“Price is what you pay, value is what you get,” Warren Buffett once said, harking back to days when money came to money and financial engineering could deliver a healthy return to private equity. But no more. Marc Mullen looks at how buy-out firms and their corporate finance advisers are driving value in their portfolios
For an acquirer, ‘buy low, sell high’ could be a simple mission statement. Replace ‘simple’ with ‘far too simplistic’. The global pandemic has shaken up many sectors and businesses, and there have been winners and losers. Buying low in a dramatically changing market might just mark the start of a very long period to deliver value to the investor, with enormous inherent risk. Some deals might never turn into ‘sell high’ opportunities.
Private equity is sitting on $1.5trn of dry powder globally, according to Preqin. Data from Refinitiv shows 6,298 private equity deals completed worldwide in the first half of 2021, worth a total of $513bn – the busiest six months since records began.
The other key takeaway is that valuations, bifurcated between ‘good’ and ‘bad’ businesses, have been at record levels for private equity, as their capital chased quality assets. Financial engineering still plays a big part, of course. But value creation is the key driver underpinning many growth strategies for portfolio companies.
“Quality businesses are commanding high prices,” says Suzanne Pike, partner and head of deal origination at mid-market firm ECI Partners. “So, the starting point for us is having confidence and conviction in the decision around the price we’re offering. Many people think the primary activity for ‘deal origination’ teams is generating leads, but really for us it’s about driving focus into our pipeline of deals, and looking in depth at the businesses we want to back and their subsectors to really understand them to an extent that we maybe didn’t need to 10 years ago.
“We need to because of the level of competition we face, and because we are going to have to work to get the value we need from the price we are paying. We need to have proper knowledge about what we are getting into – to get to the value drivers of the business.”
Pike explains that ECI looks at very specific subsectors, and wants to see both growth and resilience in the businesses it backs.
With competition for good assets driving prices, early identification of the value drivers is key. Some private equity firms have set up ‘value creation’ teams. Richard Kirby joined LDC from AON in 2018, as director and head of LDC’s value creation partners team. “Our team has become more involved at the inception of the investment, from the first consideration of the transaction,” he says. “Getting involved pre-investment is absolutely key – we understand the business more, their market position and the macroeconomic factors affecting them, and together we evolve the strategic plan.”
Appetite for growth
During the first half of 2021, LDC invested £180m to back eight new management teams and help its portfolio, supporting 36 strategic acquisitions. It has investments in every sector of the UK economy. The mid-market private equity firm uses benchmark analysis of a sector to understand where a target sits versus its competition. “We look at the current performance, earnings, the growth plan against industry benchmarks and best practice data to help us understand where they are on their journey and to understand the potential growth areas,” says Kirby. “We agree them with management and help them to build the strategy.”
All of the private equity firms interviewed for this feature mentioned a 100-day plan. For Kirby, that’s central to a ‘very structured process’ for a seasoned investment firm: “It ensures we’re working with the management team to create value straight after completion.”
This is echoed by Guy Blackburn, portfolio partner at Mobeus Equity Partners. “Before we write the cheque, we make sure we have a plan,” he says. “It must be thought through, agreed with management and well resourced. We don’t want to invest in a business and then on day one say: ‘Right, what are we going to do?’ You just waste three months that way. Identifying value drivers upfront and how to unlock and deliver them is a core part of the process. We need to hit the ground running.”
Blackburn’s colleague at Mobeus, partner Justin Maltz, says the due diligence process is increasingly focused on developing the strategy. “Traditionally, due diligence would be used to work out whether we wanted to buy and whether the price was right. But now, we use due diligence to improve our knowledge of the opportunity and what the value drivers are to feed into the plan. We meet management teams and they may present a plan produced with their advisers to maximise the selling price. This often includes a wide range of possible avenues for growth, without a clear assessment of which are most attractive or deliverable.
“By completion, we have a refined strategy, crisply targeted at how we can grow the business in the real world. There will be a handful of things that will genuinely move the dial. So, how are we going to get those things done?” he says.
