Crowe Horwath: John Kurkowski on finance

 
 John Kurkowski

Why do private equity firms tend to underinvest in the finance organizations of the companies they back?

Higher valuations and ever-increasing costs of doing business create pressure on private equity groups to make sure they make the right investments and cut the right costs to improve the earnings of their portfolio companies.

Initiatives with the most impact typically are centered around accelerating growth, improving margins, or realizing synergies. Investments in the finance organization sometimes are viewed strictly as incremental costs that would not appear to support the growth of the business or help drive synergies. This flawed view can lead to actions that actually cost the organization more in the long run.

What are the possible consequences of an underinvestment in finance?

Underinvesting in finance often leads to higher costs – some obvious, some not – as well as a lack of timely, quality information for making decisions and avoiding surprises that result in the company constantly reacting to the previous month’s issues. Examples of negative consequences include:

• Unexpected write-offs of uncollectible receivables from a customer that never merited the credit limit that was approved;
• Disposal of excess inventory at fire sale prices due to purchases based on unrealistic sales forecasts; and
• Covenant violations arising from poor forecasting, surprise year-end accounting, or audit adjustments leading to increased bank fees and higher audit fees.

How should private equity groups look at investing in the finance function?

One of finance’s most essential and critical responsibilities is to provide timely, accurate financial information and insights for decision-making by users such as the management team, the board, and the company’s investors and lenders. Without this foundational information, management often is flying blind.

For example, assume that a company decided to discontinue production of a number of low-sale, low-margin products that required considerable setup time in a plant that was out of capacity and already outsourcing some production to a higher-cost co-packer. Two months following the product discontinuance, the company had not achieved the margin growth it was anticipating.

It turned out that the production cost savings were achieved but that material costs rose unexpectedly, thus eroding the other gains. The point is that the organization underinvested in finance, and the management team lacked valuable insights that left it constantly reacting to outdated information and settling for mediocre output.

At the other end of the spectrum, a high-performing finance team would have known the business well and understood information that the rest of the management team could have used to drive the business. It might have been able to provide information in a timely manner so that appropriate actions could have been taken to plan for increased material costs.

Reducing the frequency and severity of effects such as those mentioned generally requires greater investment in the finance organization and therefore some element of increased costs.

But it is important to realize that those incremental costs typically are less than the costs of doing nothing. More important, companies must make sure that any added costs appropriately align the capabilities of finance with the needs and maturity of the organization.

In other words, private equity groups must make the right investment. A $250 million domestic manufacturing company does not need a Fortune 500 CFO, but it should have someone who has successfully worked in a similar-sized organization with the skills and experiences that align with where the company is headed.

This article is sponsored by Crowe Horwath. It was published in a supplement with the October issue of pfm magazine.