Private Equity Needs To Up Their Game

Follow-up on my 2024 prediction

The second prediction I had for 2024 was that private equity outfits are going to have to have to develop a new game plan if they want to generate returns in a higher interest rate environment. My hypothesis here is that the established chemical industry is already somewhat vulnerable and fragile due to decades of “cost efficiency,” and a perpetual rearranging of specific businesses. Go read my prior article about how Hexion was a big “roll-up” effort by Apollo, which I think culminated when they turned it all into Momentive, but then decided to tear it all back down to pieces. Then, some of those pieces got rolled up again and again. The focus on this current strategy has been for companies to be “pure plays” that can be added to investment portfolios to get very specific exposure to very specific sectors.

With the constant rearrangement of chemical businesses I think there are a few things that start to emerge:

1. Employees who are tired of not knowing if their company will be stable start leaving. Those who are the most talented are often the first to vacate.

2. The employees are remain often have to do more work and get stretched thin. This can lead to burnout or eventually deciding to leave.

3. Eventually, employees who have rotated through enough companies decide to just vacate the industry completely (It’s what I did)

4. Eventually, we will start to see key person vulnerabilities where 2-3 people who make a few mistakes will cost millions of dollars such as:

   1. Unable to avoid costs increases because you are single sourced and only have 3 R&D people covering your billion-dollar business and there are only so many fires (proverbial not literal) they can deal with at a time.

   2. Claims against company for shipping bad product (you shut down the Ford plants again because Donny the QC Tech mixed up some numbers)

   3. Holding bad product in inventory (Donny the Operator forgot to add something to the batch)

5. Thus, any savings you get in the short term can do significant damage long term to whoever ends up being the shareholder.

My suggestion and prediction are that we will see a PE firm in 2024 actually figure out that just cutting costs to boost short term profits is not the way and I suspect that this will be from specialists (a firm like SK Capital comes to mind) in specific end-markets. I think a generalist firm like Apollo will whiff. So, at this point you might be asking, “if cutting costs and boosting profits isn’t the way what is?”

Digital Frameworks That Enable New People

Part of the problem that I outlined earlier with my post on AI is that many companies do not take their data seriously. Chemical companies often rely on a few key people to know a bunch of stuff and when those people decide to leave that knowledge leaves with them (if you consider an unorganized folder of random files on a server somewhere to be sufficient then you are part of the problem).

Let’s use R&D/Innovation as an example for why companies need to be digital first and in this example you, the reader, are the most responsible person.

Reinventing the Wheel

You hire three new graduate students from top programs to build out a completely new product portfolio focused on creating a lot of value to both current customers and ideally new customers. Your board of directors have given you 5 years to figure it out because McKinsey told them that’s about how long it should take (McKinsey doesn’t really know, but neither does your board). These chemists and engineers enter into the company and ironically probably want to spend the first few months reading about what you’ve done previously throughout the entirety of the company, decades before you were in charge, but the problem is it’s just a jumble of lab notebooks that are in storage that haven’t been digitized yet and some random files on an internal server or sharepoint site.

After a while your new hires decide to just get in the lab and start making cool stuff.

About a year into it all there is a big presentation about the work they have done and problems they encountered. That really old guy who used to be in R&D but decided to just run the GC-MS at the plant and listen to podcasts all day is invited, and he sits in the back of the room drinking coffee looking at his phone and about halfway through the presentation he interrupts and says the dreaded phrase, “I tried this 10 years ago and it didn’t work.”

Now, is that year of work by the new hires wasted or did they find out something new that 10 years ago wasn’t discovered? There are so many unknowns here (I would know, because I’ve been in the new person’s shoes), but the bigger problem is that there is no system in place for ensuring that this doesn’t happen again.

This doesn’t just happen in R&D. It happens in sales, marketing, supply chain, regulatory, and on and on. The worst part is, everyone gets annoyed at the wasting time, but no one ever does anything to fix these problems. Eventually, some activist investor (e.g., Starboard) gets wind that you are mismanaging things a bit and an activist shareholder campaign starts to occupy all your time and the actual business process fixing the operationally will bring the most value to everyone gets pushed to the side.

By the time the five years rolls around, the new hires have left along with a bunch of other people, the board is gone, you are gone, and the company has been sold to a private equity firm. The PE firm is gonna do what PE does, but nothing will actually get fixed. That old guy who runs the GC-MS in the plant took your office chair and he took that Yeti mug you left behind.

Stop Reinventing the Wheel

I think that PE firms have a unique ability to affect change in chemical companies. The fictional anecdote I wrote above is rooted in experience, but a PE firm could start introducing digital systems that enable new people to rapidly on-board, learn the history of the organization, find all of the necessary things to do their jobs, and then be effective for however long they decide to stay with the company.

I think investors view the employees as 100% replaceable, including the executive team, but just because you replace someone it doesn’t mean the next person will be as effective in that role as the last person. Maybe they will be less effective or maybe more effective, but a digital system that allows for the capture of meaningful data by the institution for employees to use later in their jobs is a veritable gold mine of wealth. Having a system like this in place is also an implicit acknowledgment that talent comes and goes and it should at least allow the new talent to think, “hey, this is really awesome. I should probably think about staying here long term.”

The only problem is you might have to pay some SaaS company a bunch of money to help you implement a culture defining digital first solution.

But maybe it won’t be a bunch of money if the promises of AI actually take off and the costs of SaaS start to fall.

Your move Private Equity.

Tony