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%."