Private equity firms’ race to create value often begins with grand strategies and ambitious platform acquisitions. While these initiatives can indeed transform businesses, there’s a fundamental aspect that may be overlooked: the core drivers of unit economics. Understanding the hypothetical “P x Q” is essential before diving into value-creation mode.
Going back to the basics of unit economics can itself be an effective value-creation tool today, which we explore below.
Understanding Unit Economics in Different Industry Contexts
Given the high volume of delivery, unit economics is particularly indispensable in a number of industries, including but not limited to:
- Retail: Unit economics often revolve around metrics like average transaction value (ATV), market basket size, and price/volume analysis. While these may sound like obvious KPIs, they’re critical in understanding profitability at a unit level, allowing owners to act quickly when faced with margin erosion.
- SaaS: Key unit economic drivers include monthly recurring revenue (MRR), customer churn rate/retention, and customer lifetime value (LTV). These metrics help determine the sustainability and scalability of the business model and identify any upside or weakness in the customer population.
- Manufacturing: Diving into the details behind product quality, equipment run-time (versus available run-time), and the overall efficiency of production (speed-to-product) helps management gain a better understanding of overall equipment effectiveness (OEE). The OEE metric sheds light on poorer-performing production lines and may prompt necessary capital expenditure.
- Healthcare: The intersection of revenue cycle management (RCM) and FP&A is critical for provider organizations. Aligning the right volume-driver to production and collections by date of service allows organizations to accurately bridge net patient revenue and track value-drivers of the business across multiple cohorts, such as payer, procedure, and geography. Analyzing key performance metrics over fully adjudicated periods can help finance teams quickly analyze revenue recognition, close the books faster, and forecast with increased accuracy.
How PE Sponsors Benefit From Mature Unit Economics Infrastructure
When scanning the portfolio for opportunities and risks on the horizon, a framework for leveraging unit economics can be a powerful tool that helps generate:
- Enhanced decision-making: By understanding unit economics, PE sponsors and their portfolio companies can make more informed decisions regarding pricing strategies, cost management, and investment in growth opportunities. For example, knowing the exact cost to serve each customer segment allows for tailored pricing models that maximize profit and help achieve investment theses.
- Risk mitigation: Clear insights into unit economics help identify potential risks early. For instance, a sudden spike in customer acquisition costs (CAC) might indicate market saturation or increased competition, prompting a strategic pivot.
- Improved operational efficiency: Detailed unit economic analysis can surface inefficiencies in operations. In a manufacturing portfolio company, identifying high defect rates in specific production lines can lead to targeted quality improvements and deployment of limited capital where it’s needed most.
- Strategic resource allocation: Resources can be allocated more effectively when the economic impact of different business units is understood. A sponsor might decide to divest from underperforming units and double down on high-margin products, for example.
- Value-creation transparency: Clear unit economic metrics provide transparency and accountability between sponsors and management teams. This makes it easier to track progress and demonstrate value creation to stakeholders.
Leveraging Technology and Business Intelligence Tools
A strong data foundation is the bedrock of effective use of technology. Once a data strategy is established, portfolio companies are well-positioned to convert that data into useful insights through:
- Dashboard visualizations: Interactive dashboards in business intelligence (BI) tools help visualize complex data, making it easier to spot trends and anomalies. This visual approach simplifies the communication of unit economic insights across the organization, especially within the C-suite and the Office of the CFO (OCFO).
- Real-time data analytics: Implementing tools like Power BI or Tableau allows portfolio companies to connect various data sources and provide real-time insights into unit economic drivers. This real-time analysis can help identify trends and empower decision-makers to make prompt operational adjustments.
- Predictive analytics: Utilizing machine learning algorithms and predictive analytics can forecast future trends based on historical data. For instance, predictive models can anticipate changes in customer behavior, allowing for proactive strategy adjustments.
Piecing It All Together
Let’s walk through a hypothetical example to illustrate the importance of understanding unit economics before embarking on strategic initiatives. Imagine a recently acquired SaaS business poised for several add-on acquisitions. The company, keen on growth, is eager to expand its market presence through these acquisitions. However, the FP&A and BI teams, along with specialized consultants, decide to take a step back and analyze the unit economics of their existing business first.
Step 1: Data Integration and Initial Analysis
Using a combination of Power BI and Snowflake, the teams consolidate data from various sources, including customer relationship management (CRM) systems, billing platforms, and customer support databases. SQL queries help in extracting relevant data, providing a comprehensive view of CAC, MRR, and customer LTV, creating a foundational data layer.
Step 2: Identifying Key Drivers
Through detailed analysis, the team uncovers that a significant portion of revenue is driven by a specific segment of high-value customers. These customers have a lower churn rate and higher upsell potential compared to the broader customer base. However, they also identify that the cost to acquire these customers is relatively high.
Step 3: Scenario Analysis and Strategy Adjustment
By leveraging scenario analysis capabilities, the team models different strategies, such as targeted marketing campaigns and pricing adjustments, to optimize CAC and LTV. They find that reallocating marketing spend toward channels that attract high-value customers significantly improves overall unit economics.
Step 4: Decision-Making
With a clear understanding of the core unit economics, the company realizes that focusing on enhancing the value proposition for high-value customers is more cost-effective than immediate platform acquisitions. This approach not only promises a higher return on investment but also lays a stronger foundation for future acquisitions.
Step 5: Continuous Monitoring and Adjustment
The BI tools are set up to continuously monitor key metrics on a regular cadence, providing real-time insights into the effectiveness of implemented strategies. Snowflake’s data warehousing capabilities ensure scalable and efficient data management, while Power BI’s dashboards offer actionable insights at a glance. Now that this is set up, the foundational data layer enables future scale.
Creating Future Enterprise Value
Unit economics is the essence of effective private equity management. By leveraging modern BI tools and data analytics, sponsors can uncover critical trends and make data-driven decisions that drive sustainable growth for stronger, more resilient portfolio companies.
To harness the power of your own data and begin creating value today, contact CrossCountry Consulting.