This is a follow on from my post about the amplifying effects of diminishing sales, which was just a simple explanation about how a 20% earnings drop could lead to a 60% value drop. A likely consequence of this phenomenon is that a plethora of vendors under earn-out agreements will now be counting their chickens and discounting their eggs. Whereas not long ago they had visions of majestic chateaux on la Côte d’Azur, they now mostly have visions of decimated pension funds and impossible earn-out targets. 

There are a number of ways to look at unpaid earn-out targets, some optimistic and some pessimistic. Firstly, unpaid earn-outs can still be a boon for private equity firms because, in an absolute sense, they’re paying less for the business than otherwise (although, in a relative sense they could be paying a higher multiple if earnings fall enough). However, this is only beneficial if sales return to budgeted levels and a track record of maintainable earnings is restored. 

Unfortunately, the probable reality is that maintainable earnings have dropped and earn-outs may not have been large enough to protect private equity firms. The saving grace is that this should be a short-term issue for great businesses and they should be able to pick up market share and return to status quo. But, this is reserved only for great businesses; it’s all about product/service differentiation, financial discipline, low-moderate gearing, a dynamic management team and a proactive private equity partner. Without all of these qualities, investees may find these are tougher times than expected.

With all of that said, this is business and business is cyclical. I could insert many clichés here about wheat and chaff, men and buys, good and bad apples, etc., but there’s not much point dwelling. The most beneficial take away is that private equity firms must always invest in the best businesses if they want to maintain reputation and edge.

This is quite an elementary topic. Actually, it’s very elementary. But, in this economic climate and with the profligacy of some managers, it’s important to keep front of mind. I’ll introduce the topic with a few quick calculations. Consider a business with sales of $100m, gross margin of 60% and EBITDA of $20m. If sales drop 20% down to $80m, you’re also losing gross profit of $12m. Usually at a minimum, this will fall directly to the EBITDA line.

So, in this example, EBITDA will now be $8m. This is quite a serious problem for investees, but made much worse by the continued profligacy of managers and inflation in fixed expenses.

So what’s the implication of this? For starters, you’ve conceivably just dropped 60% of EBITDA and therefore 60% of value (that is, if the new EBITDA is deemed the new maintainable EBITDA). That’s a BIG problem. The obvious reaction is to reduce fixed costs so EBITDA doesn’t drop by the full GP loss, but that carries risks too. It obviously creates tension if you have to let people go, but it also limits your ability to return to previous sales levels if you have to sell off important equipment.

What are the other options? I’d say one of the better options is to delay cuts to people and major equipment and put as much effort as possible into taking market share and boosting sales. Also, make sure that costs don’t blow out as a result of the sales drive. It’s just as much about sales as it is financial discipline.

I found the ISO risk management principles while conducting research and thought they may prove useful in jerking one’s memory when conducting a risk assessment. On reflection, some of them sound a little too bureaucratic to me, but most are worth the effort.

• Risk management should create value
• Risk management should be an integral part of organizational processes
• Risk management should be part of decision making
• Risk management should explicitly address uncertainty
• Risk management should be systematic and structured
• Risk management should be based on the best available information 
• Risk management should be tailored
• Risk management should take into account human factors
• Risk management should be transparent and inclusive
• Risk management should be dynamic, iterative and responsive to change
• Risk Management should be capable of continual improvement and enhancement

I’ve said it many times before, but private equity is about risk management (or value preservation) first and value creation second. It is unnecessary to take undue risks, especially when the mid-market end of the industry has access to so many different opportunities.

There can be a fine line between investing in great businesses and investing for investment’s sake.  A great business may have risks, it may have question marks, but it only takes a handful of information and 30 minutes with the prospective manager to have that feeling. That feeling doesn’t negate the need for rigorous analysis, but it goes a long way to making sure you’re on the right track in terms of acceptable risk.

The purpose of this foreword is to propose that it is very easy to use a risk management strategy as a tool to justify a not-so-great investment. Risk management is temporal; a valuation should be based on the risks of an investment at the time of the investment, not just what they’re planned to be at a later point in time. For example, if a business only offers one product, your valuation should be congruent with this concentration risk. Don’t pay a price that is contingent upon the acquisition of an unknown business that you expect to diversify the product base.  If you’re doing the work to improve the business, why pay the vendor for your hard work? 

The theory of risk management requires (and deserves) a large tome. However, as an aside, I’d like to share the very basics of the risk management process. The steps in the process according to the International Standards Organisation , although slightly abridged, are as follows:

1. Establish context: understand the situation and the need for adequate risk management. In a private equity context, realise it is linked to price and performance and is a prescient concern. 
2. Identification: think about objectives, scenarios, best practice, etc. to identify the risks that are present. Look at other businesses and their risks to ensure you’ve been exhaustive.
3. Assessment (analyse and evaluate): analyse the risks and understand their likelihood, impact, sources, consequences, etc. Evaluate this data to prioritise the mitigation of the risks.
4. Treatment (plan, implement, review): create a plan to treat the risks, but remember treatment means treating them now, not in the future. Implement the treatments and review success. Ensure that a variety of objective people agree with the treatment and the perceived results.

