There’s never-ending conjecture around the value that private equiteers really bring to investees. Ask a private equiteer and the list is long; ask certain jaded investees and the list is non-existent. The truth is probably somewhere in the middle.

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.

This may sound a little strange, but whenever I look around a private equity shop, including my shop, I think to myself what on Earth are we all doing? I don’t mean this in an existential sense (although that begs answering too), but more in a productive sense. We seem to spend way too much time in perfunctory meetings or way too much time analysing the past to predict the future. And, it disturbs me that this is the life of the average private equiteer.

Now, I know it’s human nature to lament our long working hours and to celebrate our stoic commitment, but let’s spare a moment to be honest with ourselves. Success in private equity is partly making good investments and partly making good investments better. Success isn’t a PowerPoint presentation, it isn’t a founder’s mistake in 1943, and it certainly isn’t a rhetorical discussion where we lionise ourselves for great work (that we haven’t really done).

If we are looking to make great investments, then we should discuss great companies, call them, visit them, sell our wares and make investments happen. If we are looking to make existing investments better, we need to visit them, understand them, distill their drivers, talk to the market, model initiatives and make improvements happen.

The problem is that most people would read those steps and exclaim that’s exactly what we do!. But, I don’t see it. I see meetings that disrupt discussions without tangible results. I see analysis that is so technical that you’d think we were exploring permutations of DNA pairs in the human genome. I see hubris attached to accoutrements, guest lists, gated estates and public appearances. I see inefficiency.

What I’d expect to see in my private equity Elysium, is a truly cooperative team, a team completely open to sharing opinions, a team with humility, thoughtfulness, self-honesty and a focus on those oh so simple objectives. A team that is so opposed to conventional wisdom that it doesn’t even know what constitutes conventional wisdom. A team that spends most of its time either in thoughtful discussion or out discovering the world, not sitting at a computer or in box-ticking meetings. In this fantasy world, my team would kick ass.

We’ve all heard the aphorism, a private equity investment is like a marriage. And, it’s even more true once you realise the dependence that private equiteers and managers have on one another. The success of an investment firmly rests on the shoulders of senior management (they operate the business after all), while senior managers are often at the mercy of the various legal controls that private equiteers have over the business (they provided much of the capital).

It is with this thought that I’m relating John Gottman’s marital communication research to private equity. It may sound like an opportunistic and somewhat tenuous connection, but I’ve come to realise how heavily private equity success depends on human factors. What’s more, people are irrational; poor relations could see parties working against each other even if it means working against themselves. And in private equity, the last scenario we want is managers working against the interests of the business.

Gottman has suggested four communication styles that predict the destruction of a relationship (he refers to them as the Four Horsemen of Marital Apocalypse).

1. Defensiveness – the destruction starts with defensiveness; it shows a loss of respect for your wisdom. Symptoms may include investee managers disregarding your advice, arguing excessively, changing opinions to counter yours, or simply using excuses to answer general enquiries. A heart-to-heart, face-to-face, honest and open discussion is all that may be needed to steer the relationship back on course.
2. Criticism - this is about making nonconstructive critical remarks about others. In private equity, this starts with managers attacking the credibility, integrity, usefulness, etc. of their private equity investors. See this as a positive, because it means you’ve caught issues early enough to resolve them. Don’t become too defensive; see it as a sign that you’re not managing your relationships properly. The key is to be open and friendly and show some humility.
3. Contempt - this is more a visceral feeling of distaste or disdain. And unfortunately, it’s difficult to turn back from a truly contemptuous relationship. Once the sight of you makes your manager’s skin crawl, it’s usually too late. Signs of contempt include lack of contact, cold communications and a general feeling that the manager wants nothing to do with you. It is resolvable, but it involves taking large risks and breaking through the cold amour of the contemptuous manager.
4. Stonewalling – according to Gottman, stonewalling is the most dangerous stage of all. It reflects complete apathy, detachment and separation. It’s the point where the manager has already made plans to remove themselves from the situation (even if years away) and now feels an odd contentment that better times are on the horizon. Private equiteers can mistakenly view stonewalling as resolved contempt because the manager seems happier, but this is rarely the case. A potential resolution (from the perspective of the firm) is to bring another partner into the investee and cut all ties. Hopefully, the slate will be wiped clean and the new partner will create a fresh new relationship.

