joby investment thesis

JOBY Stock Analysis: This Flying Car Company Could Be Worth a Gamble in 2024

I n the electric vertical takeoff and landing (eVTOL) world, Joby Aviation (NYSE: JOBY ) stock remains a top stock I think long-term investors should focus on.

Based in California, Joby aims to create scalable eVTOLs for short-distance passenger and cargo transport. Recent partnerships in California, New York, and Dubai hint at Joby’s potential in the emerging industry. 

Securing the FAA’s Part 145 Repair Station Certificate marked a significant milestone, ensuring JOBY’s ability to maintain its eVTOL aircraft effectively. Collaborating with Dubai’s Road and Transport Authority for air taxi services by 2025 signifies Joby’s pioneering innovation and global presence. 

Although revenue still needs to materialize, Joby’s strategic moves suggest future prominence in the market. Here’s more on why it’s a top flying car stock I think long-term investors should have on their radar right now.

Latest Joby Updates

JOBY stock recently expanded its partnership with the U.S. Air Force, committing to supply two eVTOL aircraft for training and testing at MacDill Air Force Base in Florida. This agreement adds to Joby’s $131 million contract with AFWERX, marking the most considerable contract value in the eVTOL industry.

MacDill Air Force Base, housing various military units, hosted testing and training for Joby’s aircraft. CEO Joe Ben Bevirt highlighted the significance of the U.S. government’s early support. Joby’s electric air taxi offers eco-friendly travel with impressive speed and minimal noise.

Through AFWERX, the Air Force experimented with aircraft like Joby’s, avoiding hefty development costs. This funding enabled manufacturers to fly pre-certification, aiding design refinements and pilot experience insights. Lieutenant Colonel John Tekell expressed excitement about advancing vertical lift technologies with Joby’s aircraft.

Additionally, Joby partnered directly with DOD units at MacDill, deploying aircraft for logistics and various test missions. The company delivered the first of nine eVTOLs to Edwards Air Force Base ahead of schedule. Service members visited Joby’s California facility for flight training and explored diverse operational applications.

Joby is Working Hard and Smart

JOBY stock has positioned itself well for success by enhancing nationwide urban air mobility infrastructure. The company has additional partnerships in California and New York that should provide strong growth over a meaningful time horizon. These initiatives paved the way for the company’s upcoming air taxi service launch. Furthermore, Joby secured exclusive rights from Dubai’s Road and Transport Authority for a six-year air taxi operation starting in 2026.

Moreover, in February, the company announced the acquisition of a facility at Dayton International Airport , initiating hiring for initial manufacturing operations at this facility. The plant will support aircraft part manufacturing for Joby’s Pilot Production Line in Marina, California, with operations slated to start later in the year. Joby plans to develop facilities capable of producing up to 500 aircraft annually in Dayton, including a more giant greenfield factory. 

Despite being pre-revenue, Joby’s partnerships hint at long-term potential, supported by progress in type certification and a substantial cash balance exceeding $1 billion.

JOBY is a Shining Buy

Financial figures are crucial in analyzing stocks, especially for startups like JOBY. Despite being pre-revenue, its partnerships hint at long-term potential in the emerging sector. Advancements in type certification also indicate future opportunities. 

With a loss of over $513 million in 2023, Joby has a few years of conservative runway. Further equity raises could fund research and development.

So, for those with an investing time horizon longer than two years, this could be a stock to pick up on dips. And considering JOBY stock is now down roughly 50% from its peak during the middle of last year, I’d say now is a great time to consider adding or building a position.

On the date of publication, Chris MacDonald did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com  Publishing Guidelines .

Chris MacDonald’s love for investing led him to pursue an MBA in Finance and take on a number of management roles in corporate finance and venture capital over the past 15 years. His experience as a financial analyst in the past, coupled with his fervor for finding undervalued growth opportunities, contribute to his conservative, long-term investing perspective.

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• Jan 13, 2023

WHAT JOBY AVIATION LEARNED FROM TESLA - BATTERIES, CHARGING, COOLING

Joby Aviation are developing electric vertical takeoff and landing / eVTOL aircraft. Two of their pre-production 'S4' experimental prototype airframes have been registered with the FAA - N541JA Serial #JAS4 -101 and N542BJ Serial #JAS4 -202 (one of which was damaged in a crash last year) - as well as a sub-scale 55lb / 25kg Unmanned Aerial Vehicle / UAV:

Following a merger with LinkedIn co-founder Reid Hoffman 's Special Purpose Acquisition Company / SPAC in 2021 the company are publicly listed ( NYSE: JOBY ). We've used a combination of information shared by the company themselves (press releases, job ads, blog posts etc.), excerpts from media coverage, alongside SEC and patent filings to investigate Joby's approach to batteries, charging and cooling of their electric aircraft.

