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What’s the full potential of the business? A private equity perspective
Ask the executive management of an ambitious small company what the full potential of their business is and they will most likely reply along lines such as “the UK’s leading provider of widgets”, or perhaps “to be much bigger”. Ask a private equity (PE) manager about the full potential of a portfolio company and the answer will be far more specific.
PE firms invest in businesses to make a superior return on the invested capital. The typical timeframe for an investment in a company is three to five years and the PE house will set an equity target value to be achieved over this period. It is this value that the PE manager will say represents the full potential of the business.
But how high a valuation can the company achieve? Can it turn £1 of equity value today into £3, £4 or £5 after a period of ownership of three to five years? If so, how?
Strategic due diligence
The way to set the number for our business is to conduct a strategic due diligence – a comprehensive, rigorous and dispassionate, outside-in analysis – which focuses on five core factors:
- Market demand – what are the true underlying drivers of demand for our products or services, how are these drivers changing, and how will these changes affect demand?
- Customers – who are our customers, why and how do they buy our products or services? How compelling is the need for what we offer? What are they going to do in the future?
- Competitors – who are our competitors, what are they doing and how well are they performing? Do we have any gaps to address, where and how? Are our products and services sufficiently differentiated to command a premium price? What are customers demanding and competitors doing that will affect our future pricing?
- Macro-environment – what are the technological, environmental, regulatory, demographic or other trends that may affect our future performance, positively or negatively? How and by how much?
- Micro-environment – how do we really make money and where? Do we have unprofitable products? Do we make money on all our customers? Are our costs truly competitive? If we change things, what is the upside? What are the risks?
None of the questions posed by these analyses are easy to answer. If we really want to define the full potential of the business, the facts need to be dug out, bottom up. With this discovery process we need to see what the facts really highlight about the company and its environment.
Armed with these insights, we can pinpoint the levers that can actually be pulled to create value. The equity target value for full potential can then be fixed.
The roadmap
Having set the full potential, the way to get there is to create a roadmap that focuses on those key initiatives that will have the greatest impact three to five years down the road. The roadmap lays out the who, what, when, where and how. Usually three to five initiatives, rarely more than six, is crucial to achieving success.
It is human nature to overestimate what can be achieved in a year but also to underestimate what can be done in five years. The mindset of the executives therefore is to be ambitious. The practical, actionable time frame when embarking on an initiative requires a medium-term focus – precisely the typical three to five years’ timeline of the PE investor.
Achieving the full potential becomes the central goal of the management team. Deriving the initiatives requires management to start with a ‘blank sheet of a paper’, challenge the status quo and think along multiple dimensions:
- What incremental moves will make our current activities more profitable?
- What bold departures will reposition some or all of our activities for much greater success?
- What resources should we direct away from activities that don’t represent the future of the company?
- What things should we not do? They can preserve tremendous value.
The traditional five-year plan usually boils down to overly simple and under-ambitious goals. These plans are based on assumptions that activities will continue to grow at their historical rate. The strategic due diligence fundamentally challenges that thinking.
Conversely, sometimes the five-year plan sets naively hopeful targets based on assumptions which have not been validated. The strategic due diligence lays out very challenging but nevertheless achievable goals and the roadmap captures the practical initiatives for getting to that full potential destination.
As the initiatives progress, an ongoing culture check is essential – is there inertia anywhere in the business that’s holding back our progress, what's causing it and what do we need to do to remove the roadblock? And then repeat the due diligence again, two to three years after the first one.
Repeating the process is crucial – smart PE owners must think about sustainability. As they will be selling the business to another buyer at some point, the owners need to ensure that the company has built a sustainable platform for value creation. Otherwise the next set of owners, when doing their own strategic due diligence, will likely unearth any future value deterioration and offer a far lower purchase price, devastating the seller’s return on capital.
Conclusion
The full potential of a business is about defining how high a valuation the company can achieve in three to five years. A strategic due diligence is how you set that valuation and a roadmap of key initiatives is how you get there. But this is not a one-shot exercise – developing a sustainable process for creating value is central to delivering superior returns for all shareholders.
Hat tip: Lessons from private equity any company can use, Bain & Co, 2008.
PE firms require non-executives to sit on the board of portfolio companies.
They are the same as executive directors, with some differences.
It may be the best decision the board ever makes.