they have poor customer service and 9 percent customer churn per annum! Or for example: “why is their gross margins different” – the answer we found was because they have 15 plants around Europe where as the competition has only one plant.

Benchmarking should stimulate you to anticipate and determine the answers so you are informed when meeting the management team. 

What are the limitations in benchmarking?

One of the restrictions to benchmarking is the quality of the information used; “rubbish in rubbish out”. Do you have the relevant peer group and the relevant information? If the target is a private company or the subsidiary of a quoted company, do you have accurate information or information which correctly reflects the company as a standalone entity? 

An example of this is the pharmaceutical sector. It would only be relevant to compare generic to generic producers, contract to contract producers and drug development to development companies. We are working with a pharmaceutical development company where its profits are determined through transfer pricing to be generated by active subsidiaries in the lowest tax regimes. So a benchmarked analysis of the public information would give a distorted interpretation of the performance of its subsidiaries. It would also miss the expiry dates of its patent protections which have a major impact on future revenues.

My experience is that if I were to take the output of a desktop benchmarking exercise to the chief executive officer of a target company, more than 80 percent of them would tell me it is not relevant. Every chief executive believes that their company is unique and special for any number of reasons; “it’s based in China whereas we are based in France”, “we have got a completely different culture”. 

The risk of taking the benchmarking to the chief executive is that it may give the impression you do not know the sector and the company. After all, if you knew the sector and the company, you would not need benchmarking. It is key during meetings with the executive management team that you avoid looking like “a suit” that’s flown in with a desktop analysis. 

The chief executive will have a voice in the sales process even in an auction and more so in an off-market transaction. A top executive will also have the choice of whether to stay or go! A replacement executive will have a choice whether to join. You want to develop a peer group relationship with the management team who will be more inclined to open up with you. You would find a lot more through that route than through benchmarking. 

My experience is that you should keep the benchmarking in your back pocket when meeting the management team. Use it to stimulate a discussion with professionals experienced in the sector to identify the improvement opportunities in advance

What are the alternatives to benchmarking?

You would not have to use benchmarking if you had sector specialists in-house. A lot of private equity funds say that they go to market by sectors, but actually admit this is largely a marketing pitch and that they will turn their hand to many sectors and be opportunistic.

My experience is that the funds that are best at identifying targets and developing a peer group relationship with the chief executive are those that have identified a sector they want to build a portion of their portfolio in and have then hired a successful former chief executive of a successful business within that sector.  This could be the chief executive of a business they have owned and realised, it could be someone identified through sector connections or head-hunters. It should be someone recently active in the sector who knows it and which companies to target for acquisition. 

That minimises the need for benchmarking. You can go straight to the right targets, have better relationships within the management and accelerate the implementation of the value creation strategy!