Their July 2021 investment memo is a key document in researching the business:

In it Joby reveal that:

" Each propeller is powered by two independent electric motors, each in turn driven by independent electric motor drive-units. Each drive-unit draws power from a separate battery, of which there are four onboard the aircraft"

BATTERIES AND VERTICAL INTEGRATION

Slides in the investment memo show example battery pack locations in the aircraft's wings / forward nacelles:

This seems to still be the case - stills taken from a December 2022 YouTube video posted by Kirsten Dirksen recorded at Joby's facilities spread across Marina Municipal Airport (a former US Army airfield in California) show charging and cooling connections affixed to similar locations on the aircraft:

THE TESLA CONNECTION

Joby Aviation CEO JoeBen Bevirt hired Tesla veteran Jon Wagner back in 2017 to head up powertrain and electronics. Wagner was " team leader for battery pack design engineering " at Tesla, a role which included work on the battery packs in the Model S/X, Model 3 and Powerwall:

Wagner's experience included work on " mechanical, thermal, structural, electrical, and system engineering " and he has introduced a similar set of in-house capabilities at Joby - setting it apart from competitors.

This vertically integrated approach is harder, more capital intensive and requires the recruitment of a diverse and highly skilled workforce, but the tight integration of design and manufacture can yield significant performance and speed advantages once the requisite labour force, facilities, equipment and processes are in place. Joby are likely to be able to iterate quicker than the competition - mimicking an approach that has been so successful at Tesla and SpaceX.

Whereas Archer Aviation ( Source ), SkyDrive ( Source ) and Supernal ( Source ) have, in the short-term at least, elected to procure integrated battery modules from Utah's Electric Power Systems , Joby are procuring battery cells and then designing, engineering and testing the packs and modules that contain them, in-house:

One way that Joby says it’s achieved its performance goals is by building practically all of the aircraft in-house apart from the battery cells

Source: Forbes, Nov. 2020

Here's a brief glimpse of Wagner talking to Andersson Cooper about Joby's batteries in a segment on 60 Minutes :

A Joby patent filing for an Aircraft Propulsion Unit / APU from August 2022 (on which Wagner is named) illustrates well the Cell > Module > Pack hierarchy:

Tesla's battery strategy has seen them predominantly source cylindrical form factor lithium ion battery cells. Much of that supply in the US has been from factories co-developed with long-term partners Panasonic, though increasingly they source around the world from a range of suppliers - the Shanghai factory permissions likely coming with a stipulation for local supply (provided by li-ion global market behemoth CATL).

Previously having favoured steel encased cells measuring 18 x 650mm or 21 x 70mm (referred to as 18650s or 2170s respectively) Tesla are transitioning to a larger form factor 48 x 60mm or '4860' cell, developed with Panasonic. This could be considered the cutting edge of mass-produced li-ion battery cells.

The electric vehicle industry also use lithium ion cells in pouch and prismatic form factors, a selection of which can be seen below:

WHAT WE KNOW ABOUT JOBY'S BATTERY STRATEGY

Joby will initially use cells already in production for automotive use

They'll start with 811 NMC cathode, graphite anode cells

The S4 batteries are liquid-cooled, both on- and off-aircraft

Joby want to leave their options open to swap in alternative batteries / power sources in future

Joby and third party sources have made multiple references to using batteries already in high volume production eg. for electric cars - reducing technology risk and hoping to smooth the path to certification of their aircraft for passenger-carrying commercial work on which their business plan depends:

The automotive cells he’s using pack “almost” 300 watt-hours per kilogram in specific energy, Bevirt says, well short of battery chemistries under development promising 400 Wh/kg and up that some other electric VTOL developers appear to be waiting for to make their aircraft viable.

Source: Forbes, Nov. 2020 )

Chairman Paul Sciarra said in an interview with IPO Edge:

" ...certainly batteries and the progression of batteries will continue. The target that we set for ourselves is look, we’ve got to be able to hit these specifications with batteries that are already in high volume, high quality production for another application now.

We did not want to be in a scenario, John, where we were trying to pull brand new batteries out of the lab and onto the manufacturing line. That’s a stacking of risk, technical risk on the aircraft plus technical risk in terms of the ability to scale and manufacture battery production. And you know, that double risk felt like one that was not worth taking.

