PAUL MORRIS: DEMYSTIFYING PRIVATE EQUITY – AN INSIDER’S VIEW
DEMYSTIFYING THE COMPLEX WORLDOF PRIVATE EQUITY
HEAD OF GROWTH ADVISORY BDO UK
DISGUISE TECHNOLOGI ES
SHOULD I STAY OR SHOULD I GO?
PE; ONE SIZE FITS ALL OR ENDLESS POSSIBILITIES ARE YOU READY FOR PE INVESTMENT?
FIVE COMMON MISTAKES TO AVOIDWHEN PITCHING TO PE FIVE TOP TIPS TO HELP YOU JUDGE POTENTIAL PE INVESTORS
BOARD MEETINGS – FIVE SIMPLE WAYS TO MAKE BOARD MEETINGS GENUINELY USEFUL FIVE WAYS INVESTING IN YOUR FINANCE DIRECTOR WILL HELP CREATE VALUE MEETING YOUR PE INVESTORS’ EXPECTATIONS OF FINANCE OPERATIONS
YOUR NEXT DEAL; FIVE WAYS TO PREPARE FROM DAY 1
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SHOULD I STAY OR SHOULD I GO ?
It’s often said of entrepreneurs and owner-managers that they spend too much time in the business and not enough time on the business. It’s the nature of the role that you tend to focus flat out on the work at hand, head down, dealing with immediate needs and priorities. There simply isn’t much time or space to look beyond the next 12 months. This has never been more true with so many businesses and business owners struggling to deal with the impact of the COVID-19 pandemic. But every so often, you have a moment where you look yourself hard in the mirror and think: ‘I’ve had enough’. Is it a passing thought or an indication of something more serious? It can be hard to tell the difference because running a business is a lonely role and you don’t always have external input. This can be even more acute when you operate in a fast and ever-changing market landscape. To help you sort out your thinking, it can be useful to focus on each of the factors involved so you can make an informed decision about what to do next. What are the typical triggers that could make you think about stopping? What are the indicators, external or internal, that could help you understand if it’s really time to consider an exit? And if you do decide it’s time to change, what are your options? Is it really a black-and-white choice, or is there a middle way between the two extremes of staying and going?
TYPICAL TRIGGERS I have spent more than 15 years talking to owner-managers about their options and investing in businesses looking to upscale. There are some triggers that recur frequently, sometimes in combination. These include: Age. You reach a milestone birthday – it used to be 50 or 60, but these days it’s just as likely to be 40 – and start to wonder how much longer you want to continue. Is it time to retire or do something else? Health. The rigours of running a business – wearing all those different hats, bearing all that responsibility – can take their toll, especially if you have to deal with any health issues Family circumstances. A family issue is another obvious trigger to give the owner- manager pause. Sadly, divorce is quite common and may require the release some of the business’ value to fund a settlement. You may have seen the business as a way of providing for children and they may benefit from a sale. What’s it all worth? Another trigger for an existential moment is when the entrepreneur realises that they are, in fact, wealthy but don’t have much to show for it. Their wealth is all tied up in their business. This can trigger an urge to diversify your wealth so you have more to show for all your hard work. A potential investor or buyer. Both buyers and investors are constantly seeking opportunities for successful investment in growth businesses. As a result, you may receive an unexpected and unsolicited approach from a PE house or trade investor. The figures could seem simply too good to turn down even if you weren’t planning to sell. Time for a change. Whether it’s getting involved in a charity, a creative endeavour or another business venture, you may simply have reached a point where you want to do something different. It may just feel like the right time to do something you’ve always wanted to do but had to put on hold because of the business. Appetite for risk (or lack of it). The business may have reached a point where it needs significant reinvestment or re-engineering in order to keep growing. How are you going to generate the cash to fund new systems, new premises, and increased staff? Coupled with your personal triggers, you also need to weigh the rational, factual indicators which could argue for or against an exit. These can be divided into external and internal indicators.