The purpose of talking about these factors is to keep them in mind when making critical decisions that affect investees. Remember there’s much more to success than numbers and contracts; the introduction of a small fee has the potential to change the dynamic of your investee relationship forever and ultimately lead to investment failure. Identifying the four horsemen and having the humility to admit fault is critical to avoiding irreversible damage between your firm and investees.

We people are complex and it’s worth keeping aware of human factors to ensure investment success.

I don’t think you can learn to be an entrepreneur as such, but I believe you can build your knowledge in particular areas to support your aberrant ventures and pursuits. This knowledge base  is often referred to as your EQ (Entrepreneurial Quotient). I realise the term sounds somewhat silly, as if it came straight from the annals of a stuffy Yale or Harvard lecture room, but let’s ignore that for a moment.

The following list contains the competencies I believe make up your EQ. This may be helpful to private equiteers as they appraise potential investees and associated founders and managers.

• Financial management – you really need to understand how money flows through a business, from its income statement, through its balance sheet and out via the cash flow statement; plus there are all of those concepts aside from the standard statements, such as cash flow management, working capital management, inventory management, capital structure,  etc.
• Sales - you need to be able to sell to gain customers and you need customers to have a real business; grass roots experience with sales gives you the perspective needed to understand why people may or may not buy your product or service, which is paramount to being successful as an entrepreneur
• Organisation - as your business grows, the business needs someone with the organisational nous to direct efforts into the most efficient, effective and profitable activities; being organised is key to keeping focused
• Deals and transactions – deal experience gives you clout with external investors; it also helps you appraise opportunities and prepare for capital raisings, exits, acquisitions, etc; understand the potential exists for your venture is also helpful in directing its growth and it shows VCs that you have aligned goals for the business  
• Strategy - I personally believe we’re of an age in which people are overly besotted with the idea of corporate strategy, but with that said, a business still needs a strategy to pave a path to its objectives and goals; strategic experience is necessary if you plan to work on your business and not just in it
• Business modelling - this sounds simple, and you sure don’t need to inject innovation into your business model to be successful, but it helps to understand various business models when dreaming of new ventures
• Marketing -most of us are tempted to lump marketing with sales, but it really is a different kettle; marketing is less direct and requires an in-depth understanding of your customer; you should gain experience in learning from your customers as practice will lead to more targeted products and services

If you have any others, I’m all ears (pardon the pun re the picture and implicit reference).

I am totally into Customer Development at the moment. Well, I hope it’s been for more than a moment and I hope it’s for more than a moment more. Anyway, I’ve been devouring Steve Blanks’ blog lately, which has a great focus on Customer Development and how it should work in practice. The underlying theory (okay, it’s not theory, it’s fact) is that an entrepreneur should live and breathe the customer. Not in a warm and fuzzy love thy neighbour way, but more in a they pay the bills and make my business awesome therefore they are my business way.

One of my previous posts talks about responding to investee underperformance and keeping the focus on building a great business. Well, there’s a lot that comes to mind that opposes this idea and only a few things that come to mind that are in sync with the idea. Customer Development is in sync.

I can’t even nearly do it justice, so here’s the link to Steve’s Customer Development blog posts. Also, check out his slides that explain Customer Development in more detail. Enjoy.

http://steveblank.com/category/customer-development/

What the heck is a Corporate Governance Framework (CGF) anyway? It even has its own acronym for Pete’s sake. According to this acronym, not only does a corporation need governance, but that governance needs a framework. And, not only does corporate governance need a framework, but it needs interminable discussion about what constitutes this framework. Wow, I have a headache already.

What happened to working towards a greater good and being a part of something innovative and rewarding? What happened to only acting in a way that you would be proud to see published and proud to tell your mother? What happened to just being a decent person who gives, shares and empathises with others? Truth be told, I’m not so sure.

Corporate governance somewhat ties into the idea of the principal-agent problem because it is associated with executives that don’t act in the interests of the people (whether those people are shareholders, members of society or the man on the moon). I realise it’s a necessary evil, mostly for large listed businesses (that have lost the plot), but what concerns me is talk of a CGF in SMFEs (the F is for fast growing). If you refer to my previous post (Responding to the current unpleasantness), you’ll see I’m a fan of keeping it simple, especially in times of turmoil. So, my nonconstructive advice regarding CGFs is to get a grip, be brutal with anyone wavering from the greater good, and get on with the business of building a great company.

