So how does an LP conduct due diligence on a GP to make their investment decision?

1. Past performance: in public markets you often hear the disclaimer, “past performance is no indication of future performance.” If you watched the men’s snowboarding at the Winter Olympics, you’d probably disagree. Actually, if you look at most things in life, you’d have to disagree. If a PE firm consistently outperforms, through thick and thin, that’s a very good bet. But, people and times change, so it’s important to look at other factors too.
2. Team dynamics: I can’t overstate how important team dynamics are in a fund. You need the team committed, engaged and motivated to do its best work. But more importantly, you want them to care about the success of the fund. LPs wrongly think that giving GPs equity will make them care. We’re not that rational. People care about whatever the heck they want to care about. Visit the team, talk to a sample of people, and ask questions that will gauge their emotional commitment. If GPs aren’t excited and engaged, there’s probably an underlying problem that you won’t be able to uncover in the time allotted.
3. Leadership: any group of people can do amazing work if they’re inspired by a great leader. The group doesn’t need to be intelligent by IQ standards, or have contacts within the industry, or even have a history of performance, as long as they’re inspired. An LPs questioning should test whether the employees think they work for the best people in the industry. Any indication otherwise is a bad sign. Apart from the fact people will jump ship, it shows something fundamentally wrong with leadership at the firm.

You may be wondering why I’ve concentrated on the “soft” aspects of a firm. Why haven’t I talked about education, qualifications, seats on boards of public companies, industry lobbying, etc? It’s for one simple reason. An uninspired and unmotivated team is dead wood, no matter how qualified they are.

I’ve seen it time and time again, qualified people who are absolutely useless because they aren’t engaged. But I’ve also seen engaged novices originate leads, close deals and make a difference, without an ounce of finance experience. That’s why I think it’s important for LPs to focus on team dynamics, leadership and care factor.

Of course, I’m not an LP, so I wouldn’t know what works best, but that’s my take nonetheless.

People will make up their minds about you in these first few weeks. They’ll be watching and analysing your every thought, every word and every action. They’ll use this to decide whether they’ll work for you or against you. It may sound unjust of them, but you probably closed the deal by promising the world. So now it’s showtime.

Here are a few other thoughts to consider once you make a new investment:

• There may be lingering bad blood from the negotiation phase, so make sure you reconnect with everyone who’s still involved in the business; change the focus from the transaction to the future
• Make sure you act on the findings from due diligence; it wasn’t just for show, it was commissioned to better understand the business and better understand the next steps to strengthen the business
• Communicate with management and visit them often to show your support; again, you need to transcend the adversarial relationship that developed during deal negotiations
• Minimise the annoyance of implementing new systems by making changes fast; this applies especially to new financial reporting processes, which often require a lot of effort upfront
• Offer your services and your firm’s services over and over and over again, and act quickly on any promises; you will gain respect and credibility by showing you don’t mind rolling up your sleeves
• Focus on tasks that businesses often neglect, for example, contacting acquisition targets, renegotiating bank terms, gathering intelligence from competitors, collecting customer feedback, etc.
• Most of all, keep acutely aware of the culture, people and politics and adjust quickly and ask for explicit feedback; you need the support of the people, without it you’re doomed from the outset

As you can imagine, your performance early on sets the stage. It feeds back to others and especially onto other entrepreneurs who may be looking for investors now or far into the future. Think of that extra effort now as what it takes to future proof your firm.

Image: It’s only the beginning? [source: Shutterstock]

The problem is that the other guy is often no guy at all. That is, a business may decide to fund its growth using its own cash flow. Such businesses understand private equity is an expensive proposition (i.e. a high cost of capital), so they don’t see the logic in employing external funds if they already have the funds. This may sound somewhat limiting, but with millions of dollars of free cash flow and significant borrowing capacity, most successful businesses can do quite well without external investment.

However, there’s always the what if scenario: what if we had unlimited funding and what if we could achieve world domination? This is where private equity enters the fray. With virtually unlimited capital and an extended team of highly experienced businessmen, there are fewer limits; the sky is the new limit. Additionally, it’s human nature (and the nature of most entrepreneurs) to become more excited about potential upside than potential downside.