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EXTERNAL INDICATORS When your business began, chances are you seized a gap in the market and capitalised on it. You did something better or differently to everyone else. Having to constantly evolve the product, in order to just stand still, can be very challenging. But unless this is done, the competition can catch up and your advantage erodes. Where once you were an innovative force, you may now be in danger of being disrupted yourself. The challenges of evolving product and business offering can be daunting. Disruptive newcomers may threaten not just existing business models but also your revenue and point of difference. To compete, you may need to bring in whole new skillsets and systems, and re-educate prospects. Do you have the appetite and the capabilities to take on this new fight? The COVID-19 pandemic has resulted in increased pressure on businesses. In many instances owners need to evolve and adapt current business processes or product offerings, not to grow but just to survive. INTERNAL INDICATORS You also need to look at potential internal issues too. If the business needs to evolve significantly, for example, do you have the systems, processes and people in place to manage that transition? Can the business find the cash and the expertise to facilitate such an overhaul? For your business to grow, you need a management team in place with the competencies and experience to perform against aggressive targets. In many owner- managed businesses, the team isn’t really an executive C-level team but more likely a group of general managers who are more execution-focused than strategic. Are you ready to bear the opportunity and time costs and the possible personnel issues of a more strategic recruitment policy that will help create a more scalable business?
WEIGHING UP THE OPTIONS
All of these triggers and indicators need to be considered, together with your own personal feelings and wishes. If your business needs a significant overhaul, are you energised by the prospect of a new challenge or do you feel weary and worn down by the idea? Either way, what are your options?
If your business is in need of significant investment and/or re- engineering in order to deliver on its growth potential and you are falling out of love with it, this may point to an exit. The obvious routes here are to sell to a trade investor or to a PE house. A trade investor or buyer won’t necessarily have a problem with a team of general managers. They’re likely to be buying for defensive reasons with a view to folding it into their own operations rather than selling it on again at a significant profit. For example, a larger trade buyer might be building a portfolio of products. A PE buyer, on the other hand, will need to see evidence of a senior and successful management team as well as a credible growth story.
Staying means that you can find a way to fund the growth that the business needs, either internally or by taking on debt. You probably also have the makings of a management team able to help you evolve. It may be that you can engineer a change in ownership structure, perhaps by transferring key responsibilities to a board member and staying on in a different role, such as a non-exec. This assumes, however, that there isn’t a need for wholesale investment.
PE MONEY-OUT DEALS – THE BEST OF BOTHWORLDS? A third option is to do a “money-out” transaction with a PE firm; a kind of managed transition. Typically, the PE firms offers to buy a significant minority stake (30-40%) and keeps you involved in a senior position. The PE firm will sit on the board and build a succession team by hiring an FD, CEO or Head of HR as required. Ideally, you get to focus on the elements of the business you’re best at, such as strategy, selling or product development. You will get an initial lump sum, allowing up-front diversification of wealth, as well as a significant extra pay out when the PE investor successfully sells the business on. By that time, the business should be fully scalable, with a stronger management team and a credible growth story in place. If you have reached a point of existential doubt, the benefits of the type of arrangement are obvious. You get some money up front, plus a trusted partner and adviser to help you take your business past its current challenges and up to the next level. You retain a majority stake in the business, succession is addressed as your role is gradually migrated out. If the outcome is a successful sale there’s more money to come. PE can provide a middle way for all those owners who, for any number of reasons, have started to think; ‘The only thing I can do here is sell’.
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PE; ONE SIZE FITS ALL OR ENDLESS POSSIBILITIES
There is a misconception amongst many business owners that PE is one size fits all. The belief is that PE investors are only interested in investing in big businesses and then only when they can take a majority stake. Management and owners therefore discount PE as a viable option when thinking about funding and future plans.
The truth is that PE investors come in all shapes and sizes. They have the firepower and appetite to do all kinds of deals with all kinds of potential portfolio companies. They also have unique personalities and approaches to working with businesses to achieve their goals.
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PE INVESTMENT SEGMENTS
PE; A COMPLEX LANDSCAPEWITH ENDLESS OPPORTUNITY
Owners and management teams might find it helpful to think of the investment market segments as falling into following broad categories: Start up – where venture
The investment landscape has further variability as even within each of the above broad categories investors have different approaches. Here are a few examples: X There are sector specialists who focus on areas such as technology or healthcare X Some investors insist on having
So as you can see the investor landscape is complex and varied. This may seem daunting if it is the first time you engage with PE. You should also recognise this as a positive. There will be an investor for virtually any type of situation; every size of company, in every sector and for any type of deal. My advice to any business owner looking for PE investment is to be clear what type of deal and investor you are looking for. Appointing the right advisor will be critical in helping you find the right investor and then negotiating the right deal.
