The following is adapted from The Private Equity Playbook.
When a private equity firm purchases a company, it wants that company to grow. Private equity firms rely on a few levers to accelerate that growth, one is which is known as margin expansion. This is a way to grow EBITDA (earnings before interest, taxes, depreciation, and amortization) and add shareholder value without raising price, without adding a single customer, and without selling a single new product or service.
Margin expansion is simply becoming more efficient at servicing the revenue you already have by working on process efficiency. It’s accomplished in two ways: investing in technology and challenging the status quo. Let’s take a look at both methods.
Invest in Technology to Drive Productivity
Technology can be vital to a company’s growth. There are so many ways that software and devices can transform your platform, from sales to marketing to operations.
Let me give you an example from my career. For the laundry company I ran, we worked with a lot of quarters. There were hundreds of thousands of machines installed in tens of thousands locations around North America. Some had card systems or electronic payment methods, and certainly that technology is increasing very fast, but back in the day, it was run almost entirely on quarters dropped into the slots of washers and dryers.
Back in 2004, we kept track of these customers using a very manual method: three-by-five paper index cards. Our collectors would drive to their managed locations and collect quarters, keeping track of the collection activity using an index card system that looked like a throwback to the old Dewey Decimal System cards used in library catalogs.
We used this system to determine collection routes. If we added a new location, a collector servicing the area would slot the collection call in the catalog of locations that he managed. If a location was lost, the card was removed from the drawer.
The first thing we did when I arrived was to invest in technology. We began to track the movement of vehicles using satellites. We loaded the locations into the system and used algorithms to calculate routes based on how busy each location was.
The computer’s much higher sophistication determined the best routes for the collectors. The end result was a huge increase in employee productivity.
Now the collectors were carrying so many quarters in their trucks that they started breaking axles while driving down the road. This was quite a “high class problem”! We had to redesign the vaults and reposition them in the trucks so they were forward of the rear axle and balanced. Some routes with more volume needed heavier duty trucks.
We moved from index cards to technology, taking an existing process and making it much more efficient. We didn’t raise prices, and we didn’t add a single customer; however, we lowered the cost of servicing the revenue, which made the collectors more efficient and vastly improved our margins. Every dollar of margin gained in this fashion drops right to EBITDA and creates tremendous shareholder value because the incremental cost of sustaining is very low in comparison to the benefit.
Challenge the Status Quo
It’s always critical to challenge the status quo. People become very complacent, especially in a mature company. Processes that have existed for years, decades, or generations are never reconsidered. Many companies have “if it isn’t broke, don’t fix it” mentality. What they don’t realize is that what isn’t broke may not be efficient.
Every time I come to a new company, I begin with a discovery period and interview the employees. I spend time asking questions, seeking opinions, and doing ride-alongs with the major job classes to better understand what people do at work. Spreadsheets aren’t sufficient to see the entire picture. I want a vision of what these people do every day. I don’t make assumptions; rather, I try to learn from the employees themselves.
I make observations and look for strengths, opportunities, and weaknesses.
At the laundry company, we talked about improving margin by implementing technology to improve the routes. On my original ride-alongs back in 2003, I learned that each collector carried hundreds of keys on a string attached to their belt.
As they would go from location to location, someone who had been doing the job for years could reach down and, with muscle memory, pull out the correct key to service a particular machine. To make it even more complicated, each route had its own string of keys, a different one for each day, and a different one for each route. I was amazed at the complexity and the skill of these collectors.
I was like, “Let me try this.” I took a string of keys, and each time I tried, I reached for the wrong damn key. I had to painstakingly correlate each key and machine with their numbers on the index cards. It took me hours to complete one roomful of machines.
I kept thinking, This collector moves quickly from muscle memory, and he’s doing a great job. But what if I put him on a different route? Or what if he retires and I need to bring someone else in? Productivity would drop off dramatically.
When I got back to the office, I started asking why we used this process. Inside every branch office, there was a room with drawers for all the keys used in each city. There was a steel cage for security and someone whose job was to watch the keys to the kingdom. There were cameras on the wall and loss prevention people watching the guy who watched the keys. This security was detailed but also drastically inefficient.
I asked a collector why he did it this way. He had no idea; it was just how he had been trained. I kept asking until finally someone told me the story behind this methodology.
Back in the 1960s, the biggest theft problem the company had was lock picks. These guys didn’t look like criminals. They wore nice clothes and would walk into a laundry, pick the locks on the machines, take the quarters, put the machines back together, wipe them off, and disappear. The collectors would appear, and the money would be gone.
It was so rampant that they took extreme measures to defeat the lock picks. They had manufacturers create special locks with keyways that no locksmith in the country could get and make keys for. It was proprietary to the company. Then they created specific rules. You couldn’t use the same key in the same room. You couldn’t use the same key more than a certain number of times in the same city, and you couldn’t use the same key more than a certain number of times in the whole company.
After I heard the story, I asked when the last time was somebody picked a lock on one of our machines. “They haven’t done that since the 1960s.”
Great, problem solved. But is it necessary today? Has the threat shifted?
The average criminal today is going in with a sledgehammer to beat the hell out of a machine until it capitulates and gives up its quarters! The loss prevention team defeats that problem with an entirely different strategy that has nothing to do with keying.
With my newfound knowledge, we started an initiative called “One Room, One Key, One Lock.” We still have limited the number of times you use a key, but if you walk into a room and have the magical right key, you can open every machine in that room. Then you roll that key over your key string, and when you get to the next room, you pick up the second key and that opens every machine in that room.
The result was another huge increase in productivity.
Looking back at the original problem, the process was grounded in very good science. There was a great reason they implemented the system, but the problem and threat had changed, and nobody adapted the process. In defeating the problem, a new one was created. Nobody ever asked, “Why do we do it this way, and is there a better way?”
When you combined simplified keying with our other initiative for more efficient routing, it led to a total increase in employee productivity of over 40%. The result was millions of dollars in additional EBITDA. It also led to more quarters, but as I mentioned, the company addressed that problem already with new vaults and heavier trucks!
The process of challenging the status quo and asking why you do the things you do is applicable to anything. Whether it’s a consulting business, a service business, or a manufacturing business, these are uniform concepts.
For more advice on margin expansion, you can find The Private Equity Playbook on Amazon.