Over time, there have been many distinct management ideas that have shaped the thinking of corporations and their incumbent management. Corporate strategy, as one of these ideas, has existed for almost 50 years and formed the basis of many subsequent ideas. But, has the idea of corporate strategy become something other than what was originally intended? Have strategic consultants over-bureaucratised business with their own overly regimented version of corporate strategy? Are companies even benefiting from all of this centralised instruction?

The father of strategic Management, Igor Anhoff, said that strategy is a “rule for making decisions”. Michael Porter told an American business school that strategy “has to do with what will make you unique”. However, Richard Koch, Mr 80/20, believes that despite these clear and concise definitions, corporate strategy has done more harm than good because “the Centre” typically enforces it.  That is, people without real-world experience and by people detached from the coalface usually run it. 

In light of my experience with what I see as new-age corporate strategy, I am feeling a pull towards the management idea of adhocracy, especially for small, medium and fast-growing enterprises. While some define adhocracy as the opposite of bureaucracy, I like to think it’s a more responsive structure borne by decentralised strategy. It puts strategy in the hands of business units, which arguably, best understand what works and what doesn’t work. More importantly, what it doesn’t do is put strategy in the hands of external consultants, fresh out of business school, without a minute’s worth of coalface experience.

Unlike what critics may espouse, adhocracy doesn’t have to be unfocussed. It doesn’t have to mean the engineering unit only strives to be bleeding edge, that the marketing unit only works to build the biggest brand, or that the finance unit only tries to cut costs. An adhocracy should always work towards the greater good (which is usually market positioning, customer satisfaction and all of those staid ideas), but by recognising the benefits of decentralised thinking. Anyway, after the nonsense I’ve seen lately (mostly coming from strategic consultants), I really think adhocracy is worth a second thought.

What does it take to become a lean, mean entrepreneurial machine? I’m not so sure, but I’ve listed a few points to keep in mind (this is just as much a note to self as it is a post for you). All of these points involve differentiating yourself from the herd; they involve working hard mentally, which really means leaving your comfort zone and realising the scarcity value of certain skills.

• Live simply: it’s a monumental advantage to not need what others need. To not need expensive clothes, gourmet food, a luxurious condo, a regular cup of coffee, an LCD television, etc. Living simply saves money, time and brain power, and it promotes lateral thinking.
• Think big, think laterally: swing for the fences, like really swing for the fences, but do so independently. Make your goals unachievable, but find innovative ways to achieve them. Thinking laterally isn’t about inventing another Google or Facebook; it’s about working with a clean slate. No limits, no preconceptions, no egos, no vices, no money, no skills, no rules, no bureaucracy… just a few thoughts, a pencil and a bag-full of determination. Traditional wisdom is your enemy.
• Debt is king: this is daring to say right now, but let’s be honest, if you have great ideas, great skills, great conviction and great execution, what’s the problem with debt? You’re putting everything on the line anyway, so why dilute your equity if you have the cash flows and ability to raise debt? Buffet would disagree, Trump would agree; but we’ve ditched traditional wisdom remember, so who cares who agrees? Do it properly, do it sensibly, only do it with conviction, and hopefully you and debt will remain best friends.
• Scalability is paramount: your potential market needs to have serious scale to provide the necessary opportunity and to allow for miscalculations and mistakes. Rock stars and movie stars are wealthy because their work is scalable. If there’s anything you need to learn from a rock star, it’s the value of scalability.
• Education begets success: identify what matters to business success and learn to be successful in those areas. Learn what matters; prioritise what matters; become an absolute master at what matters. This doesn’t mean enrolling in degrees to learn low level skills. It means talking to competitors, learning the market, understanding the customer, knowing how to run tight cost centres, etc. You should never need to take an exam for this education; exams are for company-men/women who need to justify their existence. (I realise we all need to do exams at some point, whether it’s in prep school or college, but work with me here.)
• People provide the power: it’s not easy leading people, but people give you more leverage than debt. People allow you to build a phalanx of business mercenaries with which you can take down the most difficult markets. You can invest $100,000 a year in one person whom can easily make you $500,000 a year; now that’s an investment. Many highly intelligent and motivated people would rather work for the certainty of a salary, and this is one of your greatest assets in business. Learn to lead and work as a team with other people and realise they don’t all need equity to be motivated.
• Patience is not a virtue: waiting for you is procrastination, waiting for others is subservience. An entrepreneur doesn’t wait; he/she moves constantly in mind, body and spirit. Time is money, time is scarce, allowing time to lapse unnecessarily is certainly not an entrepreneurial virtue.
• Be honest with yourself: even if not with others. What is your actual situation, what do you actually need, how is your business actually placed in the market, etc? This can be as simple as realising you don’t need a new suit. Or it can be as critical as realising you need to improve your communication skills. Be honest about what really matters and be honest with what really needs to be done.