So, getting back to your point, we do think that there are going to be opportunities to take advantage of improvements in batteries over time. And we think there may be opportunities to even do a, what’s called a sort of supplemental certification, to our initial type certification of the vehicle, that would certify new battery packs that would basically go into what would otherwise be the same vehicle, to really begin to take advantage of those progressive improvements in energy density over time. "

(Source: SEC Filing, July 2021 )

In a July 2021 Press Release Joby confirmed that their prototype aircraft:

" ...uses commercially available lithium ion batteries that have been adapted for aerospace use. An 811 NMC cathode and a graphite anode cell were selected, following internal testing.. ."

(Source: Joby Aviation, July 2021 )

811 NMC CELLS

811 NMC lithium ion battery cells are a relatively high energy density cell chemistry that stand up well to high numbers of charge cycles, but are a little more thermally unstable and hence 'less safe' than other available li-ion cell chemistries - hence the need for well managed cooling during charge and discharge cycles.

NMC 811 is the cell chemistry favoured by Tesla for their longer range and higher performance model variants. The cathode comprises of nickel, cobalt and manganese in a ratio of 8:1:1 - it's quite brittle and (in Tesla's latest 4680 cells at least) bonded to an aluminium film:

The graphite anode is typically bonded to a copper strip:

Most major li-ion battery manufacturers now have an 811NMC offering in one form factor or another - from smaller players like Germany's Custom Cells and China's Grepow to major volume producers like CATL , Panasonic Energy and SK On .

WHAT JOBY MIGHT BE DOING

If Joby's approach does mirror that of Tesla we'd expect them to procure cells made in the US (with a high % of US derived mineral content as per Inflation Reduction Act incentives ) - and to then integrate those cells into packs and modules in-house. We initially thought this might be at their planned Marina production facility (see the planning application for Joby's Marina facility in full here ):

Since first publishing this post we received a suggestion to check the location of battery-related job vacancies at Joby and doing so confirms that battery, powertrain and power electronics positions all list the company's facility in San Carlos, California as the place of work. As such it seems a safe bet that cells are integrated into packs at this location, not at Marina as we first posited:

We'd expect Joby to be working directly with battery manufacturers on future cell types, and it might be that a prismatic or pouch cell is being considered, but we suspect they'll have started out with a 2170 Tesla/Panasonic cylindrical cell or similar.

Indeed a patent filing dated October 2022 for a Battery Thermal Management System and Method naming Wagner alongside fellow Tesla battery veteran Ernest Villanueva (a battery module design specialist) indicates that the company are at the very least keen to protect system architectures that might include cylindrical as well prismatic / pouch cells:

WHO IS JOBY AVIATION'S BATTERY SUPPLIER?

Given Joby Aviation's involvement with the US Department of Defence - including participation in the US Air Force's Agility Prime programme which has a stated goal of securing strategic eVTOL supply chain capability on US soil - we believe it unlikely Joby would select a Chinese cell supplier, nor one who lack US-based cell manufacturing capacity. At the very least their volume supplier would need to have demonstrable plans to establish / increase a US manufacturing footprint to supply a production line of eVTOL aircraft.

We go more in-depth on lithium ion battery manufacturers and their plans for US production here - including taking a look at Joby Aviation investor Toyota's progress on a li-ion battery cell manufacturing facility in North Carolina - we'd suggest this could be a likely candidate for volume cell production supply to Joby, if the two EV specific production lines are up and running in time c. 2025.

The majority of the world's 10 largest battery companies can likely be ruled out on the basis that they are either Chinese or have the majority of their manufacturing capacity in mainland China - leaving us with Japan's Panasonic Energy and SK On as possible candidates from the global top ten . Given Panasonic's tie-up with Toyota on prismatic cell production in North America - read more on the Prime Planet Energy JV here - and their history of working with Tesla, we'd say Panasonic are the most likely candidate to supply Joby with battery cells in the near-term, with a view to procuring in greater volumes from Toyota's under construction US battery facility in North Carolina .

It's reported that Joby scoped sites for their manufacturing facility across the US, including in North Carolina, for their aircraft manufacturing site under the codename ' Project Aniram ', before settling on Marina Municipal Airport in their native California.

Given that Toyota's $2.5bn USD investment in a li-ion battery manufacturing facility is also located in North Carolina , it seems obvious that the companies would be, at the very least, coordinating future battery strategy and that cell supply from the under-construction Toyota plant in NC has at the very least have been under serious consideration.

