HELPING PRIVATE EQUITY FIRMS PIVOT TO RECOVERY THROUGH FIXED COST RESTRUCTURING

PRAGMATIC ZERO-BASED BUDGETING: MAXIMISING VALUE IN A COVID-19 WORLD

1PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

Contents

Key insights 2

A need for rapid fixed cost restructuring 3

Why reset fixed costs to the forward-looking plans and 'new normal'? 4

Why is sustainable fixed cost restructuring critical to Private Equity? 6

What are the implications of inaction or delay in the current recessionary environment? 7

Why consider a ZBB-led cost restructuring approach? 8

Why follow a tailored Pragmatic-ZBB approach and how to deliver the promise? 10

What are the key success factors to realise the benefits of Pragmatic-ZBB? 14

Key contacts 16

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Introduction & key insights

Pragmatic-ZBB is a company-wide initiative that needs buy-in and role modelling from executive management. Ambitious and intelligent top-down target setting is critical to delivering the required impact and ensuring that the bottom-up budgeting isn't reduced to a rationale generating exercise.

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Companies that restructure their fixed cost as part of their annual planning cycle outperform their peers on both EBITDA margin and revenue growth metrics by 5-10 percentage points.

The current recessionary environment is expected to establish a 'new normal' over the next 24-36 months – the ability to urgently align fixed costs to this 'new normal' will be crucial to survival and success.

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Many companies have embraced Zero-Based Budgeting ('ZBB') to truly embed a cost-conscious culture. Pragmatic-ZBB is particularly beneficial for PE firms since they can lever the benefits via the exit multiple and can use ZBB capability across multiple pre-close and post-close deal situations.

Pragmatic-ZBB can deliver savings over 10-12 weeks following quasi-forensic examination of each fixed expense line. ZBB-led fixed cost restructuring is considered a game changer by PE operating partners and CEOs for elevating the cost agenda, with each executive accountable for specific cost items.

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This paper sets out how Private Equity ('PE') firms can pivot to recovery through fixed cost transformation.

We review traditional approaches to Zero-Based Budgeting techniques and then outline how the adoption of a Pragmatic-ZBB approach can deliver significantly faster results with double digit Return on Investment ('ROI') while creating resilience against further shocks.

Here are five key insights from the report to consider:

3PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

A need for rapid fixed cost restructuring

In recent years, to embed a cost-conscious culture, many companies have embraced ZBB.

As a result, resetting P&L-wide fixed costs during the annual business planning cycle has become an important value creation lever to improve EBITDA and/or re-invest savings towards a growth agenda.

Even before the COVID-19 crisis, the case for regularly re-aligning fixed costs to forward-looking business plans has been growing due to the accelerating pace of technological change.

The disruptive shock of COVID-19 and uncertainty about the resulting economic climate is unprecedented and is setting new thresholds for both business supply/demand and the underlying cost base, which over the medium to long-term, will become business as usual.

The ability to align fixed costs to this 'new normal' will be crucial for PE-backed businesses to survive the current crisis and pivot to recovery faster by deferring, reducing or even eliminating non-essential expenses.

The potential benefit of ZBB is significantly higher for PE firms, which can use the power of ZBB across multiple situations such as post-close value creation, carve-out and pre-deal synergy assessment for 'Buy-and-Build' deals.

In this report, we discuss the why, what and how of a structured Pragmatic-ZBB approach tailored to Private Equity's needs, leveraging our experience of working with funds and their portfolio companies.

The authors, Naresh Kumar, Mark Bennett and Bob Rajan, have served in senior interim roles and share proven operating principles and expertise in delivering sustainable cost savings.

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49%

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Healthcare

Automotive

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Environmental

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47%

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Figure 1: Fixed operating cost as % of total cost

Fixed operating costs such as Supply Chain or SG&A overheads, such as rent, insurance, marketing spend and staff salaries, typically account for circa 29-49% of the total cost base (Figure 1)1. Total fixed costs, including production overheads, might be even higher after applying a reality check to the accounting-based cost classification. For example, direct labour cost is considered a variable while, in reality, production line staff costs tend to be relatively fixed.

Over time, rapid and uncontrolled organic growth and events like acquisitions and divestments tend to delink business plans from the optimal fixed cost structure. Furthermore, in the absence of detailed visibility, most savings come from isolated, top-down cost-cutting initiatives, which companies struggle to sustain. In the absence of enablers such as structured cost control or regular monitoring, costs then catch-up again or reappear elsewhere in the organisation.

