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4.6 Value Chain Types

In this chapter, we discuss the three classes of the Value Chain, the final pillar of PECCS, and offer guidance on how to divide private companies into these classes.

Motivation

Value chain refers to the processes or activities by which a company adds value to its products and services, including aspects of its production and after-sales services. Key characteristics of the value chain are how a company manages its supply chain, after-sales support, and logistics arrangements. Such characteristics can be an important source of operational value gains for investors (Alvarez and Jenkins, 2007).

 Generating operational value in a private company investment is a large source of value creation, especially when interest rates are low and there is a high degree of competition among Private Equity funds. Moreover, supply chain induced inflation (e.g., increased costs of raw materials and/or support services) and contemporaneous increases in interest rates, as witnessed in 2022 and subsequently, have increased both the opportunities and threats to private company investors, related to the value chains of their products and services.

 

Why and how would value chains be associated with private company valuation? A key shift in modern business management is the reduction in competition among businesses (i.e., horizontal competition) and an increase in cooperation or coordination as supply chains (Lambert and Cooper, 2000) (i.e., vertical sectors). Production of cutting-edge equipment involves extremely sophisticated value chains with considerable investments, which when properly designed are effective to the extent of being considered as organisational intangible capital (e.g., Stulz, 2020).

Effective value chain management generally involves reducing costs, improving the flow of goods downstream and flow of information in both directions. Private Equity funds rely on seasoned industry experts or professional advisors for improving value chain processes to address profitability at the SKU (or stockkeeping unit) level, improve order fill rates, minimise lost sales, lowering cost of goods sold through labour alignment, lowering shipping rates, and improving customer satisfaction, and thus subsequently create value.

To understand the value chain proposition, we examine the characteristics of a private company’s output. Most outputs can be dichotomously characterised as being either products or services, and these two categories require very different approaches to value chain such as supply chain management, and after-sales support requirements.

For example, products require sourcing of high-quality raw materials, logistics to bring everything to the point of production, extensive sales channels, and reverse logistics to deal with returns or repairs post-sales. The key value chain considerations for products include their life cycle, demand predictability, product variety, and market lead times (e.g., Fisher et al., 1997). Differences in these considerations can help tailor management decisions on working capital, supplier orders, and inventory levels.

Consistent and sustainable revenue can be generated (in the case of businesses) or utility can be obtained (in the case of individuals) from an installed base of products with a long life cycle, suggesting products as a category, may have implications for valuation.

On the other hand, services are usually delivered in the presence of the customer, and require fewer logistics, while needing more training and support for the customer Value chain management for services is principally different. A key distinguishing feature of services is that they take place at an interface with the customer (e.g., Sampson, 2012), thus making the customer crucial in the design, creation, and delivery of the service (Bitner et al., 1997). Specifically, value chain management in the context of services refers to the management of information, processes, capacity, service performance, and funds from the earliest supplier to the ultimate customer (e.g., Ellram et al., 2004)

Services, in general, can support higher margins than products and also can provide a more recurring source of revenue as they are arguably more resistant to the economic cycles that influence investment and equipment purchase decisions (Anderson et al., 1997; Quinn, 1992), thus implying there could be systematic differences in valuation of a private company that delivers services as compared to one that produces products. Although theoretically, the differences are stark, in practice, many private companies offer a combination of products and services, thereby motivating the third class, the hybrid, which combines both products and services in its offering. The classification is described in the next subsection.

Value Chain Classification

The above arguments lead us to select the following groups to make up the value chain pillar of PECCS:

  1. Products: Private companies whose majority revenue is derived from the sale of products that are tangible in nature are included here. Some defining characteristics of a product include a lower level of customisability, needing material inputs to be produced, requiring the company or its distributors to have an inventory, and the need to be transported or delivered to the customer or allow to be picked up after a sale. If a company offers products and services, and more than 80% of its revenue comes from these products, it is classified as belonging to this class. These thresholds are borrowed from the accounting literature, where a source of revenue, when constituting over 20% is considered significant for consolidation.

  2. Services: Private companies whose majority revenue is derived from the sale of services that are intangible in nature. Some defining characteristics of a service include being non-physical, allowing a higher level of customisability, delivered with the customer in attendance, and often is recurring. If a company offers products and services, and more than 80% of its revenue comes from services, it is classified as belonging to this category.

  3. Hybrid: Apart from this binary classification, some product-based companies are also integrating services with their products to enhance the utility of their products, giving rise to a distinct integrated product-services kind of firm output (Beuren et al., 2013). These outputs represent a marketable set of products and services capable of jointly fulfilling a customer’s needs (e.g., White et al., 1999).