So, the decision often comes down to the volume of that niggling voice. The voice that brings dreams into the scope of reality. The voice that feeds an entrepreneurs voracious appetite for risk and adventure. The voice that ignores the size of your offer and currency of your attire. It all comes down to an irrational voice.

Images: Owners of successful businesses have many options [source: Shutterstock]

Preparation for sale or exit should start the day you make an investment: potential buyers of your business in three or four years will look at long-term trends in determining their price. A sudden spike in earnings just before sale will likely be discounted and an abnormally good working capital profile will likely be ignored. You would do the same if you were the buyer, so put yourself in the potential buyer’s shoes from day one.

As part of your initial 90-day tactical plan, you should aim to make all of the working capital improvements discussed in Working Capital Series: Improvements and one-off cash wins. Implementing these early will establish a good working capital profile and show long-term structural improvements to potential buyers.

As a potential sale looms (before you even prepare a prospectus or deal book), draft a plan to deal with the negotiation tactics of potential buyers. The following list provides a few hints to maximise the final sale value:

• Pay out excess cash as dividends before anyone gets there hands on your financials. Buyers will no doubt try to justify why it’s not in fact excess cash and is actually required working capital. So pull out the cash long enough before the sale to show it’s not required.
• Make a particular effort to collect bad debts and late debtors. Potential buyers will exclude these from any net asset calculations, so it’s important you don’t give this cash away for free.
• Sell obsolete and slow-moving inventory. Buyers won’t place a value on excess inventory, so it’s better for you to profit from selling it. It will otherwise be absorbed by the buyer’s earnings multiple valuation.
• Sell all other excess and non-operational assets. Again, buyers will typically value your business on earnings, so excess assets don’t enter the equation. It’s best for you to profit from an asset sale, but make sure it doesn’t appear that you’re preparing the business for sale; buyers don’t like such premeditated actions.
• Fully prepare yourself for the “net asset” conversation. At some stage you will need to decide what the buyer will receive at the date of settlement. This means putting a stake in the ground and declaring final debtors, creditors, inventory, cash, etc. Understand all of the options, test all of the calculations and consider all of the scenarios. This will help you to maximise value when the topic arises, which it inevitably will (see Working Capital Series: the locked-box approach for the theory behind net assets at settlement).

As you can see, the best way to prepare for a sale is to imagine you’re on the other end of the transaction. Think of all of your own negotiation arguments when you’re making an investment and then turn them around to help you prepare for those same arguments, but from the other side.

Images: Stop potential buyers from discounting their valuation at exit time [source: Shutterstock]

I’ve previously harped on about how working capital drives an investee’s value (see, Working Capital Series: Valuation). It receives this attention because it can affect value more than we often want to believe. Additionally, it’s not something that’s easily controlled; many external forces are at play (forex, shipping, terms, supply, demand, etc.)

But, with risks, we get areas for potential improvement. And, just as working capital can collapse a business, it can make a business thrive too (see, working capital profiles).

The primary drivers of working capital are the trade accounts: debtors, creditors and inventory. These accounts financially represent the trade cycle, which starts from the moment a customer commissions a product or service, to the moment all cash settles (inflows and outflows). Optimising working capital is really about optimising this trade cycle. This means ensuring your bottleneck is customer demand rather than your production cycle or payment terms.

One-off cash win #1: Payment Terms

When financial analysts think about improving working capital management, they immediately think of improving payment terms. This means getting your customers to pay sooner and your suppliers to accept payment later. Sometimes these are non-negotiable, but most of the time there’s potential movement. A particular area for improvement is on the supplier side, especially if they’re overseas. Most overseas suppliers will ask for a prepayment before they even ship the goods. But, if you can build trust and have them waive payment until the goods arrive at your local dock, this can lead to a monumental improvement.

One-off cash win #2: Inventory Management

It goes without saying that if you can sell the same amount and spend less on inventory, you’ll be better off. You can achieve this through streamlining any number of parts of your production and sales processes. You can also achieve this by rationalising your offering and reducing your number of SKUs (stock-keeping units). Overall, you need to find a balance between the inventory kept on hand and satisfying customer demand. Often it’s better to disappoint customers than to keep hundreds of slow-moving SKUs. Also, a great one-off cash win is to put your obsolete and slow-moving stock on sale, but make sure to keep your stock rationalised after you get rid of the dross.