LI-ION BATTERY COOLING

Tesla fuse their batteries together into packs / modules (most recently using polyurethane foam) with ' micro channel extrusions ' running between them, through which a liquid coolant runs, channeling heat away from the sides of the cells. It's not the *best* solution as cylindrical cells reportedly heat up most at the top and bottom, but it works:

Managing thermal runaway can be an issue with li-ion cells - particularly as they can also expand and contract slightly when under high charge or discharge loading. In electric car battery packs an elegant solution has been adopted by Tesla:

The top of the battery module container is made from a strongly heat resistant metal (steel we believe), which functions like an aircraft's firewall, forming a strongly heat resistant barrier between the passenger cabin and the batteries in the event of fire

The bottom is instead made from aluminium, so that in the event a cell / multiple cells start venting material this base will sacrificially melt and the cells can simply drop onto the ground where fire crews can more easily extinguish them, and away from the rest of the battery pack, occupants etc.

Ejecting burning batteries from an eVTOL aircraft is presumably *not* an option! We suspect much of the work being undertaken by Wagner and his team at Joby will be on the packaging around the cells and managing thermal loading / runaway to the satisfaction of the FAA's certification teams.

Bevirt is quoted as saying that their vertical integration includes the metallics used in some of the aircraft’s components, which are machined and manufactured in Germany ( see our July 2020 scoop on Joby's establishment of a Munich operation in close proximity to competitor Lilium) - this might well include elements of battery housing / packaging:

“ That manufacturing team of engineers in Munich are the ones that are doing that work and making those parts efficiently and cost-effectively ” [ Source ].

A 2020 article in Aviation Week indicated that the battery packs in its eVTOL would have onboard liquid cooling, which should help keep them at a constant desired temperature during discharge [ Source ].

For recharging, Bevirt said during an IPO Edge webinar the company will be using proprietary chargers “ that do both the charging and the thermal management of our battery system while we’re charging, and that allows for a very rapid charge rate and a very rapid turnaround time that’s on the order of the time that it takes for us to unload one set of passengers and load the next. ”

We recently caught a glimpse of that charging setup from the October 2022 patent filing in a YouTube video tour of Joby's facilities at Marina Municipal Airport in California:

Joby Aviation have confirmed their intention to use lithium-ion cells already in large-scale production for automotive applications, to reduce risk

The company have publicly stated that their preferred cell chemistry is an NMC 811 cathode combined with graphite anode - a high energy density chemistry used by Tesla

In the short-term, for development aircraft, Joby are likely to have used the same cylindrical cells found in most Tesla cars - which might have been sourced from Tesla / Panasonic directly or even through the purchase or new / used Tesla vehicles

The cylindrical cells would likely be in 18650 / 2170 (our best guess) / 4680 form factor, are likely liquid cooled with fluid flowing between the sides of the cells within the pack / module casing on the aircraft, with additional off-aircraft cooling provided when charging by a bespoke, patented, on-ground charging apparatus

Joby are forming the cells into bespoke battery modules in-house, which together form larger battery packs, all of which undergo extensive in-house testing and verification

We expect that for volume production Joby might source cells from Toyota Battery Manufacturing North Carolina (TBMNC) whose planned $2.5bn plant is under construction and expected to produce first cells 2024-25

UPDATE 23-01-23 - we noticed that Joby are listed as a partner on Redwood Materials' website - the battery recycling company started by ex-Tesla CTO and co-founder JB Straubel - that's raised nearly $800m USD in funding:

Notably Redwood also have deals inked with both Toyota [Source: Forbes ] and Panasonic [Source: CNBC ].

READ MORE ABOUT TOYOTA'S NORTH CAROLINA LI-ION BATTERY FACTORY IN OUR POST HERE :

• Archived Aerospace and Mobility Pos

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Technology Snippets

Technology, Venture Capital

Friday, July 30, 2021

Joby investment thesis.

https://d1io3yog0oux5.cloudfront.net/reinventtechnologypartnersa/files/pages/reinventtechnologypartnersa/db/1158/content/Joby+Investment+Thesis.pdf

• Lilium-stock
• News for Lilium

3 Flying Car Stocks to Watch Now: May 2024 

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

In the 1990s, some of us may have thought we would have had flying cars by now. In 2024, we may not have flying cars like the ones featured in those 1980s science fiction films. Indeed, Blade Runner-esque flying cars seem to be well off the table. That said, a class of intriguing electric vertical take-off and landing (or eVTOL for short) aircraft looks very intriguing.

