Characteristics of an Attractive Industry and Market

Firstly, the characteristics of an attractive industry or market 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 or market today isn’t necessarily an attractive industry or market tomorrow; fundamentals can change quite quickly. Lastly, an attractive industry or market for you should also be an attractive industry or market 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 or market 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 or market. 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 or market is at the most valuable point in its value chain; that is, the industry or market 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 or market 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.

Financial Crisis and Industry and Market Attractiveness

There’s a great opportunity now for private equity firms to differentiate themselves in their response to the current global economic unpleasantness. (I’m talking about the way we react to investee underperformance.) But, what is the right response? Is it to provide passive guidance and let the entrepreneurs do what they do best? Is it to seize control and implement a strict regime of cost cutting? Or, is it to be as profligate as ever and increase investment to flummox, bewilder and bemuse the competition?

The diplomatic answer is that it’s probably a little of all of the above. But, that’s not what you want to hear and it’s certainly not what I think is helpful.

For my investees, I believe it’s about keeping it simple and focusing on tangible results. In a high-level conceptual sense, it means ditching the bureaucracy, working within the bounds of the existing culture and empowering people to create and share positive outcomes. On a lower-level tactical plane, it means being disciplined about granular financial monitoring, it means attacking problems with pragmatic solutions, it means keeping abreast of opportunities in depressed markets, and it means being honest with oneself about what is essential spending and what is profligacy.

I’m a strong believer in building great companies first and watching shareholder value grow as a result, not the other way. So, let’s throw the idea of shareholder value out the window for the moment and commit to building great companies… built to last (as Jim Collins would say). And let’s not focus too much on the Financial Crisis and the characteristics of the related Market Attractiveness.

Industry and Market Attractiveness in the New Year

At the end of last year, Alex asked,

In the last couple of weeks a lot of deal activity has spiked up that was painfully absent for most of the year: both at the larger mid market (eg Apax buying Marken, Carlyle bidding for Shanks, Permira & Just Retirment) and down among the smaller houses (eg Matrix and Inflexion both did multiple deals in December).
… how do you read this and care to make some predictions for 2010?

The significance of size and location (of private equity firms) became clearer and clearer as activity increased in late 2009. We saw many micro firms in resilient economies at full-steam, but also larger global firms reeling from negative press. This isn’t to suggest anything about the quality of nations, or firms, or people, or decisions; it’s just the way the cookie crumbled (if you’ll let me take the easy way out).

most of us paid too much pre-GFC. I’ve heard many smaller players chastise larger players and congratulate themselves on exhibiting more restraint. But we ALL paid too much at a point, and if nothing else, we should be a little humble after such a display of ineptitude. Sure, there’s no point living in the past, but there’s no point celebrating losses either.

With this in mind, I think the defining characteristic for 2010 will change from size and location to the composition of existing funds. The same way firms couldn’t escape their genetic make-up in 2009, they won’t be able to escape the overhang of under-performing assets in 2010. It may sound somewhat sombre, but 2010 will be the beginning of the end for firms with net negative equity. It will take much more than an uptick in a few economic indicators to restore value, even if just to original purchase prices.

For everyone else, this overhang will still clearly define their deal-making activities going into 2010, but to different degrees. For new funds, I see 2010 as a time of unprecedented opportunity, which will warrant furious deal-making efforts and we have to also consider characteristics of market attractiveness. But the reality is that most of us will be finely balancing our fiduciary duties to existing investees with our determination to capitalise on seemingly unprecedented opportunities.

Above all else though, I think the ingenuity of private equiteers will reign supreme once again. We’ll see countless casualties in terms of companies, shareholders and even private equity firms, but we all know life in a capitalist world is a roller-coaster: ups and downs.