One-off cash win #3: Operational Efficiency

When you optimise your payment terms (see #1), you’re bringing your inflows closer and pushing your outflows further. But, what does this really mean? Well, you may pay a supplier 60 days after you receive your raw materials and you may demands customers pay within 14 days of receipt of the finished product. But, there is still one major variable left: the time between receiving the raw material and shipping the finished product. This is where operational efficiency matters. You want to minimise this time to further optimise your cash cycle.

Operational efficiency deserves a few textbooks of its own, but for the purpose of this post, just consider what drives timing in your organisation. Often it’s people and process. Keep your people motivated and continually improve your processes and there’s no reason you shouldn’t excel in the area of operational efficiency.

Images: Good working capital management can make it rain money [source: Shutterstock]

Swapping Capital

• Transition – many private equity transactions occur because, for whatever reason, there’s a transition of ownership and/or management. We know these transactions as MBOs, MBIs and, of course, BIMBOs (we’ve actually done one of these transactions). The drivers for transition can be anything from an outrageous offer to the current owner simply calling it a day.
• Succession – this is a form of transition, but more specifically involves an owner reaching pension age and passing the business on to family members or new owners. In either case, a private equity firm can sponsor the buyer to purchase the business from the seller. This often works well because the prospective buyer has an entrenched understanding of the business, but doesn’t have the funds to help pay the seller a hefty one-off pension payment.
• Privatisation – we hear about many private equiteers that exit investments via the public markets (i.e. IPOs). But sometimes, if a listed business is undervalued or the private equiteer has lost his/her mind, we also see them enter via public markets. We know these transactions as public-to-private deals. However, they’re not as common as other transaction types because the process can be painful. Apart from needing to convince thousands of stockholders to sell, you often need to pay a premium to convince them to sell.
• Consolidation – sometimes it can be a pain in the backside to have a fragmented stockholder base, even if there are only 5 or 10 investors. In this case, a private equiteer will sponsor a more enthusiastic stockholder to buy-out the less enthusiastic stockholders, giving him/her more control to drive growth. This may also be the result of a succession or expansion transaction.
• Equitisation – this involves changing the balance of debt and equity in a business. Often a private equiteer will invest to de-leverage a business by paying down some of the debt. This may be a turnaround situation or as a way for a business to bring in a private equiteer (for their skill, contacts, etc.) without burdening the company with new equity it doesn’t yet need.

Injecting Capital

• Expansion – this is the typical venture capital scenario, but also a private equity scenario, when a business needs more money to expand. The money may fund plant & equipment, working capital, staff, professional services, marketing, or any number of other needs. In this case, the investment requires the issuance of new stock, often with preferred status. This isn’t as common as one may think (in private equity) because typical private equity candidates already produce significant cash flows to fund growth or at least the interest payments on debt (which we know is much cheaper than private equity). It’s more common in businesses with unstable cash flows, already high gearing, a lack of financial sophistication, or a specific need for a private equity investor.
• Acquisition – this is simply a specific example of expansion funding, but it differs because it often requires capital that can’t be funded by maintainable cash flow. Acquisition funding is a very common driver for private equity funding, and unlike my comments above for expansion funding, it is often needed by businesses with stable cash flows and only moderate gearing.

As you can imagine, most transactions fit into more than one of the above categories. Expansion deals may consolidate the stock register, acquisition deals may involve ownership transition, and privatisation deals can often trigger some form of equitisation.

As a private equiteer, there are many tools in the toolbox, and by using these tools, we can structure deals that appeal to the most stakeholders while also delivering value to our funds.

Images: Capital injections are not the only form of private equity [source: Shutterstock]

1. Those you know will be unprofitable, and
2. Those you don’t know will be unprofitable

The first group is often the result of a “loss leader” approach where you expect to create future value from sacrificing some current value. The potential future value may be in the form of increased volume, new synergies, higher prices, better reputation, etc.

Something as simple as sample paint (that you take home to compare to other colours in your home) is a loss leader; the paint company loses money on supplying free paint, but it gains from brand loyalty/awareness, should you like the sample colour and decide to purchase it.