Many eVTOLs today resemble “giant drones” or mini helicopters (some aspects of the technology are quite similar), while others look like futuristic mini jets. Either way, they aim to solve the traffic issue, especially in crowded cities like New York, Los Angeles and Vancouver.

Indeed, many eVTOL companies may be worth putting on a watchlist. As it stands, the eVTOL market remains highly speculative. It’s tough to pinpoint which firms will rise should the eVTOL market finally take off. Of course, only time will tell as the eVTOL plays to test the skies.

In short, eVOTLs are remarkable technologies but be cautious about the extreme volatility and uncertainty in flying car stocks . Here are three to keep on the radar.

Joby Aviation (JOBY)

Joby Aviation (NYSE: JOBY ) is perhaps the most impressive flying car (or eVTOL) stock for investors who believe in the future of the nascent transportation technology. Until now, JOBY stock has been trading extremely wildly, with a beta of over two, implying a much more turbulent ride than the S&P 500 .

With the stock going for just over $5 per share, traders may wish to monitor the name as it looks to gain traction following recent progress with its pre-production flight test program. Undoubtedly, such progress represents a small but meaningful step in the right direction, but don’t expect air taxis to start rolling out anytime soon. There’s still a long way to go.

The eVOTL play is looking to launch in the United Arab Emirates (UAE ) to grab the world’s attention. Specifically, Joby is looking to Dubai as a place to take the skies first.

As to when the launch will happen, I have no idea. Further, given the uncertainties and lack of profitability, I struggle to value the stock. I’m okay with staying on the sidelines, but it won’t stop you from buying if you’re keen on investing in the industry.

Archer Aviation (ACHR)

Archer Aviation (NYSE: ACHR ) is another big name in the eVOTL scene. The company boasts a $1.23 billion market cap, less than half of Joby’s $3.55 billion market cap at the time of writing. At $3 and change per share, ACHR stock has an even lower admission price for small retail investors with an appetite for high-risk speculation.

Recently, the stock has been on the decline, now off over 47% from its 52-week peak of over $7 per share. Undoubtedly, there’s a haze of uncertainty as Archer (and Joby) looks to fly into the UAE region.

Whether the UAE flights happen in late 2025, 2026, or further out, ACHR stock will surely be a major mover when the big day comes. Should such flights have a smooth take-off and landing, ACHR stock could be a major mover.

I wouldn’t touch the stock because it’s lacking in profits. Until progress on that front, I’m content with holding off. But if you want to watch the market, ACHR is a name to put on the radar.

Lilium N.V. (LILM)

Finally, we have Lilium (NASDAQ: LILM ), which has actually been picking up traction in recent weeks. Over the past month, shares are up over 48%. With a $666.4 million market cap at the time of writing, Lilium is the smallest of this trio, but perhaps things could change as rampant volatility strikes.

What’s contributing to the recent run? The company is reportedly discussing expanding its production capacity with France’s government. Indeed, it’s a positive development, and though Lilium arguably has one of the most impressive-looking eVTOL jets of the pack, I’m just not sure how much of the recent momentum can be sustained given the steep ups and downs of the eVTOL market.

In any case, it is encouraging that the firm keeps progressing and hitting milestones. Despite this, I hesitate to recommend loading up at current levels until I see some profits. I’d much rather stash the name on my radar and watch it closely.

On the date of publication, Joey Frenette did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com   Publishing Guidelines .

Joey Frenette is a seasoned investment writer specializing in technology and consumer stocks. Contributing to the Motley Fool Canada, TipRanks, and Barchart, Joey excels in spotting mispriced stocks with long-term growth potential in a fast-paced market.

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Bridging private equity’s value creation gap

For the past 40 years or so, private equity (PE) buyout managers largely invested capital in an environment of declining interest rates and escalating asset prices. During that period, they were able to rely on financial leverage, enhanced tax and debt structures, and increasing valuations on high-quality assets to generate outsize returns for investors and create value.

Times have changed , however. Since 2020, the cost of debt has increased and liquidity in debt markets is harder to access given current interest rates, asset valuations, and typical bank borrowing standards. Fund performance has suffered as a result: PE buyout entry multiples declined from 11.9 to 11.0 times EBITDA through the first nine months of 2023. 1 2024 Global Private Markets Review , McKinsey, March 2024.

Even as debt markets begin to bounce back, a new macroeconomic reality is setting in—one that requires more than just financial acumen to drive returns. Buyout managers now need to focus on operational value creation strategies for revenue growth, as well as margin expansion to offset compression of multiples and to deliver desired returns to investors.