Why reset fixed costs to the forward-looking plans and 'new normal'?

1 Source: A. Damodaran (2020) – NYU Stern [A&M industry definitions aligned with data set for fixed operating expenses]

5PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

Gaining a competitive advantage

In the current economic climate, rapid fixed cost restructuring is critical for success, and sometimes survival.

To a company, freeing-up the fixed cost base, by deferring, reducing or even eliminating non-essential expenses and allocating resources to where they are most needed, is the key benefit. In the short term, this creates a substantial opportunity to improve both the bottom-line and liquidity.

However, in our experience, incremental cost reduction is not an option when revenue or EBITDA drops by more than 10% and that seems to be the case now for most companies and offers a significant opportunity for zero-based cost review.

Accordingly, resetting P&L-wide fixed costs on an annual basis has become an important value creation lever to improve EBITDA and/or re-invest savings towards higher ROI growth initiatives.

Time

£

Double impact of ZBB on P&L

Cost

Revenue

EBITDA improvement

by 5-10%

Figure 2: Re-invest savings for double P&L impact

A&M InsightCompanies that restructure their fixed cost as part of their annual planning cycle outperform their peers on both EBITDA margin and revenue metrics by 5-10 percentage points (ppt)2. Re-investing savings into a growth agenda benefits from a multiplier effect on operating margin and provides a strong narrative to enforce a cost-conscious mindset (Figure 2).

2 A&M insights and experience

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For PE firms, any fixed cost savings realised by their portfolio companies are leveraged by the EBITDA multiple on exit. As a result, PE firms are incentivised to cut cost even in the absence of a fact-based understanding of the value drivers. This can lead to criticism for 'cutting too much' and 'too fast' or even 'cutting to the bone'.

With easy to use analytical tools, PE portfolio operations teams can now compare financial and operational KPIs at the sub-sector level. This helps scrutinise any variance for the potential opportunity and, more importantly, make benefits sustainable by offering teams best practice support from peers in the PE portfolio.

This allows PE firms to ensure that savings are sustainable during the holding period, and the benefits are realised through the exit multiple.

Why is sustainable fixed cost restructuring critical to Private Equity?

Besides ensuring financial benefits are realised in the P&L,

mature PE firms also insist that cost savings

are sustainable.

7PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

As the current economic crisis unfolds many healthy businesses are already prioritising liquidity management. Over the next 24-36 months, we expect to see a 'new normal' become characterised by three factors:

Coupled with continued economic uncertainty, this will drive the setting of new cost thresholds, which over the medium-term we expect to become business-as-usual.

Crucial to survival

Even before the COVID-19 crisis, the case for regularly re-aligning fixed costs to forward-looking business plans has been growing stronger due to the accelerating pace of technological change such as Artificial Intelligence. Inability to move quickly might prolong the recovery or put survival at risk as already seen in various companies across the globe. Some of our clients operating in Travel, Entertainment and Hospitality sectors have recorded up to 80% drops in revenues so far during 2020. Hence the ability to urgently align fixed costs to this 'new normal' will be crucial to surviving the current crisis. Fixed cost restructuring must be addressed now when a business is still able to recover; inaction is likely to result in a loss of competitive advantage, amongst other negative consequences down the line.

What are the implications of inaction or delay in the current recessionary environment?

Decline in revenue, driven by reduced consumer spending;

increased direct costs due to social distancing, and;

intense shareholder pressure to preserve margins.

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A&M Insight

On the positive side, some companies are taking this opportunity to fundamentally change their ways of working, including driving digital transformation with new pace and urgency.

For example, a retail client realised that they can generate the same sales revenue through e-commerce and Out-of-Home channels whilst their physical stores largely remained shut during COVID-19 lockdown period. This has led them to redesign their Target Operating Model ('TOM') by leveraging new digital channels and remote working delivering a significantly lower cost base – in terms of both personnel and footprint.

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Traditional cost budgeting focusses solely on the variance to the prior period and adjusts it to arrive at the new budget. Although widely adopted for its speed and simplistic nature, it faces three notable deficiencies:

These limitations and the top-down financial tasking from the Chief Financial Officer ('CFO') eventually lead to a 'spend it or lose it' mindset driving sandbagging by budget holders and business units hiding opportunities by moving savings and on-cost between different budget lines.

An effective cost budgeting approach should combine three essential elements:

1. Detailed cost transparency is paramount to assess the cost drivers and hence optimal budget across functions and hierarchies.