However, the risk with loss leaders is that they continue to lose and don’t start to lead. Imagine if someone took enough sample paint home to paint their entire house. Or, imagine if potential customers used your sample paint, but bought the identical colour from a competitor at a lower price. So, you really need to keep abreast of  loss leaders and ensure they stop losing and start leading.

The second group of unprofitable customers is generally the result of mispricing. Either your investee didn’t estimate costs accurately or they didn’t charge the customer enough at the time of purchase. This is inevitable in most businesses, but it shouldn’t be accepted without action. The loss can be more than just lost profit; it could set a precedent, it could convey a message of inferior quality, or it could create a price war.

To prevent customers becoming unprofitable, it is important to monitor investee profitability by customer (in addition to by product/service, by location and by salesperson). This granular approach will ensure the sources of losses are found quickly and rectified effectively. If you’re thinking it sounds overly bureaucratic to take such granular measurements, then you must simplify the process. Get the investee comfortable with a standard reporting template and ensure the process of measuring, calculating and reporting data is consistent.

One of the most contentious issues when buying/selling a business is the working capital adjustment at settlement. This is often a bone of contention because it goes to value, is easily manipulated and changes on a daily basis.

My suggestion in a recent post was to draw a line in the sand and agree a working capital figure so a dollar-for-dollar adjustment could be made at settlement. For example, we may agree that working capital will be $10m at settlement, with at least $4m in cash. So at settlement, if working capital is different, we can make a dollar-for-dollar adjustment to the purchase price. The problem with this method is deciding the level and dealing with all of the variables in the interim period.

A few comments from readers suggested I consider the locked-box approach. I have seen this used previously, but my initial thought was the settlement date would need to closely follow the receipt of audited statements. Otherwise, you’d be getting the upside of a business that you don’t legally own (you’re not exposed to the full risks yet). However, there’s a solution, which I’ll mention after explaining how the locked-box approach works.

In the broad strokes, the locked-box approach uses the most recent financial accounts to lock working capital drivers and hand economic interest of the business to the vendor. In simpler terms, the vendor cannot take a cent from the business after the accounts are locked, and the investor bases his/her valuation on this scenario. Of course, working capital won’t be the same at settlement, but any movements will offset net debt in the EV calculation and the original valuation will hold true. If the vendor must take value from the business for some reason, a similar adjustment can be made.

As for the problem of receiving profits while not holding business risk, well, the solution is to introduce an interest charge over the business whereby the vendor receives compensation for holding the risk. Most likely this interest charge will offset the purchase price. This isn’t a perfect solution by any means, because the interest charge introduces subjectivity. But, it does seem to be the lesser of two evils.

Unlike venture capital, most private equity firms don’t have domain expertise in all of their investees’ industries. But, what private equiteers undoubtedly bring, is a fresh, external and highly-motivated perspective. And, just as a second set of eyes improves most writing (this post is a good example), a second set of minds improves most investees.

So, if we’re not industry gurus, how do we expect to add value through applying a second set of minds? Well, it’s best to start with what we know best… business. Rather than trying to teach aeronautical engineers how to design planes, we should show them how to make money from planes as a business. We should provide the complementary skills to take an ordinary business with great products & services to a great business with amazing products & services.

The is all much easier if you start with the most complementary areas first. Back to the aeronautical engineering company, chances are, they aren’t as good at selling planes as they are at making them. And, they probably aren’t as good at negotiating strategic acquisitions as they are at appraising the technologies used in those potential targets. So, know your strengths and start by adding value in the most obvious places first. Consider:

• Sales Generation
• Financial Management
• Business Transactions

Now, I’m not saying these are the only areas in which private equiteers can add value. I’m simply saying that my experience is that private businesses are weakest in these areas.

It’s an interesting exercise to consider your investees right now. Are you doing everything possible for them in the areas in which you have the most complementary skills? Everything possible? Do they have an amazing sales team? Are they aware of the most important financial drivers and do they monitor them very regularly and act on the data? Are they fully aware of acquisitive opportunities and are you doing everything to land them? Conceivably, if you can’t say yes to all of these, then you’d have to ask yourself what you’re really doing.