Such outputs can include the below three types of product-services, following Tukker and Tischner (2006)

  • Product-orientated services such as advice and consultancy that enhance the product (e.g., dedicated customer care services to aid the use of a technologically complex product).

  • Use-orientated services such as allowing leasing of the product to the customer (e.g., an auto retailer providing the customer a lease to an automobile), and

  • Result-orientated services (e.g., Rolls Royce charges its customers a fixed price for each hour the engine is in the air while taking care of all the maintenance, support, and parts supply for it (Yang and Evans, 2019)).

Another independent dimension of value chains that has the potential to significantly affect an asset’s characteristics relates to the geographical proximity of organisations involved with the product or the service (i.e., suppliers). For example, a car manufacturing company can obtain its parts from halfway across the world or from the same geographic region as it is located. These choices have significant economic effects on its operations, inventory policies, profitability, quality management, and consequently valuations. Also, the threat of chronic geopolitical risks can affect the valuation of companies with value chains that are exposed to sensitive geographies.

Moreover, such choices can have differential implications for services. For example, even in services, providers can be geographically far away and render services virtually or remotely. Like call centres may provide aftersales support services to a technology company and could be located in a country far away. However, it is to be noted, that the implications of a geographic subclass in services are likely very different from that of a similar geographic subclass in products, especially in terms of customer perception of the product or service. To illustrate, availing of a call centre service operating out of an emerging country may be perceived differently from buying a product whose raw materials are sourced from an emerging market country. Thus, it is conceivable to nest geographic proximity of value chains within the classes of PECCS value chain as these subsegments have different implications in the context of whether the output is a product or service or both.

To define categories of geographic proximity, a conservative approach is adopted and value chains are bifurcated into 1) global and 2) national. Although theoretically, it is possible to consider a regional subclass as well, data limitations on sourcing and suppliers are likely to severely restrict what could be gleaned about private companies on the nature of their suppliers. Therefore, from an application perspective, the subclasses are made to span the global and national value chain within each of the three value chain classes.

A summary of the three classes and the nested subclasses of the value chain are provided in Table 6.

 

VC Subclass Code

VC Class Name

VC Subclass Name

Description

VC01001

Hybrid

Hybrid Global

i) Key suppliers are geographically diverse, i.e., at least one key supplier is in a different country than the private company's operating country.

ii) Outputs that include a marketable set of products and services capable of jointly fulfilling a customer's needs.

iii) includes product-oriented services such as advice and consultancy that enhance the product, use-oriented services such as allowing leasing of the product to the customer, and result-oriented services.

iv) Less than 80% of revenue is attributable to products (or services).

VC01002

Hybrid

Hybrid Regional

i) Key suppliers are within the same country as the private company's operating country including inter-regional (e.g., in different states in a country), regional (e.g., within a state) or local (e.g., within a city).

ii) Outputs that include a marketable set of products and services capable of jointly fulfilling a customer's needs.

iii) includes product-oriented services such as advice and consultancy that enhance the product, use-oriented services such as allowing leasing of the product to the customer, and result-oriented services.

iv) Less than 80% of revenue is attributable to products (or services).

VC02001

Products

Products Global

i) Key suppliers are geographically diverse, i.e., at least one key supplier is in a different country than the private company's operating country.

ii) More than 80% revenues come from products that are tangible in nature.

iii) Tangibility includes an output that has a lower level of customisability, needs material inputs to be produced, requires the firm or its distributors to have an inventory, and needs to be transported or delivered to the customer or allow to be picked up after a sale.

VC02002

Products

Products Regional

i) Key suppliers are within the same country as the private company's operating country including inter-regional (e.g., in different states in a country), regional (e.g., within a state) or local (e.g., within a city).

ii) More than 80% revenues come from products that are tangible in nature.

iii) Tangibility includes an output that has a lower level of customisability, needs material inputs to be produced, requires the firm or its distributors to have an inventory, and needs to be transported or delivered to the customer or allow to be picked up after a sale.

VC03001

Services

Services Global

i) Key suppliers are geographically diverse, i.e., at least one key supplier is in a different country than the private company's operating country.

ii) More than 80% revenues come from services that are intangible in nature.

iii) Intangibility includes an output that has a higher level of customisability, is non-physical, delivered with the customer in attendance, and is often recurring.

VC03002

Services

Services Regional

i) Key suppliers are within the same country as the private company's operating country including inter-regional (e.g., in different states in a country), regional (e.g., within a state) or local (e.g., within a city).

ii) More than 80% revenues come from services that are intangible in nature.

iii) Intangibility includes an output that has a higher level of customisability, is non-physical, delivered with the customer in attendance, and is often recurring. 

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