Pricing in the PE hold period: the EBITDA lever left unmanaged

Price is the largest EBITDA lever available to a private equity owner during the hold period, and in most mid-market portfolio companies it is the least managed. Pricing Insight works with PE owners and portfolio company management to size that opportunity before acquisition, capture it in the first 100 days and protect it through to exit.

Executive summary

One per cent of price, held without loss of volume, adds one per cent of revenue to EBITDA. On a portfolio company with A$370M revenue that is A$3.7M of annualised EBITDA and, at an assumed 8x exit multiple, about A$30M of enterprise value. No other operating lever converts so directly. Across the 2,463 companies in the original Harvard Business Review study, a 1% price improvement lifted operating profit by 11.1%, against 7.8% for variable cost, 3.3% for volume and 2.3% for fixed cost.

Most mid-market portfolio companies do not manage price. They set it by cost-plus rules, delegate it to the sales force and discount without conditions. In a Bain survey of more than 1,700 B2B leaders, 85% said their pricing decisions need improvement and only 15% had effective tools to set and monitor prices.

PE owners can act at three points: in due diligence, where pricing upside can be sized from the data room inside the exclusivity window; in the first 100 days, where quick wins fund the longer program; and in the 12 to 24 months before exit, where margin gains must show in the trailing numbers a buyer will test.

Pricing Insight has completed more than 160 engagements since 2007, including work for PE owners and their portfolio companies in building materials, distribution, packaging, retail and logistics. Engagements are fixed-fee, delivered by senior people and built to leave pricing capability inside the business.

Why does price carry more weight than any other lever?

Four levers, unequal weight. Price, variable cost, volume and fixed cost all move operating profit, but a price gain that holds volume flows straight to the bottom line with no offsetting cost. Marn and Rosiello measured the effect on the average economics of 2,463 companies and published the result in 1992. The ratios have been cited ever since because the arithmetic has not changed.

Exhibit 1. Effect of a 1% improvement in each lever on operating profit

• Price: 11.1%
• Variable cost: 7.8%
• Unit volume: 3.3%
• Fixed cost: 2.3%

Source: Marn and Rosiello, Harvard Business Review, 1992 [average economics of 2,463 companies; price and volume gains assume the other is held constant].

For a PE owner the multiple does the rest. Each dollar of annualised EBITDA added during the hold period is capitalised at exit, so a modest and durable price gain is worth many times its first-year value. Exhibit 2 sets out the effect at three revenue levels.

Exhibit 2. Annualised EBITDA and enterprise value from price realisation

[Assumes no volume loss and an 8x EBITDA exit multiple; both to be tested for each business.]

• A$100M revenue: +50 bps adds A$0.5M EBITDA (A$4M EV); +100 bps adds A$1.0M (A$8M EV); +200 bps adds A$2.0M (A$16M EV)
• A$250M revenue: +50 bps adds A$1.25M EBITDA (A$10M EV); +100 bps adds A$2.5M (A$20M EV); +200 bps adds A$5.0M (A$40M EV)
• A$500M revenue: +50 bps adds A$2.5M EBITDA (A$20M EV); +100 bps adds A$5.0M (A$40M EV); +200 bps adds A$10.0M (A$80M EV)

The no-volume-loss assumption is the one to test, product by product and customer by customer. In B2B supply chains a large share of lines carry little measurable price sensitivity, because the item is a small part of the customer's cost, is specified into a job or is bought on availability. Other lines are exposed to direct competitors and will lose volume if price moves. The work lies in telling them apart, and in setting price separately for each.

Why do portfolio companies leave pricing unmanaged?

Price rarely has an owner. In a typical mid-market business it sits between finance, which sets the cost base and the target margin, and sales, which negotiates the final number with the customer. Neither function is accountable for price realisation, and the gap shows in the data. Bain's survey found only 13% of companies had effective front-line incentives for pricing integrity.

Five patterns recur across Pricing Insight engagements:

• Cost-plus pricing. Prices are built up from cost and a standard mark-up, so they track the supplier's invoice rather than the value delivered to the customer. Two products with the same cost carry the same price even when one is worth far more to the buyer.
• Every salesperson a pricing manager. In one PE-owned packaging business, 20 sales representatives were each setting their own prices. The result is wide dispersion: like customers buying the same item at materially different prices, with no commercial reason recorded.
• Discounts with no conditions attached. Rebates and discounts are granted to win or hold an account and are never reviewed. Many outlive the volume commitment that justified them.
• No line of sight to margin. Management cannot report margin by customer and SKU without a manual exercise, so leakage goes unseen. Bain found only 15% of companies had effective tools and dashboards to set and monitor prices.
• Incentives that reward volume. Commission paid on revenue tells the sales force that a discounted sale is as good as a full-price one.

PE owners tend to address cost and working capital first, because the playbooks are familiar and the results are easy to measure. Pricing is left to management, and management has usually run the business on the same pricing habits for years.

Where in the deal cycle does pricing pay?

Three points in the investment cycle, each with a different question. Exhibit 3 sets out the work at each stage.

Exhibit 3. Pricing work across the PE investment cycle

• Due diligence (2 to 3 weeks, inside exclusivity). Question: how much pricing upside is in this business, and how much margin is at risk? Work: data-room analysis of price dispersion, discount leakage and margin by customer and SKU, with management interviews. Output: a sized EBITDA range, the risks to it and the pricing section of the value-creation plan.
• First 100 days (about 12 weeks). Question: which gains can be captured now, and what must change to hold them? Work: pricing diagnostic, quick wins on the highest-leakage customers and lines, decision rights and governance. Output: cash margin within the period, a roadmap and an operating model for price.
• Hold period (6 to 18 months). Question: how does the business manage price without outside help? Work: price architecture, algorithmic price optimisation, sales capability and incentive design. Output: repeatable price realisation, owned by management.
• Pre-exit (12 to 24 months before sale). Question: will a buyer accept the margin gain as durable? Work: an evidence pack on price realisation, governance and customer retention. Output: margin that stands up in vendor due diligence.