In most franchise businesses, there’s constant conjecture around the ideal balance of franchised versus company-owned stores. Prima facie, you may think company-owned stores breach the idea of the franchise model, but we also interminably hear how repurchased stores operate more profitably when company-owned.

Maybe franchises only work in certain industries, maybe it’s just not easy to find great entrepreneurs to run stores, or maybe the fault lies with franchisors.

As a private equiteer, it’s important to analyse the dynamics and differences between franchised and company-owned stores. But, more importantly, be wary of bold plans to repurchase stores just because the franchisor thinks they’ll become more profitable. I see countless deals solely based on this premise, but I just don’t buy it. If anything, these audacious repurchase plans seem to be exercise in palliation, rather than value creation. And, they’re especially questionable if the businesses success was founded on the original franchise model.

With all of that said, company-owned stores are great for franchisee training, market and product testing, and benchmarking; they’re not all bad like it may sound. There are also situations in which the franchise model was only originally needed as a workaround for limited capital. And in these situations, it’s hard to make a case against a franchisor looking to buy back great money earners with the support of a friendly private equiteer.

Just be wary of spurious claims and Band-Aid solutions for terminal problems.

To recap, we care about working capital because it is a direct driver of free cash flow and everyone loves free cash, ergo, everyone cares about working capital. But, before we talk about improving working capital, it’s important we understand how to measure and monitor it. If we measure it in a consistent way, we’ll learn the effectiveness of our improvement initiatives and may even find ways to create more cash from the same accounting earnings.

So, what are we actually measuring? We’re measuring something called working capital absorption. That means, we’re measuring how much cash is absorbed by our working capital profile. The best case is negative absorption (production of surplus cash) and the worst case is total absorption (no one pays their bills; imminent insolvency). The most common way to measure this absorption is via a ratio of working capital and sales (WC/Sales), which conceptually tells us what percentage of sales is tied up in paper earnings and not yet realised as cash.

The genius of WC/Sales is its simplicity and scalability. Even as a business grows, we can monitor how our working capital profile is changing with that growth. Ideally, it will get better as our customer and supplier power increases through shear size, but it can also get worse if our growth is borne by lower credit standards and less reliable debtors. Either way, WC/Sales is best measured weekly or even daily and viewed as a trend over weeks or months.

For a more granular measurements, we can look at the day measurements. That is, debtor days, creditor days and inventory days. Don’t be fooled, these are just ratios converted to turnover measures. For example, debtor days is simply Debtors/Sales multiplied by the number of days in the year (note: some people use year-end debtors and some use average debtors). The creditor and inventory day measures are the same, except they’re a ratio denominated by COGS rather than sales, for obvious reasons. In a conceptual sense, these day measurements tell you on average how long those items are turned in a year. For example, debtor days of 45 means on average debtors are settling their accounts within 45 days.

In practice, I like to use WC/Sales and debtor/creditor/inventory days in unison. If I see an investee’s WC/Sales increasing, I immediately look to my day measurements to find the offending driver. Often there is a single offending driver, which I can place most of my focus on to help management rein it in. However, there are often cases where that driver has become unruly due to some uncontrollable factor, like a structural shift in the market. In those instances, I can focus my attention on an opposing driver to help management rein in the broader WC/Sales metric.

Since working capital can be influenced greatly by a single payment or shipment, it is important to measure it often and monitor trends continuously. In fast growing businesses, you won’t believe how quickly poor working capital management can yield devastating results.

An agreement on value doesn’t necessarily signal the end of all deal negotiations and troubles. Partisan vendors will likely hand the business over with zero debtors, zero inventory and a mountain of creditors… oh, and no cash, of course. A scenario like this may see you paying millions more for a business than you had originally planned.

As I’ve discussed in a litany of working capital discourses, working capital goes to value. But, it’s not just the value imputed to the business at a particular point in time; it drives the value you’ll actually get when the business is handed over. And, the last thing you want is to base your valuation on favourable working capital terms and receive the business in an opposite state.

The simplest solution is to decide the settlement accounts at the time of valuation. That is, place a few imaginary stakes in the ground and peg your working capital drivers (decide a fixed amount for inventory, debtors, creditors, cash, etc). If at settlement working capital is not equal to the trigger amount, then the purchase price is adjusted on an equal basis ($1 less in working capital leads to $1 downward adjustment to the price paid). Many private equiteers will try to enforce a one-way adjustment,  but as Sergey and Larry say, don’t be evil.