I hope this has helped, but more critically, the purpose of my post was to propose that risk management is temporal. Planning to ameliorate a risk in the future doesn’t mean you have managed it now. Also, invoke an iterative risk management process and be diligent about the entire concept. After all, it can literally mean the difference between a horrific failure and an outstanding success.

To follow on from my last post about Porter’s 5 Forces, I’m going to briefly discuss suggestions that the model should be expanded to include additional forces. Keeping things simple is always good, but there’s also an argument for covering all bases. This is an especially interesting topic because the model is practicable and applicable; I don’t think many would bother with this discussion if it was only academic. Some suggestions for a 6th, 7th and/or 8th force are as follows:

1. Government: the thinking being that government regulation and intervention can drastically change the dynamics of an industry. And some industries are more exposed than others.
2. Complements: since substitutes are included, many argue that complements should also be included. The thinking being that complements can drive an industry in unique ways too.
3. The Public: similar to government, the public (in the form of pressure groups, lobbyists, trends, etc) can play an important role in the dynamics of an industry.

When Michael Porter himself revisited the model recently, he considered the inclusion of new forces but ultimately decided against it. His reasoning was quite vague, but this doesn’t necessarily mean there shouldn’t be other forces.

Playing the role of a cynic, maybe he just wanted to save face or keep it simple. Then again, maybe he’s right in keeping the model simple and maybe government/complement/public analysis belongs at the business, opposed to industry, level. At this moment (and not necessarily the next moment), I tend to side with the latter.

Maybe I’m not speaking for everyone when I say this, but I found many of the models and theories presented at university to be largely theoretical and not very practicable. CAPM comes to mind immediately, as do many of the monetary policy theories. However, on reflection, a few make honest sense. 

For example, I recently posted on the principal-agent problem and it’s salience in regard to public vs. private markets. It is a model that underpins the very existence of these markets; no complexity, few assumptions, and a concept of much clarity. I concede that it is hardly a solution to a common problem, but I think it goes quite far in supporting the concept of private equity.

Similarly, Porter’s 5 Forces model won’t give you the meaning of life, but it is an honest, simple, applicable and highly useful model for the private equity industry. Again, it won’t give any profound answers, but it will go a long way to understanding whether an industry is attractive. I say this because as private equiteers, we know there are many sources of value creation, but an attractive industry is always a salubrious start. Something to keep in mind though, is that the model is designed to analyse industries, not businesses, sectors or markets. Be diligent with your definition of an industry or see web resources for further guidance.

I’ll give a very brief description of each of the 5 forces (see the image above for a pictorial representation):

1. Substitutes: understand the threat of substitutes within the industry. A moderate to high threat will result in high price elasticity of demand because it will be easy for consumers to swap when prices move (if networking costs are low). 
2. Competitors: if barriers to entry are low and competitors can enter the market easily, then a business won’t enjoy economic profits for very long. Equally, it will be difficult to maintain a competitive advantage and the associated high margins.
3. Competitive Rivalry: high levels of competition can turn industries into price wars, which doesn’t help anyone, including the consumer, if quality is affected. Rivalry is less intense when the fundamentals of the industry hinder it: think scale economies, differentiation and diversity.
4. Customers: if customers have high bargaining power, industry players will have a low likelihood of securing an economic profit. The customers will use this power to shift value to themselves. This power will also lead to higher price elasticity of demand.
5. Suppliers: similar to customer power, high supplier power can lead to a loss of economic profit and lower margins. Power on either side of an industry player typically leads to a shift of value along the value chain. The ideal industry to be in is one at the most profitable point in the value chain.

Based on each of these forces, an industry receives an arbitrary rating. For example, a 5 star industry is one that is attractive and one that receives a positive rating for each force. A 0 star industry is unattractive for similar reasons. However, this doesn’t necessarily mean that a particular underlying business is given the same rating; great managers use differentiation to stand out in any industry; their job is just easier (and success is more likely) in attractive industries.

According to Wikipedia, the principal-agent problem is as follows:

the principal-agent problem… (addresses) the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent.

One of the most encountered real-life examples of the principal-agent problem is the misalignment of interests within public companies. The primary interest of shareholders is to realise a favourable return, whereas the primary interest of the management team isn’t necessarily the same. Arguably, their interests should be the same, but managers may be more interested in working shorter hours, building a bigger (but not necessarily more profitable) business, or making high-profile (yet incompatible) acquisitions. This misalignment of interests is the principal-agent problem.

Public companies have a multitude of strategies to surmount the principal-agent problem. For example, issuing performance options to the management team creates more of an alignment with shareholders. However, the other interests still exist and the shareholders are still limited in their influence over the management of the company. Shareholders may be able to vote out CEOs and other executives by majority vote at general meetings, but this is a far cry from the granular influence that investors would benefit most from.

Logically, private equity represents a real solution to the principal-agent problem (albeit, still not a perfect solution). Firstly, the principal (private equity firm) has much more influence over the agent (management team) to the point where they are an agent. For example, if a private equity firm wants updated debt covenant data from an investee, they can generally expect a response within the day. Try to request this from a public company, and in six months’ time, you may have a vague, ambiguous and sugar-coated announcement that doesn’t nearly include enough information. The reduction of information asymmetry is the key to private equity firms experiencing less of the principal-agent problem.