2. Joint cost ownership-based governance, which negates power dynamics and enables fact-based challenges to budgeted demand in terms of both quantification and specifications. This cost-conscious mindset removes any conflict of interest and political games as everyone involved considers and spends the company's money as their own.

3. The above must be supported by a proven and repeatable methodology, which guides the participants and reduces ambiguity during the regular cost forecasting cycle.

Why consider a ZBB-led cost restructuring approach?

The game changer

Zero-based budgeting combines these three essential best-practice characteristics and provides a systematic approach to identify, eliminate and prevent unproductive expenses on an on-going basis. in line with a forward-looking corporate strategy. Furthermore, it scrutinises every expense to build a bottom-up budget.

A quasi-forensic examination of each expense line makes ZBB projects very impactful in large de-centralised companies, and many have now adopted it as their default cost control process.

Figure 3: Joint cost ownership truly challenges demand

Budget/Decision Entities HR BU1 BU2

Entity Lead Mr A Mrs B Mr C Accountable CxO member

Cost package sponsor

Functional Lead Ms C Mr D Mrs C Responsible CxO-1 member

Cost package owner

Cost packages

Procurement support

Finance support

Mr X Ms YConsultant & Contractors

Ms A Mr B IT & Telecom

A lack of detailed cost transparency in terms of unit price and volumes;

disconnect between fixed cost and the strategic plan, and;

the inability to challenge cost drivers because of the organisation's hierarchy and power dynamics.

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02

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9PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

Enabled by effective governance to enforce a cost-conscious mindset, ZBB-led cost restructuring is considered a gamechanger by PE operating partners and CEOs for elevating the cost agenda, with each executive accountable for specific cost items (Figure 3). For example, just the fact that the CEO is the accountable sponsor with visibility into consulting spend and may challenge a consulting project is a powerful deterrent to nice-to-have discretionary spend.

In our experience, companies can realise more than 20% cost savings on simple spend areas such as temporary labour, and more than 10% on complex cost workstreams such as logistics.

There are many examples of corporates that have been able to realise at least 10% savings year-on-year on a sustainable basis even after multiple budgeting cycles since the first ZBB roll-out.

Holistic business transformation approach that adds resilience

ZBB-mature companies also re-align their headcount to the new workplace paradigms (e.g. remote working, automation) every two or three

A&M Insight

years whilst wisely avoiding the emotional toll of iterative and reactive headcount reduction. Savings can be significantly higher in re-aligning permanent staff cost to the 'new normal'-based operating model, and PE firms have realised between 10% and 30% on overhead staff costs.

Detailed activity-based cost visibility allows leadership to have a 'one-view' of labour productivity and make cost-efficient resourcing decisions across payroll, temporary labour, fixed-term contractors, consultants and outsourcing staff. Depending on scope and complexity, it typically takes 12-18 months to build the required capability and embed ZBB as the default way of working.

Subject to the maturity of the company, the stated recurring savings are typical first-year gross savings realised in the context of de-centralised mid-to-large cap companies (see Figure 4)4.

10% savings year-on-year

Figure 4: First year ZBB savings for mid-to-large cap companies

SG&A Production & Supply Chain

Finance HR Marketing IT Legal Supply Chain Maintenance Total

FTE Cost 10-30% 15-20% 15-40% 10-20% 10-15% 10-15% 15-30% 10-30%

3rd Party Spend 5-10% 8-12% 10-15% 5-10% 8-10% 10-15% 10-15% 5-15%

4 A&M Insights

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There are several key differences between A&M's Pragmatic-ZBB approach versus the traditional ZBB process:

Why follow a tailored Pragmatic-ZBB approach and how to deliver the promise?

Pragmatic-ZBB approach

Typically double-digit ROI on project cost

10-12 weeks long Zero-based review, building savings into the budget

Focus on mindset change among senior management and no additional ZBB team required on an on-going basis

Fact-based understanding of cost drivers in terms of activity, unit price and spend volumes

Focus on pragmatic-led value targeting using bottom-up cost insights

One-pager golden rules to change behaviours and control demand

Adapted to suit different organisations and maturity levels

Enables reinvestment of savings in areas such as advertising, promotions and acquisitions

Traditional ZBB approach

High ROI only for companies with immature demand management capability and a bloated cost base

>6 months process heavy project led by Finance and IT

Focus on process and requires a new ZBB team to run as a BAU process

IT-intensive integration efforts required to create BI data cube before on-demand visibility becomes a reality

Broken linkage between top-down targets and bottom-up cost savings potential

Detailed ZBB policies, which need enforcing and compliance tracking

No leniency and process-centric

Effort intensive and distracts employees from their 'business as usual' job with impact on morale and productivity

11PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

Time to rethink your ZBB approach?