This isn’t a perfect solution. But, it is a solution designed to be communicated upfront with complete transparency. It will avoid most resentment later on because there is a lot less subjectivity. With that said, there will be some subjectivity in deciding the trigger values for the working capital drivers, but ideally you can make a case based on rigorous analysis of the historic financials.

The simple rule is that you value a business as a going concern and so the business should be left to you as a going concern (therefore, not requiring extraneous investment to support working capital after purchase). Make sure you decide early what constitutes a going concern and then stick to your guns.

There are various methods used to value investees, but private equiteers tend to focus on earnings multiple valuations and discounted cash flow (DCF) valuations. Working capital affects these valuation methodologies in the following two ways:

1. The earnings or cash flow figures may be influenced by changes in working capital (delta) across periods
2. The net debt (specifically cash) position may be affected by the operational working capital requirements of the business

In a discounted cash flow (DCF) valuation, working capital is analysed to help calculate free cash flow (FCF) for each period (see right for equation). These free cash flows are discounted and summed to arrive at a valuation. This is simple textbook stuff, so I want to concentrate on working capital considerations in earnings multiple valuations for the remainder of this post.

Unlike a DCF, an earnings multiple valuation is based on maintainable earnings; that is, the level of earnings that can be maintained indefinitely. If all else is equal, working capital (from an analyst’s point of view, i.e. ex-cash) remains the same across periods and so there is no cash surplus or shortfall between periods. And so, there should be no working capital offset in the maintainable earnings calculation.

You may be thinking, “but we don’t expect earnings to stay flat and so there will be working capital consequences and since different businesses are affected differently as they grow, we need to consider it somewhere.” Well, you need to account for this via the applied price multiple. What does that mean? If the firm’s working capital profile spins off a lot of cash, investors will be willing to pay a higher multiple, and vice versa.

Remember, even though growth may increase the theoretical cash shortfall, growth also generates greater earnings and greater value.

So, the verdict on point 1 (from above) is that the earnings figure used in an earnings multiple valuation should not be adjusted for working capital delta because it is a maintainable estimate. However, you may account for a firm’s working capital profile in the multiple if it is abnormal or if the multiple is already assuming high growth.

The one exception is where you know of a material change to working capital that will create a material difference between current and future earnings figures.

Onto point 2 (net debt position): working capital may affect the enterprise value (EV) because not all cash at bank can be used to repay debt. You may remember from the basic EV calculation that EV equals equity value plus total debt less cash; the idea being that cash can pay down debt. However, you shouldn’t simply assume that all cash at bank is excess cash to pay down debt.

There are numerous examples where cash is needed to support a firm’s operations and hence, is part of its earnings multiple valuation. The simpler way to think about it is, how much cash can I remove from the business without causing disruption? Since an earnings multiple valuation is theoretically based on future earnings, I personally believe that enough cash should be left in the business to support working capital gyrations for the first year.

This doesn’t mean that if cash momentarily dips $2m that the vendor should leave $2m for the new investor. What is does mean is that enough cash should be left to pay the finance/opportunity costs of supporting that $2m working capital requirement for the first year. I think this is fair since you’re valuing the business on future earnings and it will take a momentary investment of $2m to create those earnings.

There are also other scenarios in which vendors should leave cash in the business. In retail businesses for example, if all cash is taken from the tills, the business won’t operate properly. Ipso facto, the money required to adequately fill the tills is operational and included in the earnings multiple valuation (and shouldn’t be considered excess cash). It may be difficult to agree a number in this case, but theoretically I believe the reasoning to be sound.

So, the verdict on point 2 is that not all cash at bank should be thought of as excess cash in a earnings multiple valuation. Any cash required for the operations of the business and/or to subsidise the opportunity costs of cash shortfalls should be left in the business. In an EV calculation, this cash should not be used to reduce debt to arrive at a net debt figure.

This is a long post, but I hope it helps to form your own views on working capital and valuations. It should be a simple topic, but theories seem to change daily; depending which side you’re on in today’s latest deal. If you think I’ve left something out or if you have alternative views, please let me know.