funds look to back a concept or idea. Often businesses are pre profit and sometimes even pre revenue! Funds are typically used to develop a product and build business infrastructure such as opening an office and recruiting some staff. Scale up – where venture capital or smaller PE funds invest in smaller businesses who need capital and expertise to grow further. The funds are typically used to build more substantial business infrastructure such as grow the sales team and develop international markets. Buy out – where PE funds invest in larger more mature businesses. The investment will help facilitate a change of ownership such as a management buy out. This allows the existing management team, who perhaps have no or little equity ownership, to buy the business alongside a PE house.
majority control whereas others are prepared to take a minority stake
X A broad spectrum from those
who adopt a passive approach when managing the investment, to the extent of not even taking a board seat, to those who are interventionist, these investors often have operational rather than financial backgrounds.
X Some investors have exit
timeframes of typically 3-5 years whereas others are happy to have longer term holds.
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ARE YOU READY FOR PE INVESTMENT?
When a PE deal process fails it is very frustrating for both management and the prospective investor. In most cases, both parties have expended significant amounts of time and effort. There are many and varied reasons why a deal can fall through, but one that is consistently cited by investors is that a business was not “ready” for investment.
So what does being “investor ready” actually mean? How can you make your business investor ready? You need to ask yourself a series of simple questions and your honest answers will tell you how investor ready you are.
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IS YOUR MANAGEMENT TEAM STRONG? Your management team must have depth and breadth. An investor will be nervous if a business is dominated by or is too reliant on one individual who clearly directs and controls other members of the senior team. A business must have a leader but others must contribute and be effective across the main functional areas such as operations, sales and finance. The COVID-19 Pandemic has resulted in another angle of questioning from investors. Investors will want to understand how the management team has dealt with the disruption which has impacted many markets. It will not reflect well on the team if the strategy is one of “more of the same” in the hope of coming out the other side. Investors will react well to the team taking the opportunity to reset strategy to adopt to the changes that will inevitably result. A good example of this is accelerating the adoption of technology to improve internal efficiency and/or enhance the customer experience. However, a PE investor will not be put off by the need to fill some gaps in the management team. A PE House will often be able to add value by attracting the right quality executives to the business. ARE YOU CLEAR ON YOUR KEY STRATEGIC PRIORITIES? Your strategic priorities must have a material impact on the growth of your business and therefore value such geographic expansion, product extension or making acquisitions. They cannot be a tactical “to-do list”. It is always worth remembering that too many strategic priorities can almost be as bad as too few or none at all! It will be enormously attractive to an investor that you have thought through and agreed a list of meaningful strategic priorities ahead of any investment. It will give the investor confidence that you are focused on growth and are ready for investment. DO YOU HAVE QUALITY DATA TO SUPPORT QUALITY DECISION MAKING? Potential investors will be nervous if your decision making process in the business is largely intuitive or made without reference to data or evidence. Regular, timely and accurate management information means that the management team are able to make the right decisions to drive growth. Key performance indicators covering operations, sales, finance and other functional areas will drive better decisions. DOES YOUR MANAGEMENT TEAMWORK “ON” ASWELL AS “IN” THE BUSINESS? Do you regularly create time for the leadership team to discuss the business’s overall direction of travel and its strategic progress? In many growth business with limited resources, the leadership team fail to find time and space to step back from the day to day challenges of running the business. An investor will not expect you to be holding monthly board meetings, this practice can be developed post investment, but the discipline of devoting time to your strategic direction and priorities will be well received. DO YOU HAVE MEDIUMTERM FINANCIAL FORECASTS? Not many privately owned high-growth business have medium-term financial forecasts. But PE investors usually have a 3-5 year time horizon for holding an investment. A medium term financial plan will underpin their investment and the shape of any future returns. Medium term forecasts cannot just be based on a top down view. For example, “Sales will grow at 20% per annum” is not a solid forecast. There should also be a bottom up analysis with carefully considered assumptions around the level of overhead
investment required to support top line growth. DO YOU REALLY KNOWYOUR CUSTOMER?
This may appear to be an odd question, as most businesses will claim that they know their customers very well. A key characteristic of successful businesses is customer insight. Do you know precisely what services are used, how much profit is made from each customer, the cost of acquiring new customers and the potential for selling other services? The more you understand your customers and how they use your products or services, the better you will be at retaining and winning business.
If you can answer “Yes” to the questions above you are on your way to being ‘investor ready’ and a more attractive proposition for potential investors. Finally, even if you don’t go for or get PE investment, your business will be more effective and profitable if you can answer yes to those key questions.