Under pressure from activist investors and buy-out firms, many large-cap companies have adopted ZBB as their default financial planning and analysis process, realising between 10% and 30% savings on fixed overhead costs. In discretionary spend areas such as third party labour and marketing, up to 70% savings have been achieved by some companies through a strict, no-exceptions ZBB implementation.

However, the ZBB approach followed by many large-cap companies is often a complicated, time-consuming and heavily finance-oriented budgeting exercise that can fail to change behaviours, engage middle management and deliver the needed results.

In such cases, a Pragmatic-ZBB approach provides a way forward to identify decisive measures with a strong focus on pace and ROI.

Adoption is rising among mid-cap companies due to the following trends:

� It takes less time without losing rigour and discipline: When PE portfolio operations or Portfolio company ('Portco') leadership decides to scrutinise cost, both time and delivery cost are of the essence. A Pragmatic-ZBB approach brings benefits in a short period of 10-12 weeks through the following:

- It challenges and resets cost aspirations in sync with business strategy;

- focuses on transforming cost drivers;

- understands demand and requirements from internal and external 'customers';

- identifies slack leading to optimal use of resources;

- develops a cost-conscious mindset and approach in the business;

- creates a repeatable process and gets to answers quickly through a structured approach.

� Adoption of cloud-based analytics and visualisation tools: Cost visibility has become less onerous with the rise of analytics and visualisation applications, which can pull and categorise unstructured data from disparate ERP systems into a central business intelligence warehouse. Rather than getting lost in spreadsheets, affordable and cloud-based budgeting tools enable budget holders, procurement and finance stakeholders to collaborate effectively on optimising cost.

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What does a Pragmatic-ZBB process look like?

Figure 5: High-level Pragmatic-ZBB process

Bottom-up Budgeting (i.e. ZBB) is only one step of four-stage pragmatic approach. Here are the key steps:

Visibility into cost and activities:

For third party spend, creating visibility is key to assess who spends how much and on what and with whom in terms of unit price and consumption. Later, leadership can leverage the detailed cost visibility to set intelligent top-down targets at both the budget owner and cost workstream level. in alignment with the corporate strategy.

2.1 Intelligent target setting:

An 'open-the-gap' mindset stresses that the opportunity to drive an ambitious cost effectiveness and efficiency agenda requiring management to be in sync with an annual forward-looking planning exercise and to take advantage of the available levers in an unconstrained manner.

2.2.Value targeting:

Tangible top-down targets drive focus and allow cost package owners to drive the initial 'value targeting' in terms of identifying savings options of each activity against a set of key questions, considering:

a. Can the activity be stopped?

b. Can the activity be improved/reduced on a 'minimum viable cost' basis?

c. Can the activity be performed at a lower cost?

01 03

02

3.1. Bottom-up Budgeting:

The 'closing-the-gap' mindset is all about making the fixed cost base leaner without starving the business. Hence, creating a bottom-up budget is critical to stakeholder buy-in and arriving at a fact-based cost challenge. Pragmatic-ZBB can also enable PE firms to arrive at informed measures, risks and consequences against stress scenarios, such as the current pandemic.

3.2. Analysis:

Reconcile bottom-up budgets, confirming adherence to budget guidelines and ZBB policies, then assess options in terms of savings upside, costs of implementation and timelines.

3.3. Constructive Review:

Constructive cost challenge concludes final value targeting process. Using insights from bottom-up analysis, budget holders revise budgets as per the agreed savings. In our experience, budget submissions remain inflated at this point. Indeed, it is remarkable how claims of customer impact or decrease in top-line revenues fail to materialise as budgets are further tightened.

04Tracking & Monitoring:

ERP-based tracking of monthly variances between the budget and the actuals with corresponding action plans are critical for the organisation to remain agile.

2.1 Intelligent Target Setting

3.1 Bottom-Up Budgeting

3.2 Analysis

3.3 Constructive Review

2.2 Value Targeting

01 02 03 04Visibility & Setup

Tracking & Monitoring

Open the Gap Close the Gap

13PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

How is Pragmatic-ZBB valuable to Private Equity in pre-close situations?

Besides a lean cost base for a specific portfolio company, the potential benefit of ZBB is significantly higher for PE firms, which can use the power of ZBB across multiple situations such as faster post-close value creation, carve-out and late stage pre-deal due diligence ('DD') assessment with exclusivity or greater management access.