I’m very interested in your thoughts and other comments about what makes a lean mean entrepreneurial machine. So please post a comment if you have something interesting.

Private equiteers need at least an ounce of entrepreneurial blood to handle the travails of the private equity industry and to make, manage and exit great investments. This ounce of said blood has its downfalls though; it constantly pulls at the strings of a private equiteer’s ambition. He/she spends so much time looking for great businesses, helping them improve performance and guiding business owners to riches that he/she often dreams of being in the opposite position.

Especially in the formative years of a private equiteer’s career, the returns (in terms of both satisfaction and cash) look much more compelling. The sobering fact is that it often proves true. The fixed management fees of a private equity fund (until raising subsequent funds), don’t allow for too much in the way of salary increases and bonuses (we’re talking mid-market funds here). And carry for fledgling private equiteers can amount to little more than gym membership once present value is calculated (note: we private equiteers calculate the present value of everything). 

So, why aren’t we all off to run our own successful businesses? Firstly, the patient private equiteer arguably has a greater chance to build greater wealth if he/she can just keep a lid on that entrepreneurial pull. Secondly, going for broke as an entrepreneur has a binary outcome, either success or failure, and not everyone is willing to gamble with their livelihood. (Note: in my opinion, the opposite of success is failure and the opposite of mediocrity is mediocrity; so, failure is a very likely outcome if you put everything into achieving success.)

Lastly, who says private equiteers aren’t running off to start businesses? It’s a very real career path and can be a very rewarding one. The fact is that we can’t all start our own private equity firms and achieve great success, so the entrepreneurial route isn’t such a bad one.

Following on from my post on working capital, I want to make a quick mention of the financing (and factoring) available to businesses to solve working capital issues. With this type of financing, a company invoices a customer, sends a copy of the invoice to the finance company, and the finance company extends a loan, which uses the invoice as security. When the customer pays the invoice, it pays the finance company to settle the short-term loan against the invoice. The terms of the financing determine whether the customer pays the financier directly or indirectly and how much of the invoice will be lent (usually up to 80%).

This type of financing (called trade, debtor or receivable financing) is most suited to B2B or to B2C in which invoices are used. And, the distinction between debtor financing and debtor factoring is that the former involves lending against the debtors, whereas factoring involves the purchase of debtors at a discount. The discount in factoring represents a financing cost in the same way an interest charge on debtor financing represents a cost.

In some cases, debtor financing or factoring competes against private equity. The process of securing financing or factoring is much quicker and less involved than securing private equity. Both are arguably more expensive than other forms of capital, but of course, a private equity investment is more than just short-term funding. So, the decision between the two depends on the objectives of the business. And, there’s no reason you can’t have both, which is really the best of both worlds for most businesses.

An important side note is that debtor financing and factoring is a common source of business fraud. As you can imagine, it’s quite easy to manufacture fake invoices to have additional funding advanced. These fake invoices are fresh air invoices and the underlying fraud is fresh air fraud. The other important note is that the focus is on the creditworthiness of debtors rather than the business itself… for obvious reasons. So, it can be much easier to secure if you have solid customers, even if you are having performance issues.

 Correct pricing is of paramount importance in any business. Pricing directly relates to demand, which directly relates to sales, which directly relates to profit, which directly relates to value, which directly relates to carry. Yes, the C word. If a business charges too much, it won’t be competitive. If it charges too little, it won’t be profitable. At worst, a business that doesn’t price correctly will be competed out of the market or driven to a lossmaking state. With the right pricing, a business will lead its field, build brand loyalty, have the cash to expand, and be highly profitable.

There are generally three different pricing strategies as follows:

• Cost-driven pricing: this involves adding up all costs and adding a profit margin to arrive at price.
• Competitive pricing: this involves using the prices of competitive products to arrive at your price.
• Price-driven costing: this involves understanding the ideal market price and incurring costs accordingly.