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FIVE COMMON MISTAKES TO AVOIDWHEN PITCHING TO PE
The prospect of raising PE investment can be both an exciting and daunting experience, even for an experienced and successful management team. Success requires weeks and months of preparation – developing a credible growth story, putting together an engaging investor pitch book and readying the business for the intense scrutiny of due diligence. But all your good work can be undone by avoidable mistakes when you pitch to PE firms. Here I explore five of the most common mistakes and advise on how to avoid them.
BUYER AND SELLER?
An inherent conflict arises when you, as the management team, already hold some equity in the business. Any deal with a PE firm will involve selling some of this equity and re-investng the remainder into the new deal. This type of deal is commonly referred to as a “money out” or “shareholder realisation”. The problem is that you are wearing two hats: you are both sellers who is looking to maximise the price for the equity being sold; and buyers who wants upside from the shares held in the business going forward. PE investors will always want you to have significant “skin in the game”. They will be focused on the returns generated in the future and will want you to have similar priorities. If you place too much emphasis on the cash realisation element of the deal rather than the future upside, this will be a red flag for many investors. It will suggest that future growth is less important to you.
BALANCING REALISMAND AMBITION
Your medium term financial forecasts are fundamental to a PE firm’s appetite to invest. These forecasts articulate the future growth strategy and the anticipated returns for shareholders.
The mistake often made when pitching to PE is making forecasts either: Over Cautious – unexciting growth rates, probably in single digits annually, because the team want to have the scope to over perform. Management teams often believe this will be viewed favourably by their PE investor. The risk is the forecasts, and potential returns, will not be enough to attract an investor. Over Ambitious – in this scenario the desire to excite an investor loses all perspective and the resulting forecasts are too aggressive. Tenfold increases in profit over 4 years may look attractive but in most cases lacks credibility. You need to find a middle ground where the forecasts are positive enough but will also stand up to the scrutiny of any due diligence exercise.
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COMPETITION, WHAT COMPETITION?
You have existing and potential competitors, whether you know them or not. If you operate in the kind of large and growing market that PE firms prefer to invest in, that competition may well be very strong.
Don’t let the hard work you have put into preparing your business for PE investment be undermined by these five simple and avoidable mistakes. You should understand and be able to articulate; X Your desire for a stake in the business X The realism of your forecasts X Your market and your competition X How your business meets a need X How meeting that need drives profit Do these things and your chances of getting a successful PE deal will increase significantly.
Investors will always want a proper analysis of your key competitors and their strengths and weaknesses. Investors will need to know how this competition might impact the potential of your business. Dismissing the competition will not be viewed favourably by an investor.
WHAT’S THE PROBLEMAND HOWWILL YOU SOLVE IT?
What is the problem faced by people or businesses and how do your products and services solve that problem? This is your business proposition.
Investors recognise that your business may be able to grow to a certain size by meeting customer needs opportunistically. However, this reactive approach will not enable your business to reliably scale to being two or three times larger than it currently is. Crucially it is this growth profile that investors will look for. Investors also have an increasing desire to back businesses which utilise technology to improve internal processes and/or enhance customer experience. The technology deployed does not necessarily have to be developed in house. The adoption of third party technology to drive competitive advantage is highly attractive to investors. You must be able to articulate your business proposition; how providing a solution to a problem will win you new business and enable your business to grow. You will struggle to secure PE investment without this key part of the story.
HOWANDWHERE DO YOU MAKE YOUR MONEY?
Investors are initially attracted to businesses with growing profitability. But for this initial attraction to last and result in a deal, the investor will want to understand exactly how these
profits are produced. Typically, they will want to know how much profit comes from each product and service line, establish the profitability of each customer and how repeatable are the profits? Understand that if you are not able to explain how profits are made and will continue to be made, investors will end discussions quite rapidly.
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FIVE TOP TIPS TO HELP YOU JUDGE POTENTIAL PE INVESTORS
If you have started looking for PE investment, this blog gives you advice that will help you choose the right investor.
When your business has strong growth prospects, you are likely to have a number of offers on the table from competing PE firms. These offers will probably be broadly similar in financial terms. The key question for you is how to make your final choice. Always remember that it is your choice.
Here are some suggestions that I hope will help you make the right choice. There are aspects of the PE house strategy and performance that you should scrutinise as carefully as the PE house will scrutinise your business. Doing your homework will help you find the right investor. Remember, you will potentially work with your new PE partner for as many as five years.