In particular, for 'Buy-and-Build' platforms, the value creation potential of ZBB capability is much higher given their need for sector-specific repeatable M&A capability. PE firms still provide capital for required 'Buy-and-Build' strategy led acquisitions, but without a robust synergy extraction plan.

Using the power of M&A-ZBB visibility, pre-deal teams can use the sector-specific internal operational benchmarks for late stage confirmatory due-diligence and granular post-close plans with access to management and data following the deal signing. With the ability to prepare a detailed value creation plan between deal signing and closing, PE firms now demand that management build specific synergy targets in the Year to Go ('YTG') forecast within the first 100 days. Subsequently, the new Board can hold management accountable for delivering the required P&L impact without requiring a large project management office ('PMO') team for post-close integration.

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Generate buy-in from top management: This is a company-wide initiative that will need buy-in and role modelling from executive management. It is essential, that both the CEO and PE firm sponsor the Pragmatic-ZBB programme.

Set intelligent top-down targets that communicate high expectations: Budget owners must hit their targets in full while calling-out associated risks and opportunities for executive review across the organisation. This is critical to deliver the required impact and to ensure that the bottom-up budgeting doesn't just become a rationale generating exercise.

Collaborate multi-functionally, using joint cost ownership to build 'on-demand' granular visibility and a cost-conscious culture throughout the organisation.

Prioritise scope by addressing the areas such as SG&A with high savings and low implementation complexity in the first phase. If you are thinking about optimising fixed costs, reviewing headquarter ('HQ') cost is a good starting point as costs usually range between 2.0 to 3.5% of revenues and Pragmatic-ZBB can deliver significant benefits.

Build required tracking and monitoring capability: Building and sustaining a 'cost-conscious' culture requires an effective cost tracking machine and making fact-based remedial decisions. ERP with automated variance reporting creates a virtuous feedback loop, which improves year-over-year ('YoY') cost visibility and drives further buy-in from budget holders (see Figure 6).

What are the key success factors to realise the benefits of Pragmatic-ZBB?

Figure 6: Feedback loop is critical to sustain ZBB

The following are key success factors to realise the full benefits of the Pragmatic-ZBB approach:

15PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

A restructuring and ZBB mindset

Resetting P&L-wide fixed costs during the annual business planning cycle has become an important value creation lever to improve EBITDA and/or re-invest savings towards a growth agenda.

However, in the current crisis, we advocate the adoption of a Pragmatic-ZBB approach and doing so with pace. In the short-term, this might be the deciding factor in preventing a catastrophic event such as bankruptcy.

In such circumstances, we believe that PE firms and their portfolio companies should deploy the best mix of Pragmatic-ZBB and restructuring skills to rapidly reset fixed costs for the 'new normal'.

In the long-run, Pragmatic-ZBB capability also prepares any organisation for the next shock, with adopters being able to take decisive actions towards quick re-alignment of their fixed cost base.

MoscowMoscowMoscowMoscowMoscow

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A&M's Europe and Middle East Offices

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If you are interested in discussing how we could help you through a Pragmatic-ZBB implementation, please get in touch with one of our experts.

Naresh Kumar

DirectorLondon

T: +44 738 702 2229 E: nakumar@alvarezandmarsal.com

Mark Bennett

Senior DirectorParis

T: +33 62 317 4737E: mark.bennett@alvarezandmarsal.com

Bob Rajan

Managing Director Munich

T: +49 89 7104 0600E: brajan@alvarezandmarsal.com

Key contacts

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Milan

Paris

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Geneva

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Dublin

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Glasgow

Madrid

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A&M's Europe and Middle East Offices

17PRAGMATIC ZERO-BASED BUDGETING: ADAPTING TO THE NEW NORMAL POST COVID-19

ABOUT ALVAREZ & MARSAL

Companies, investors and government entities around the world turn to Alvarez & Marsal (A&M) when conventional approaches are not enough to drive change and achieve results. Privately held since its founding in 1983, A&M is a leading global professional services firm that provides advisory, business performance improvement and turnaround management services.

With over 4,500 people across four continents, we deliver tangible results for corporates, boards, private equity firms, law firms and government agencies facing complex challenges. Our senior leaders, and their teams, help organizations transform operations, catapult growth and accelerate results through decisive action. Comprised of experienced operators, world-class consultants, former regulators and industry authorities, A&M leverages its restructuring heritage to turn change into a strategic business asset, manage risk and unlock value at every stage of growth.

To learn more, visit: AlvarezandMarsal.com

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