Based on our years of research and experience working with a range of private-capital firms across the globe, we have identified two key principles to maximize operational value creation.

First, buyout managers should invest with operational value creation at the forefront . This means that in addition to strategic diligence, they should conduct operational diligence for new assets. Their focus should be on developing a rigorous, bespoke, and integrated approach to assessing top-line and operational efficiency. During the underwriting process, managers can also identify actions that could expand and improve EBITDA margins and growth rates during the holding period, identify the costs involved in this transformation, and create rough timelines to track the assets’ performance. And if they acquire the asset, the manager should: 1) clearly establish the value creation objectives before deal signing, 2) emphasize operational and top-line improvements after closing, and 3) pursue continual improvements in ways of working with portfolio companies. Meanwhile, for existing assets, the manager should ensure that the level of oversight and monitoring is closely aligned with the health of each asset.

Second, everyone should understand and have a hand in improving operations . Within the PE firm, the operating group and deal teams should work together to enable and hold portfolio companies accountable for the execution of the value creation plan. This begins with an explicit focus on “linking talent to value”—ensuring leaders with the right combination of skills and experience are in place and empowered to deliver the plan, improve internal processes, and build organizational capabilities.

In our experience, getting these two principles right can significantly improve PE fund performance. Our initial analysis of more than 100 PE funds with vintages after 2020 indicates that general partners that focus on creating value through asset operations achieve a higher internal rate of return—up to two to three percentage points higher, on average—compared with peers.

The case for operational efficiency

The ongoing macroeconomic uncertainty has made it difficult for buyout managers to achieve historical levels of returns in the PE buyout industry using old ways of value creation. 2 Overall, roughly two-thirds of the total return for buyout deals that were entered in 2010 or later, and exited 2021 or before, can be attributed to market multiple expansion and leverage. See 2024 Global Private Markets Review .   And it’s not going to get any easier anytime soon, for two reasons.

Higher-for-longer rates will trigger financing issues

The US Federal Reserve projects that the federal funds rate will remain around 4.5 percent through 2024, then potentially drop to about 3.0 percent by the end of 2026. 3 “Summary of economic projections,” Federal Reserve Board, December 13, 2023.   Yet, even if rates decline by 200 basis points over the next two years, they will still be higher than they were over the past four years when PE buyout deals were underwritten.

This could create issues with recapitalization or floating interest rate resets for a portfolio company’s standing debt. Consider that the average borrower takes a leveraged loan at an interest coverage ratio of about three times EBIDTA (or 3x). 4 The interest coverage ratio is an indicator of a borrower’s ability to service debt, or potential default risk.   With rising interest expenses and additional profitability headwinds, these coverage ratios could quickly fall below 2x and get close to or trip covenant triggers around 1x. In 2023, for example, the average leveraged loan in the healthcare and software industries was already at less than a 2x interest coverage ratio. 5 James Gelfer and Stephanie Rader, “What’s the worst that could happen? Default and recovery rates in private credit,” Goldman Sachs, April 20, 2023.   To avoid a covenant breach, or (if needed) increasing recapitalization capital available without equity paydown, managers will need to rely on operational efficiency to increase EBITDA.

Valuations are mismatched

If interest rates remain high, the most recent vintage of PE assets is likely to face valuation mismatches at exit, or extended hold periods until value can be realized. Moreover, valuation of PE assets has remained high relative to their public-market equivalents, partly a result of the natural lag in how these assets are marked to market. As the CEO of Harvard University’s endowment explained in Harvard’s 2023 annual report, it will likely take more time for private valuations to fully reflect market conditions due to the continued slowdown in exits and financing rounds. 6 Message from the CEO of Harvard Management Company, September 2023.

Adapting PE’s value creation approach

Operational efficiency isn’t a new concept in the PE world. We’ve previously written  about the strategic shift among firms, increasingly notable since 2018, moving from the historical “buy smart and hold” approach to one of “acquire, align on strategy, and improve operating performance.”

However, the role of operations in creating more value is no longer just a source of competitive advantage but a competitive necessity for managers. Let’s take a closer look at the two principles that can create operational efficiency.

Invest with operational value creation at the forefront

PE fund managers can improve the profitability and exit valuations of assets by having operations-related conversations up front.

Assessing new assets. Prior to acquiring an asset, PE managers typically conduct financial and strategic diligence to refine their understanding of a given market and the asset’s position in that market. They should also undertake operational diligence—if they are not already doing so—to develop a holistic view of the asset to inform their value creation agenda.