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HITTING THE SWEET SPOT?
INVOLVEMENT POST DEAL?
You need to understand the investor’s funding ‘sweet spot’. PE funds will have a range for how much they will invest in each deal.
How will your investor be involved after the deal is done?
Will the investor take a board seat? Who from the PE house will be appointed? What type of board meeting will occur and how often? How much interaction will there be with the management team? Often, PE houses have dedicated portfolio teams, focused is on managing the investments made. The portfolio team will take over from the investment team that you may well have built a strong relationship with. I would always advise that the handover from investment to portfolio team is done as soon as reasonably possible, preferably ahead of the deal completing. This will allow you to develop a relationship and settle the questions above.
If the deal is at the lower end of their range, will the investor give the business enough focus going forward? If the deal is at the higher end of the range, there may not be sufficient appetite for follow-on investment. You are looking for a deal that is important enough to matter to the fund while allowing room for future funding.
STRONG TRACK RECORD?
Does your fund or investor have good track record of successful investments in businesses like yours?
THE APPETITE AND ABILITY TO SUPPORT THE BUSINESS?
Your potential investors will not hesitate to judge your company’s historic financial performance. So you should consider applying the same lens to your choice of investment partner. You could ask for details of the returns made from the last fund.
What kind of support are you looking for from an investor? If you are an earlier stage business, you may want more in the areas of building sales and finance teams. A larger and more established business may need help with an acquisition strategy and international expansion. You need a clear idea of the type of support you want from an investor. This can become a criteria for judging potential investors. How much experience do they have of successfully providing the kind of support you need? The COVID -19 pandemic has raised another area of focus – how supportive has the investor been with existing investee companies, in circumstances which are beyond the control of the management team. Don’t hesitate to ask to speak to existing investee companies to validate what you are being told.
GENUINE MARKET INSIGHT?
Many PE houses will cite sector specialism as a point of differentiation. Here are the things I would expect a PE house with genuine sector expertise to be able to demonstrate; X Numerous deals over many years in the market X Well connected with industry executives and non executives X Demonstrable understanding of the issues facing your sector such opinion pieces or published articles It takes more than a couple of relevant investments to develop the level of knowledge that is going to really help your business.
IT’S ONLY FAIR.
Management teams will be heavily scrutinised by PE houses. It seems fair that teams should apply a similar level of scrutiny to these potential partners! The questions that need to be asked should not just relate to the terms of any offer but also to the areas I have highlighted in this blog.
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BOARD MEETINGS – FIVE SIMPLE WAYS TO MAKE BOARD MEETINGS GENUINELY USEFUL
Does your business hold board meetings? Do you think they are a bit pointless? After all, your management team regularly catch up and therefore know what is going on in the business at any given time. If your business is about to go through a PE transaction then the board meetings will be a future requirement – but there’s a good chance you see this as a little more than a mechanism for reporting to the investor.
If this is the case then you are missing an opportunity. The board meeting creates the space for you and/or the management team to lift your heads from the day to day operational issues and focus on a more forward looking strategic agenda. So how do you make the board meeting a dynamic forward looking decision making forum? Here are a few tips you should consider;
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FAIL TO PREPARE, PREPARE TO FAIL The best board meetings are when your team create the time beforehand to consider the issues, and the possible solutions, that need to be discussed. A lack of preparation will mean the quality of the discussion and the scope to make good decisions will be limited. A STRATEGIC BOARD MEETING PACK A series of functional reports from finance, sales and operations summarising the short-term issues faced by each department will not give you strategic direction. The ideal board pack should highlight the challenges being faced, how they could impact the growth plan and ideas on how they could be overcome. Additionally, each report should draw attention to new opportunities for growth and how these might be exploited.
Management teams that successfully execute against a medium term strategic plan will inevitably increase business value – benefitting all shareholders. Board meetings, if well prepared for and run properly, will be a key part of monitoring and refining the strategic direction of the business.