So what’s my point? To most, the principal-agent problem is a distant and clouded memory from b-school. But, surprisingly, it underpins the entire private equity value proposition for investors.

The customer value proposition (CVP) is what a customer receives when he/she pays for a product or service. It is a crucial topic for discussion when understanding how and why a business makes sense. If the CVP isn’t compelling, then one would think that a private equity deal involving the business wouldn’t be compelling either. There are both tangible and intangible aspects to the CVP, but two dimensions often divide it:

1. Comparative value: this is the perceived value of the offering compared to competitors’ offerings. It could be as simple as one product is twice as good as another product and hence worth twice as much. In practice though, there are many variables and a lot more subjective analysis is required.
2. Monetary value: this is very similar to comparative value, but using money as the medium for comparison. So while it may not be reasonable to compare chalk and cheese, you can compare the price of each and the perceived value from one dollar’s worth of each offering. 

Not only should the business owner be able to communicate the CVP clearly, but also it should be reasonable and believable. Some of the components that the CVP should include are:

1. The issue or problem to be addressed
2. The need and urgency
3. The target result and its benefits and risks 
4. The merits against competitors (comparative value)
5. The cost and time incurred (monetary value)

If these aren’t clear and believable, then it’s difficult to understand how the business will survive and grow. With markets being competitive, survival and growth isn’t as easy as it may sound.

I’ve probably written quite a bit already on why an entrepreneur or business owner should consider a private equity partner, but I thought it would be helpful to discuss how I think they should go about investigating their options. 

1. I’d recommend avoiding the intermediaries (brokers, advisers, investment bankers, etc). My reason is that middle-men inherently introduce new layers of costs and complexity and in most instances, a business owner is sophisticated enough to deal directly with potential partners. However, with that said, I fully acknowledge that there are cases where an intermediary can add significant value. Such examples may be where a family estate wants to sell a business, or where the business owner is very technical and hasn’t had to be commercial in their role.
2. Talk to the principals of different investment firms to get a feeling for their mandate, intellect, philosophies, but most importantly, make sure they have direct skill and experience in your industry. If the firm says they have secondary associations with people in your industry who can help, don’t buy it. Make sure someone on their direct investment team will be able to help extract the most from your business. Even if you just want to sell and get out, most private equity firms will tie you into earn-outs and such, so this is still very important.
3. When progressing discussions, make sure you understand the firm’s intentions with your business before you commit to anything. That is, ask to see their first draft strategy and gauge the value of it. Use you intuition here and don’t let yourself be bullied. A lot of value can be created with a private equity firm partner, but you want to find the one that can add the most value. Similarly, if the firm’s intentions seem overly risky, then don’t go for it. Your chances of losing value are also much higher with a new business partner.
4. Talk to the relevant private equity association, ask their opinions about different firms and ask to see a list of registered firms and their mandates. This will help to narrow down your initial contact list. In Europe, the applicable body is the European Private Equity & Venture Capital Association, whereas in the States the applicable body is the National Venture Capital Association,  

I’m sure there’s much more to think about when approaching private equity firms, but these are a few tips that I hope would provide comfort around the process.

For businesses considering their options for accelerated growth, they tend to gravitate towards proposals that contain a financial and strategic component. With this in mind, the most compelling expansion deals are usually from trade investors and private equity firms. In this post, I’m going to compare these offerings in a formulaic manner.

So let’s assume:

• $X = The value of financial capital in a deal
• $aX = The value of strategic support in a deal

The value of strategic support is a multiple of financial capital because the whole purpose of the investment is to multiply the initial investment. Note: the “a” only represents the strategic value-add, not the realised cash multiple for the investor because there are other influences that drive the final result.

Therefore, the value of a financial+strategic deal ($Y) is:

• $Y = $X + $aX

When a business faces making a decision between a trade deal (JV, strategic investment, etc) and a private equity deal, they’re often deciding between the following two scenarios:

• Trade Deal:    $Y = $X + $aX
• PE Deal:          $Z = ($X - some) + ($aX + some)

In simpler terms, a trade buyer will usually offer a higher upfront valuation, while a private equity firm will offer greater strategic value. My thinking for this is that a trade buyer has greater immediate synergies and is often the more natural buyer of the business; hence, it may pay more. Whereas, a private equity firm has more experience in value creation AND it has more aligned interests; hence, it offers greater strategic value. I say more aligned interests because there’s the risk that the trade buyer wants to invest in the business as a defensive move and they actually don’t want the business to grow. This is a significant risk compared to a private equity investor who almost undoubtedly just wants to see growth.

With all of that said (and this is hardly an exact science), the question for the business owner is whether the additional upfront value from a trade buyer is worth more than the additional strategic value offered by the private equity firm. This is where the deal becomes self-selecting. If the business owner sincerely believes in the potential growth of the business, then they’d really choose the deal with the higher strategic value: the private equity deal.

Best regards,

the Private Equiteer