PE Play #2: Have a compelling investment thesis

In the Professional Services market that I tend toward, it is not unusual to come across companies that have grown very nicely by identifying a need and then gobbling up all the opportunities that come into the light of their "headlights".  Again, this behavior starts to break down as the business matures.  As you work to get Business Development right it is time to make sure you have a compelling investment thesis.

The investment thesis helps you in three significant ways:

1. It helps you make rational BD investment decisions.  One symptom of ineffective investment discipline is a business where executives and staff have no "white space" to tackle new large opportunities or to develop innovations that fuel organic growth.  Unless you have an unusually profitable business, this means that you need to start putting some things on the "stop doing" list.  A clear investment thesis will help you make rational decisions about what goes on that list.  Efficient allocation of resources is an essential role for executive leadership - and you need a basis for fulfilling that role in a coherant fashion, which leads to the second reason to have an investment thesis....
2. It allows you to communicate effectively with staff and other stakeholders.  Much has been written about the importance of staff engagement in the creation of shareholder value.  We often encounter businesses where the staff is either thoroughly confused about the direction and purpose of the business, or they are "change weary" because of the many inititiatives and statements that leadership has championed in an effort to get them engaged.  Vision, Mission and Purpose statements all have their place and I have facilitated the drafting of many.  But, unless these are informed by a clear investment thesis their connection with increasing enterprise value may be incidental.  Further, a Vision statement is of little interest to another important stakeholder - your banker.  When it is time to consider a major recapitalization of the business, or to negotiate a new credit line, it is extremely valuable if you are able to articulate a very clear and compelling investment thesis for your business.  
3. A compelling investment thesis increases demand for your business.  Unless your brilliant children have a strong interest in taking over your business someday, it will be necessary to eventually consider a "liquidity event".  After having looked at hundreds of transactions over the past 15 years I can assure you that a business that has the performance to back up a clear and compelling investment thesis can enjoy a 1-2x EBITDA premium as a result of the competition amongst Financial and Strategic buyers. Your family will thank you for being such a shrewd Very Private Equity investor!
   

Developing the investment thesis:

This is the hard part.  A solid investment thesis is based on facts, not opinions.   But, like a science experiment, it often begins with a hypothesis.  Ask yourself the question that a Private Equity investor should ask: "why should I be excited to invest in this business?"  Then, we develop a program of work to test and, if possible, "prove" the hypothesis.  As an early step in the process we typically inventory the real capabilities (I'll discuss the definition of a real capability in a later post) of the business and then go on a data mining expedition (PE investors might call this "due diligence") where we discover all of the facts that we can regarding historic and planned business performance, market conditions and emerging opportunities where those capabilities can be exploited.  With that work done, we have most of the facts we need to develop the thesis.  It would go something like this:

"There is an $x market for our xyz capability(ies) that is growing at a rate of x%.  Our performance and differentiation in this market justifies continued investment in innovation and business development.  Focused investment should deliver x% growth with EBITDA of x%, resulting in a 5 year IRR of over xx%."

PE Play #1: Get Business Development right

Organic growth - "Coin of the realm"

In most markets where private equity investors play, an increase in growth rate is more powerful - Enterprise Value wise - than a similar increase in the rate of profitability.  As one very successful PE investor put it to me - "EBITDA may come and EBITDA may go - but growth is the coin of the realm".  That is NOT to say that investors will tolerate losses.  But, there is a high degree of willingness to sacrifice short term profitability to fuel extraordinary growth.  That is because they know that the cost of winning new business is significantly lower than the cost of growth through further acquisition - and that future acquirors will pay a higher premium for business that has demonstrated the ability to deliver "organic" (i.e. not through M&A activities) growth.

What used to work just isn't enough...

It is remarkable how many small to mid sized businesses managed to succeed with "ad hoc" business development and sales processes.  Then, one day the business "plateaus" and the growth trend slows to a crawl.
Why? There are actually many reasons, but most of them are related to the need to start winning larger contracts (because the small ones just don't "move the needle" anymore) and/or the need to expand into adjacent markets (i.e. new clients) where the firm does not have brand recognition or mitigating deep personal relationships.
When this happens, the business needs to reach a higher level of what we might call "BD Process Maturity" in order to break through into a new period of high growth. 
Are your BD processes robust enough to deliver enhanced enterprise value?  If not, you are not managing your equity as a rational PE investor would.

Why should I emulate Private Equity investors?

There is significant evidence that common Private Equity behaviors drive outstanding returns for their investors.  The IRR (Internal Rate of Return) of a typical Private Equity fund is roughly double that of the typical S&P 500 fund. According to a 2005 McKinsey study of successful PE funds, about two thirds of these returns are generated through improvements in portfolio company performance vs. general market appreciation, financial "engineering" or arbitrage. So, they are driving great returns by improving performance - why not do that for yourself?
As I noted in my earlier post, most successful PE firms (of the LBO "flavor") are relatively long term investors who partner with existing management teams.  So, what did the PE investors do that you couldn't do?  If we are honest, the answer is probably "nothing".  Rather, they did what you "wouldn't" do - from an investor perspective.  Of the several high level behaviors that entrepreneur ownership often find difficult to exhibit there is one that truly stands out:

The investor role v. the management role:

Successful Private Equity investors understand the need to segregate their role as "investor" from the "management" role.  This is the most fundamental enabling behavior of the PE investor.  Yet, this is often a most difficult behavior for a typical founder/owner to emulate.  The PE investor is able to step back from the business and make brutally rational decisions regarding the management of the company and key investments required to fuel innovation and growth.  Small and mid-tier companies often get "stuck" when they are faced with resource constraints in their effort to fuel growth, or the management team does not possess the "professional management" capabilities that are essential to maintain a successful high growth business.  Founder/owner inertia when faced with the need to make hard decisions regarding resource allocation or the management team often grows from their inability to maintain separation of their investor/management roles.  This, in turn, gets in the way of other essential investor behaviors that are second nature to PE investors.
We will discuss those in future postings.

Fear Factor

A lot of folks who have founded and grown fantastic small and mid tier businesses misunderstand the role and value of private equity investment in their business. Many fear private equity. There is no need.

Flavors of Private Equity

Private Equity comes in a number of flavors. There are Venture Capital firms, Growth Equity firms, and Leveraged Buyout firms. For purposes of this blog, we will focus on the Leveraged Buyout flavor of Private Equity. Why? Because this is a blog for the shareholders of mature, successful small and mid tier firms. Firms in this category are past the "Venture" financing stage and will typically have access to lower cost capital than might be available through a Growth Equity firm.
Within the LBO "flavor" there are PE firms that are backed by "hedge funds" that tend to focus on short investment horizons and are looking for controlling interests in distressed or otherwise "undervalued" investments. Then, there are PE firms that are backed by a combination of wealthy individuals, institutions, insurance companies and pension funds who are focused on generating excellent returns for their massive portfolios. These firms typically have longer investment windows and generally work in partnership with strong management teams to fuel profitable growth leading to an eventual "exit", or series of "liquidity events" that yield returns to the fund's limited partners. Based on my exposure to a number of investors in this strain I would pronounce these folks as the "good guys" - in that they are the kind of people and investors that you might like to have as a business partner.

But, this really isn't about "them"...

This blog is about how shareholders in small to mid tier companies can (and should) tear a page out of the Private Equity playbook and behave more like a Private Equity investor - i.e. they should think of themselves as "Very Private Equity".
I hope you find it interesting.