A DYNAMIC BOARD MEETING AGENDA FOR DYNAMIC DECISION-MAKING
The agenda for each meeting should vary according to what is happening in your business. For example if the financial performance is in line or ahead of budget then there is no need to spend time discussing the numbers. Instead the board should shine a light on either areas of underperformance or opportunity. Your executive team should set the agenda. An agenda that is static month after month makes for stale and unproductive meetings. A BOARD MEETING, NOT THE CEO SHOW Each executive member of the board is responsible for their own functional area but must also be willing and able to contribute to other areas. The CEO is the leader of the business but he or she should not dominate the board meeting. This collaborative approach will offer different perspectives and ensure you get a better quality discussion. HOW LONG SHOULD A BOARD MEETING LAST? A good board meeting finishes within 3 hours. You make this possible with a focused and relevant agenda. Be disciplined about the time a board meeting is allowed and you remove the temptation to discuss issues that warrant little or no attention. THE ROLE OF THE NON-EXECUTIVE DIRECTOR Many growth businesses founded by an executive team will often have limited experience outside of their current roles. High performing boards have an external perspective supplied by one or more non executives. The right non-executive will have experience of numerous other situations and broad expertise. Often this means the non-executive will have worked through and dealt with many of the issues a business is likely to face.
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FIVE WAYS INVESTING IN YOUR FINANCE DIRECTOR WILL HELP CREATE VALUE
Is the role of a finance director simply to manage the finance of the business? Do they just count the cash and manage the payroll? In my experience, all too often that is exactly what entrepreneurs think. Of course, a critical part of the FD’s role is to implement good controls in the business and to manage both profits and cash. But if your FD’s remit is limited to just that, you are missing an opportunity. The right FD will create value, not just protect it. If your business invests in an experienced and skilled FD, it will reap enormous benefits. Here are just a few examples how shareholder value will be created by the right FD;
ROBUST AND ACCURATE FORECASTING Accurate and complete historic information is important but not the whole story. The right FD will be able to prepare and monitor detailed profit and cash forecasts on a monthly basis for up to three years. In addition, they should develop a set of key performance indicators covering sales as well as finance. These forecasts and KPIs will be essential for the management team to make the right business decisions in areas such as recruitment and investment in systems. CUSTOMER PROFITABILITY A common challenge for businesses is the ability to calculate the “real” profitability of an individual customer relationship. A top FD will ensure the whole business knows the levels of profitability not only at a gross but net level. The business will understand the true profitability of a relationship having taken account of allocated costs for support and administration. Arming the sales team with this information will help in pricing discussions with customers. BROADER IMPACT ONTHE BUSINESS An experienced FD will be able to take on broader business responsibilities. Typically, these could include compliance, HR, systems and legal. The FD will not be a subject matter expert in these areas, but can take decisions after receiving guidance from third parties. So in a way you will get several executives for the price of one! FUND RAISING At some point your business may decide to raise finance via a bank or PE firm. The preparation for a fund-raise and the successful management of the process will be food and drink to an experienced FD. Bankers and investors understand the value of a good FD. Their appetite to lend or invest will be enhanced when a strong FD is running a smooth process. Your business will be more likely to strike the right deal and get better terms as a result. ACQUISITIONS Any growth strategy that includes acquisitions, requires an effective FD managing the process. The acquisition process has many elements from identifying and meeting targets through to negotiating the deal and raising the finance. Having an FD who can lead the acquisition process frees up the management team to focus on driving the organic growth strategy. I have made the case for ambitious growing businesses recruiting an experienced and talented FD. The decision will deliver value across the business. It is an investment that will deliver massive returns rather than an additional cost!
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MEETING YOUR PE INVESTORS’ EXPECTATIONS OF FINANCE OPERATIONS
THE COMMON PAIN POINTS The management information produced by in-house finance teams does not always meet the needs of a PE house in terms of frequency or detail. The financial information is often historic, rather than focused on re-forecasting future results as conditions change. There can also be cultural challenges: statutory financial reporting can be seen as a necessary evil to meet regulatory requirements. The value of management information as a tool to shape and guide the strategic direction of the business is not fully appreciated. A successful PE CFO has to provide the information and insights that can drive business decisions and, ultimately, high growth. In-house finance teams may be facing new technical accounting challenges resulting from the need to account for the transaction itself, through to applying new accounting policies or even GAAP. Your existing finance team may not have experience in preparing consolidated accounts, accounting for goodwill and intangible assets, complex financial instruments (like derivatives or hedging tools) or deferred tax liabilities. Some smaller portfolio companies not have faced the rigour of a statutory audit. As a result, their financial statements can include accounting errors, for example, concerning the treatment of revenue streams or the valuation of assets. These ‘skeletons’ can lead to valuation challenges or negotiation difficulties in the completion of the PE investment. The CFO, and their team, will find that accuracy and quality become a minimum requirement.