Operational diligence involves the detailed assessment of an asset’s operations, including identification of opportunities to improve margins or accelerate organic growth. A well-executed operational-diligence process can reveal or confirm which types of initiatives could generate top-line and efficiency-driven value, the estimated cash flow improvements these initiatives could generate, the approximate timing of any cash flow improvements, and the potential costs of such initiatives.

The results of an operational-diligence process can be advantageous in other ways, too. Managers can use the findings to create a compelling value creation plan, or a detailed memo summarizing the near-term improvement opportunities available in the current profit-and-loss statement, as well as potential opportunities for expansion into adjacencies or new markets. After this step is done, they should determine, in collaboration with their operating-group colleagues, whether they have the appropriate leaders in place to successfully implement the value creation plan.

These results can also help managers resolve any potential issues up front, prior to deal signing, which in turn could increase the likelihood of receiving investment committee approval for the acquisition. Managers also can share the diligence findings with co-investors and financiers to help boost their confidence in the investment and the associated value creation thesis.

It is crucial that managers have in-depth familiarity with company operations, since operational diligence is not just an analytical-sizing exercise. If they perform operational diligence well, they can ensure that the full value creation strategy and performance improvement opportunities are embedded in the annual operating plan and the longer-term three- to five-year plan of the portfolio company’s management team.

Assessing existing assets. When it comes to existing assets, a fundamental question for PE managers is how to continue to improve performance throughout the deal life cycle. Particularly in the current macroeconomic and geopolitical environment, where uncertainty reigns, managers should focus more—and more often—on directly monitoring assets and intervening when required. They can complement this monitoring with routine touchpoints with the CEO, CFO, and chief transformation officer (CTO) of individual assets to get updates on critical initiatives driving the value creation plan, along with ensuring their operating group has full access to each portfolio company’s financials. Few PE managers currently provide this level of transparency into their assets’ performance.

To effectively monitor existing assets, managers can use key performance indicators (KPIs) directly linked to the fund’s investment thesis. For instance, if the fund’s investment thesis is centered on the availability of inventory, they may rigorously track forecasts of supply and demand and order volumes. This way, they can identify and address issues with inventory early on. Some managers pull information directly from the enterprise resource planning systems in their portfolio companies to get full visibility into operations. Others have set up specific “transformation management offices” to support performance improvements in key assets and improve transparency on key initiatives.

We’ve seen managers adopt various approaches with assets that are on track to meet return hurdles. They have frequent discussions with the portfolio company’s management team, perform quarterly credit checks on key suppliers and customers to ensure stability of their extended operations, and do a detailed review of the portfolio company’s operations and financial performance two to three years into the hold period. Managers can therefore confirm whether the management team is delivering on their value creation plans and also identify any new opportunities associated with the well-performing assets.

If existing assets are underperforming or distressed, managers’ prompt interventions to improve operations in the near term, and improve revenue over the medium term, can determine whether they should continue to own the asset or reduce their equity position through a bankruptcy proceeding. One manager implemented a cash management program to monitor and improve the cash flow for an underperforming retail asset of a portfolio company. The approach helped the portfolio company overcome a peak cash flow crisis period, avoid tripping liquidity covenants in an asset-backed loan, and get the time needed for the asset’s long-term performance to improve.

Reassess internal operations and governance

In addition to operational improvements, managers should also assess their own operations and consider shifting to an operating model that encourages increased engagement between their team and the portfolio companies. They should cultivate a stable of trusted, experienced executives within the operating group. They should empower these executives to be equal collaborators with the deal team in determining the value available in the asset to be underwritten, developing an appropriate value creation strategy, and overseeing performance of the portfolio company’s management.

Shift to a ‘just right’ operating model for operating partners. The operating model through which buyout managers engage with portfolio companies should be “just right”—that is, aligned with the fund’s overall strategy, how the fund is structured, and who sets the strategic vision for each individual portfolio company.

There are two types of engagement operating models—consultative and directive. When choosing an operating model, firms should align their hiring and internal capabilities to support their operating norms, how they add value to their portfolio companies, and the desired relationship with the management team (exhibit).

Take the example of a traditional buyout manager that acquires good companies with good management teams. In such a case, the portfolio company’s management team is likely to already have a strategic vision for the asset. These managers may therefore choose a more consultative engagement approach (for instance, providing advice and support to the portfolio company for any board-related issues or other challenges).