The diligence window is short, but it is enough. BCG reports identifying 150 to 400 basis points of EBITDA upside from pricing in diligence efforts of three to four weeks, and finds that capturing several hundred basis points after acquisition usually takes a program of 6 to 18 months. Pricing Insight's own diligence work follows the same pattern: a recent assignment for a PE buyer was completed from the data room during the exclusivity period.

Pricing work also gives owners an independent view of a portfolio company. In one case a PE owner engaged Pricing Insight to assess a retail portfolio company because management's weekly commentary did not match the reported numbers. A pricing and margin review tests what is happening at the level of the transaction, not the management report.

What can go wrong?

Price destroys value as quickly as it creates it. A pharmaceutical wholesaler acted on a consultant's recommendation to discount its top 1,000 SKUs in order to grow volume. The volume did not come, because demand in B2B pharmaceutical supply carries close to zero price elasticity, and the business lost about A$50M of EBITDA a year [as reported to Pricing Insight when engaged to repair the position]. The error was not the decision to change price. It was changing price without first measuring how customers would respond.

Three other failure modes are common:

• A price increase without sales capability. List prices rise, the sales team grants the difference back as discount, and realised price is unchanged within two quarters.
• A one-off project without governance. Prices are reset once, nobody owns them afterwards, and dispersion returns.
• A blanket increase. A uniform percentage across the range overprices the exposed lines and underprices the insensitive ones, losing volume where it matters and leaving margin where it does not.

What does good pricing management look like in a portfolio company?

Six markers separate a business that manages price from one that does not:

• One owner of price. Decision rights are written down, and centralised pricing sets the rules the sales force works within.
• A price architecture. List prices, customer tiers and price floors are set by segment and reviewed on a fixed cycle.
• Discount governance. Every discount carries a condition, an approver and an expiry date.
• Margin reporting. Margin by customer and SKU is reported monthly, with price realisation tracked against plan.
• Aligned incentives. Sales incentives reward gross margin or contribution, not revenue alone.
• A trained commercial team. Sales and category staff can explain and defend value to customers.

The results follow from the capability. At a listed building materials group, gross margin rose 400 basis points in the year Pricing Insight worked with the business. At a listed retailer, category managers lifted margin by about 1.5 percentage points after 100 of them completed Pricing Insight training. At an office products distributor, Pricing Insight identified A$6.5M of annualised margin opportunity on A$80M revenue, about 810 basis points.

How does Pricing Insight work with PE owners?

Four services, one senior team. Each can stand alone or follow from the one before:

• Pricing due diligence. A sized view of pricing upside and risk, completed from the data room inside the exclusivity window.
• Pricing Diagnostic and Quick Wins. A 12-week fixed-fee program that assesses nine domains across value, people and structures, captures early cash margin and sets the roadmap.
• Project Blackbird. Algorithmic price optimisation at SKU and customer level, built on Pricing Insight's own cloud-based software.
• Pricing University. Training in value-based pricing, selling and negotiation for commercial teams. More than 5,000 executives have been trained, and the program now runs in 15 countries.

Four principles govern every engagement. First, the work is delivered by senior people: Ron Wood leads each engagement personally with a senior associate, rather than selling the work and handing it to a junior team. Second, fees are fixed, with the risk of overrun on Pricing Insight, because a fee tied to results depends on how well the client implements, which neither party controls. Third, the engagement starts from a one-to-two page brief written by the portfolio company's management, so the team owns the problem from the first day. Fourth, the client's commercial team completes Pricing University training as a condition of the engagement, so capability stays in the business after Pricing Insight leaves.

Benchmarks from more than 160 engagements sit behind each recommendation, so a portfolio company's price dispersion, discount levels and margin structure are tested against comparable businesses, not against theory.

For PE firms, the simplest arrangement is a standing referral. An operating partner or investment director refers a portfolio company CEO or CFO with a pricing question, Pricing Insight works directly with that management team, and the owner receives the same reporting as management.

Six questions to put to a portfolio company

An operating partner can test pricing maturity in one meeting with these questions:

• Who sets price, and who can change it?
• What share of revenue is sold below list, and on what conditions?
• How far does price vary for the same SKU across customers of similar size?
• When were list prices last reviewed against input costs and competitor positions?
• Are sales incentives paid on revenue, gross margin or contribution?
• Can management report margin by customer and SKU within a week?

A portfolio company that cannot answer four of the six is a candidate for a pricing diagnostic before the next budget cycle.

About Pricing Insight

Pricing Insight is an Australian B2B pricing strategy consultancy, founded in 2007 by Ron Wood. Ron has 30 years in pricing, first as a pricing and commercial manager in FMCG, building materials and capital equipment, and since 2007 as an adviser to ASX-listed, private equity-owned and family-owned businesses. Pricing Insight has completed more than 160 client engagements, and Pricing University has trained more than 5,000 executives.

Contact: Ron Wood, Founder and Managing Director. +61 410 534 099. info@pricinginsight.com.au

Sources

• Marn, M.V. and Rosiello, R.L., "Managing Price, Gaining Profit", Harvard Business Review, September to October 1992. Exhibit 1, based on the average economics of 2,463 companies in Compustat.
• Bain & Company, Global Private Equity Report 2020, section on pricing. Survey of more than 1,700 B2B business leaders.
• Boston Consulting Group, "Evaluating Pricing in Due Diligence", 2018.
• Pricing Insight client engagements, 2007 to 2026. Client names withheld.