PE houses want portfolio companies to use the first 100 days to drive change management across the business, including the finance function. Your business will likely face substantial change, perhaps expanding its client base, its offering or growing its international presence. The finance team needs to be ready to change how it works and capable of supporting the wider business as it will look in the future. You can read our in-depth article on achieving this here. The importance and value of CFO or Finance Director to a business is clear. If a CFO is not already in place, appointing one should be a priority and the next logical step in tackling these common pain points. A competent and experienced CFO should be a cornerstone of your strategic management team. The CFO does not operate alone and should be backed by a strong finance function. Unfortunately, finance functions are often perceived as an overhead and there is an understandable desire to keep them ‘lean’. However, this can leave your business vulnerable to key person risk. What impact would losing key members of the finance team have on your business? Could it disrupt your reporting timeline and critically weaken your business?
GARETH LYNTON JONES
Before completing a deal, a PE house’s investment team will be focused on your business’s normalised operational cash flow and EBITDA growth potential. They will be looking for a compelling story that expounds revenue growth, a strong, reliable margin and the ability to turn profit into cash. PE houses place significant importance on the quality of your people, so will look at the experience, expertise and competence of your whole management team. For the CFO, and the finance function, this includes the ability to prepare and make full use of the complex financial and management information that is needed to drive the kind of transformation and growth that investors expect. After the deal, the PE house will rely on your CFO and finance function to deliver high quality management information, together with relevant key performance indicators (KPIs). Clearly, your finance function has an important role to play in accurately reporting past performance but your PE investor will be more focussed on the future, closely watching earnings, profit and operational cash generation against what are likely to be ambitious forecasts and budgets. Are your people, systems and processes geared up to deliver for these demanding new stakeholders?
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BUSINESS SERVICES &OUTSOURCING: EMBEDDING THE FINANCE FUNCTIONOF THE FUTURE
CHALLENGES FACING THEVENTURE BACKED CFO
OPTIONS TOALLEVIATE PRESSURE
X May not have built enough bandwidth internally to focus on future direction of business X Struggle with attracting and retaining skills into finance function X Often bogged down in the day to day operations X Projects and improvement initiatives rarely fulfilled to required level X Concerned outsourcing all, or part, of finance function might compromise quality X Do not fully utilise latest cloud technology to streamline processes and workflows X Unclear what is possible from an outsourcing perspective.
X Explore various outsourcing models e.g. co-sourced or fully outsourced to relieve burden X Tap into experienced resource as and when you need it from a global accounting firm X Free up time to focus on strategy by leaning on advisors to deliver on back office activities e.g. payroll, production of management accounts X Adopt and embed best practice from advisors with experience of your sector X Tap into best in class tools and technology to maximise productivity X Flexible resource at your fingertips with scope to scale up or down as required.
OPTIMISING YOUR FINANCE FUNCTION
OUTSOURCING GIVES YOU
TYPE OF SUPPORT AVAILABLE
BENEFITS OF OUTSOURCING
EXTENSION OF YOUR FINANCE TEAM
ACCESS TO TECHNICAL ACCOUNTING EXPERTISE
QUALITY AND CONSISTENCY OF MI
TECHNOLOGY ENABLED SOLUTIONS
VARIABLE COSTVS. FIXED COST
20 PAUL MORRIS: DEMYSTIFYING PRIVATE EQUITY – AN INSIDER’SVIEW
YOUR NEXT DEAL; FIVE WAYS TO PREPARE FROM DAY 1
Why would you and your team go through the emotional rollercoaster and scrutiny of a completing a deal with a PE investor, if not to realise life- changing wealth? Once you have completed the deal, you may be tempted to go back to business as usual and meeting the day- to-day challenges of running your business. That would be a mistake. You need to start planning and working towards a successful and profitable exit from the moment you have signed your deal. So if I may, I will give you a few tips to ensure that you don’t reach the end of the rainbow only to find the pot of gold is half empty!