For value- or operations-focused funds, the manager may have higher ownership in the strategic vision for the asset, so their initial goal should be to develop a management team that can deliver on a specific investment thesis. In this case, the support required by the portfolio company could be less specialized (for example, the manager helps in hiring the right talent for key functional areas), and more integrative, to ensure a successful end-to-end transformation for the asset. As such, a more directive or oversight-focused engagement operating model may be preferred.

Successful execution of these engagement models requires the operating group to have the right talent mix and experience levels. If the manager implements a “generalist” coverage model, for example, where the focus is on monitoring and overseeing portfolio companies, the operating group will need people with the ability (and experience) to support the management in end-to-end transformations. However, a different type of skill set is required if the manager chooses a “specialist” coverage model, where the focus is on providing functional guidance and expertise (leaving transformations to the portfolio company’s management teams). Larger and more mature operating groups frequently use a mix of both talent pools.

Empower the operating group. In the past, many buyout managers did not have operating teams, so they relied on the management teams in the portfolio companies to fully identify and implement the value creation plan while running the asset’s day-to-day operations. Over time, many top PE funds began to establish internal operating groups  to provide strategic direction, coaching, and support to their portfolio companies. The operating groups, however, tended to take a back seat to deal teams, largely because legacy mindsets and governance structures placed responsibility for the performance of an asset on the deal team. In our view, while the deal team needs to remain responsible and accountable for the deal, certain tasks can be delegated to the operating group.

Some managers give their operating group members seats on portfolio company boards, hiring authority for key executives, and even decision-making rights on certain value creation strategies within the portfolio. For optimal performance, these operating groups should have leaders with prior C-suite responsibility or commensurate accountability within the PE fund and experience executing cross-functional mandates and company transformations. Certain funds with a core commitment to portfolio value creation include the leader of the operating group on the investment committee. Less-experienced members of the operating group can have consultative arrangements or peer-to-peer relationships with key portfolio company leaders.

Since the main KPIs for operating teams are financial, it is critical that their leaders understand a buyout asset’s business model, financing, and general market dynamics. The operating group should also be involved in the deal during the diligence phase, and participate in the development of the value creation thesis as well as the underwriting process. Upon deal close, the operating team should be as empowered as the deal team to serve as stewards of the asset and resolve issues concerning company operations.

Some funds also are hiring CTOs  for their portfolio companies to steer them through large transformations. Similar to the CTO in any organization , they help the organization align on a common vision, translate strategy into concrete initiatives for better performance, and create a system of continuous improvement and growth for the employees. However, when deployed by the PE fund, the CTO also often serves as a bridge between the PE fund and the portfolio company and can serve as a plug-and-play executive to fill short-term gaps in the portfolio company management team. In many instances, the CTO is given signatory, and occasionally broader, functional responsibilities. In addition, their personal incentives can be aligned with the fund’s desired outcomes. For example, funds may tie an element of the CTO’s overall compensation to EBITDA improvement or the success of the transformation.

Bring best-of-breed capabilities to portfolio companies. Buyout managers can bring a range of compelling capabilities to their portfolio companies, especially to smaller and midmarket companies and their internal operating teams. Our conversations with industry stakeholders revealed that buyout managers’ skills can be particularly useful in the following three areas:

• Procurement. Portfolio companies can draw on a buyout manager’s long-established procurement processes, team, and negotiating support. For instance, managers often have prenegotiated rates with suppliers or group purchasing arrangements that portfolio companies can leverage to minimize their own procurement costs and reduce third-party spending.
• Executive talent. They can also capitalize on the diverse and robust network of top talent that buyout managers have likely cultivated over time, including homegrown leaders and ones found through executive search firms (both within and outside the PE industry).
• Partners. Similarly, they can work with the buyout manager’s roster of external experts, business partners, suppliers, and advisers to find the best solutions to their emerging business challenges (for instance, gaining access to offshore resources during a carve-out transaction).

Ongoing macroeconomic uncertainty is creating unprecedented times in the PE buyout industry. Managers should use this as an opportunity to redouble their efforts on creating operational improvements in their existing portfolio, as well as new assets. It won’t be easy to adapt and evolve value creation processes and practices, but managers that succeed have an opportunity to close the gap between the current state of value creation and historical returns and outperform their peers.

Jose Luis Blanco is a senior partner in McKinsey’s New York office, where Matthew Maloney is a partner; William Bundy is a partner in the Washington, DC, office; and Jason Phillips is a senior partner in the London office.

The authors wish to thank Louis Dufau and Bill Leigh for their contributions to this article.

This article was edited by Arshiya Khullar, an editor in McKinsey’s Gurugram office.

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