As per Peter Drucker’s Five Deadly Business Sins:

The third deadly sin is cost-driven pricing. The only thing that works is price-driven costing… to start out with price and then whittle down costs is more work initially. But in the end it is much less work than to start out wrong and then spend loss-making years bringing costs into line – let alone far cheaper than losing a market.

Drucker’s argument is certainly robust and prescient. It talks about delivering on required specifications and required price; the two go hand-in-hand. Whereas, the typical method of pricing is to design a product based on initial market testing about specifications, and price it according to the costs incurred for the desired (and assumed) specification. This ignores the relationship between specification and price; customers only want a particular specification if the price is right.

As my introduction suggests, pricing can create effect all the way down the food chain (all the way to a firm’s carry). With that said, I thought it would be an interesting topic for today, especially for investees that are proactive in developing new markets (and new pricing).

Let’s get a few things straight to begin with. Firstly, the characteristics of an attractive industry are the same regardless of economic conditions; that is, prospective industries should always present opportunity and not represent excessive risk. (Oxymoron you may say, but it doesn’t have to be.) Secondly, an attractive industry today isn’t necessarily an attractive industry tomorrow; fundamentals can change quite quickly. Lastly, an attractive industry for you should also be an attractive industry for me. Some firms may specialise, but I’m talking in general terms here. 

Here is a list of characteristics that lead towards an industry being attractive for private equity investment:

• Large market: the theory here is that the market needs to be large enough to support the type of business you are hoping to own at the end of your investment period without miracles occurring (such as abnormally large market share).
• Low reliance on uncontrollable variables: private equity is about backing a great management team and helping to drive a great business to abnormally high value creation. Uncontrollable variables such as the weather, commodity prices, burgeoning technologies, etc. unnecessarily detract from management’s ability to create value. 
• Moderate competitor fragmentation: low fragmentation may lead to fewer potential investees and a low chance of entering the industry. It may also be harder to invoke a roll-up strategy or take market share if there are fewer poor managers. However, if fragmentation is too high, it may be difficult to find a decent sized player and it may be difficult to gain traction through an acquisition strategy. 
• Low customer and supplier power: if either suppliers or customers have excessive power, than the pricing of products or services may not be adjustable. The ideal industry is at the most valuable point in its value chain; that is, the industry adds the value and the suppliers and customers are simply commodity traders or middlemen. Therefore, they have control of prices, profits and value.
• Attractive exit options: without a range of exit options, it is difficult to play potential buyers against each other and therefore secure the best price. There should always be an honest expectation to be able to list a firm because there’s no rule about a particular industry being un-listable; public markets will always be interested in a great business with sustainable and reliable cash flows. Similarly, there should be many potential trade buyers; again, if it’s a great business, others will want it. 

If you don’t agree with any item on my list or you believe I’ve missed an important point, please leave a comment for other readers to consider.

The board of directors of an investee may only meet once a month, but they have the responsibility of driving the business from the top. Being a director or chairperson may seem like a figurehead role, but it’s actually a very influential role, especially in smaller businesses. The same way that private equity firms say that a great manager can make any business, well, a great board should be able to do the same (they should be hiring the best managers as well as driving the business in the right direction).

The following points describe the anatomy of the ideal board:

1. Make sure the board consists of people who will attend board meetings. Don’t select people who are on 20 other boards or who are overseas often; for the mid-market, the board needs people that will actively add value through their actions, not just their name.
2. Involve senior management for segments of the meeting so the meeting is more directed and informed. But also make sure there’s a period when senior management are not present so the board can talk frankly.
3. Have a reasonably balanced mix of private equity firm reps, founders, executives and independents. Make sure there’s at least one independent with deep industry experience. The number of private equity firm reps shouldn’t out-number the remainder of board members.
4. Keep the total number of board members to a reasonable number; 5-7 is the maximum number needed for the mid-market. Too many people will create a bureaucratic mess and will dilute the output of proceedings. 
5. Ensure a customised agenda is prepared for each board meeting so discussion is targeted and everyone knows the intended outcomes of the meeting. Start each meeting with an outline of the agenda and be sure to stay on topic, at least until the end.
6. Send all supporting documentation earlier; at least three days to a week before the meeting so everyone has time to prepare. You don’t want people seeing information for the first time at the meeting unless it’s hot off the press and relevant to discussions.
7. Keep channels of communication open so board members can continue to provide guidance aside from the meetings. Too many boards leave issues until meetings and wonder why issues are getting out of control.