21 PAUL MORRIS: DEMYSTIFYING PRIVATE EQUITY – AN INSIDER’SVIEW
EXIT MUST STAY ONTHE AGENDA A PE-backed business is always potentially for sale so an exit is always on the cards. That is not to say that exit should be an obsession and dominate every board meeting and conversation. But it is good practice for your board to regularly have an “exit” discussion. What do I mean by “exit” discussion”? Well, the board should cover issues such as timing, who the potential buyers might be, what level of profits need to be achieved and which members of the management team will to be involved post the sale? Thinking about the answers to those questions about every six months will underpin your business’s strategy. MANAGEMENT SUCCESSION As mentioned in my last point, you and the rest of the management team must be clear amongst yourselves and with the PE investor on who is in and who is out at the next deal. A strong, experienced and established management team is critical to the value of your business whether the buyer is trade or another PE investor. If certain members of your management team are intending to leave, you must plan for that well ahead of the sale. Replacements need to be in situ and operating in the role for a minimum of 12 months before the deal. STRATEGY MUST STAY FRESH You started your PE journey with an exciting 3/4 year strategy. This strategy was the basis for securing the original investment. You cannot afford to allow your strategy to run down or become stale. Your next buyer, PE or trade, will need to see a compelling medium term strategy for growth. You need a robust, up to date strategy that will deliver ongoing success to secure you a good price when the next deal happens. WELL INVESTED PLATFORM! You should think carefully about how investment in your business supports your preparations for your next sale. There will be a temptation to starve the business of investment in an effort to maximise profit and cash pre-sale. This approach will come back to bite you and shareholders. Buyers will pay a high profit multiple when they believe the business is capable of continuing on a growth trajectory. This will not be credible if you have not invested in areas such as headcount or systems. A word of warning, investment in your business will need to show a return or yield in time for the next sale. No buyer will be prepared to factor these long term and as yet unquantifiable benefits into the price. DATA IS KING! In a previous blog I make the case for the importance of collating and storing data covering all aspects of the business such as financial, sales, operations and legal. The rationale for this is to be ready for the intense scrutiny to come from a PE investor. Why should this mind-set of collecting and updating data cease once the PE investor comes on board? My advice is to continue with the practice of maintaining a data room. This will make the sales process more efficient when the time comes. More importantly, it will also help you make high quality decisions as you will have accurate data at your fingertips. By following these five pieces of advice, I am confident that you and your shareholders will be in a strong position when it comes to getting that knockout price from the next buyer. I think it is helpful to think about your first PE investment as a transformation of how you run your business rather than an event or process that begins or ends.
22 PAUL MORRIS: DEMYSTIFYING PRIVATE EQUITY – AN INSIDER’SVIEW
The investment of funds into privately owned businesses with the aim of generating high rates of return. PE funds typically have a fixed life span of 10 years, By the end of 10 years the investors will expect a return on the original money invested. This will be achieved by the fund selling all the investments it has made. A financial buyer that obtains investment funds from banks, pension funds and insurance companies in order to make investments in privately owned businesses. A PE firm will buy either a majority or substantial minority stake in a business. It will work alongside the management team with the objective of growing the profits and then selling the business in the future, typically in 3 to 5 years’ time. Different to PE in that the investment is made into small, early stage private businesses. Venture Capital investments are higher risk than PE ones so the investor is looking for much higher returns. VC investments have a much higher failure rate that PE investments. Where an outside management team purchases all or part of a company. Because the outside management team have limited knowledge of the company an MBI is usually seen as higher risk by investors and funders. The management team of a company purchases all or part of the company they manage. Management are rarely wealthy enough to buy the company on their own so additional funds may have to be raised. The funding for the deal will come from a mixture of management team resources, PE and debt. A transaction where existing management along with outside managers decides to buy out a company. This type of transaction is less risky than a MBI as the existing management will be part of the team going forward. The outside management often add expertise and depth to the new team. Is the use of debt to purchase a company often alongside a PE investment. The amount of debt available will depend on the company’s assets and profits. The debt is expected to be repaid over 4 to 6 years. A type of investment (either venture capital or PE) to support the expansion of an existing business. Growth or expansion capital may be used for a variety of purposes including: pay for the R&D for a new product; finance a sales and marketing drive; and fund exporting to new territories. Is an investigation of a business by an investor or funder prior to purchasing a company. Examples of the types of questions due diligence will ask include: does the company have healthy cash flow; are the profits going up or down; are there any hidden liabilities; and are there any major competitors likely to enter the market?
PE HOUSES / FIRMS / FUNDS
MANAGEMENT BUY IN
MANAGEMENT BUY OUT
BUY IN MANAGEMENT BUY OUT (BIMBO)
LEVERAGEDOR ACQUISITION FINANCE
GROWTHOR EXPANSION CAPITAL
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