Of course, most strategies look great on paper, but delivering them can be far tougher. There are different approaches to this. Blackburn says there’s increasing emphasis on finding industry experts with real-world experience of delivering on strategic plans to take on the role of chairperson. “As experienced but generalist investors, we want to make sure there are no gaps between our beliefs, informed by commercial due diligence providers, and those of the industry experts, who have experienced the nuts and bolts of getting it done – people who know what has been tried and ultimately failed in the past.”
Best people for the job
Deep industry expertise is often needed to support investors, where value creation has usurped financial engineering as the source of private equity returns. “The key thing is we have the right people to deliver,” adds Blackburn. “Before we invest, management teams are not sat twiddling their thumbs – they’re busy people. If growth ambitions go up post-investment, we have to think: ‘Have we got enough people – the right people – to do what we’re trying to do?’”
In the lower mid-market, many companies have small management teams that may have little or no experience of delivering strategic transformation plans. Lucie Mills, director and head of business transformation at NorthEdge Capital, says investors have to adapt to that. “We don’t define their plan. We ask ourselves: ‘How will they do it? What people do they need? How will it be measured? What story will they tell on exit to maximise the value of the business?’ It’s connecting the long-term strategy to the day-to-day delivery,” she says.
Typical value drivers come from international expansion, new product development or improving margins. LDC’s value enhancement team has specialists in technology and digital transformation, sales pricing, operations, supply chain and procurement, and customer relationship management. Kirby says: “We identify across our team the best value creation resource to partner with that particular management team.”
LDC currently has 90 investee companies, across a broad range of sectors. “Because of the experience we have across the firm, we can very quickly make simple gains in their non-contentious overhead costs and save costs using commercial agreements that are available to our businesses because of our scale.
There are relatively simple gains to be made – operational arbitrage, supply chain, synergies or opening up new markets, perhaps through using the agreements available across LDC’s portfolio.
Joining forces
ECI has had a commercial team in place for the past decade that is experienced in the easy wins and how to execute them. International expansion as a value driver has become a much bigger part of the story. “It’s the bread and butter of what we do now, rather than the exception, particularly US growth,” says Pike.
In 2018, ECI invested in Moneypenny. While it had some North American sales, US expansion was a big value driver of future growth. In March 2020, Moneypenny acquired VoiceNation, which gave it a platform to continue that growth. At the start of 2021, ECI opened a New York office to help portfolio companies drive US growth organically and with M&A.
There are other countries that are important for expansion. Luxembourg and Dublin, in particular, are two key places for fund services. In 2019, ECI invested in Dublin-based fund compliance services business KB Associates. In February 2021, it acquired EFG Fund Management, based in Luxembourg.
“We’re not just about building scale through bolt-ons,” says Pike. “We invest heavily and proactively in helping our portfolio companies to make strategic acquisitions that add a huge amount of value, taking them into new markets, nationally or internationally, or giving them a new capability or product. All of their acquisitions are carefully selected and fully integrated. We do switch off a huge number of them, too.”
Logical approach
In 2011, ECI backed Wireless Logic, a machine-to-machine managed services provider. In 2015, ECI sold its stake to CVC, generating a multiple of 6.1x on the investment and a 68% IRR. “Off the back of having done that deal and understanding the IoT (Internet of Things) space, we invested in Arkessa off-market in 2018, before going on to complete a £250m off-market deal with CSL last year,” says Pike. “It’s an IoT-critical connectivity solutions provider in the fire, security and healthcare space. ECI partner Paul McCreadie understood the subsector inside out and had a longstanding relationship with the management team, so he had high conviction around the value drivers of the business.”
Clearly, that industry insight is attractive to a management team, which will have skin in the game and know it’s dealing with a buyer that will deliver on the deal. In some instances, that sector knowledge and strategic view may even trump a higher cash offer for the business. In any case, it’s at least as important.
Reviewing plans
What happens when the ground shifts from beneath a business? How do investors reassess the value drivers? “A three-year investment is just 36 board meetings – it’s not many,” says Mobeus’s Blackburn. “As a minimum, each year we will want to reconfirm we are still on track – do we need to revisit our plans? After the first year, we tend to revisit and update the three-year plan, checking assumptions with third parties out in the market.”
In ‘normal times’, Mobeus would have a ‘strategy day’ each year, with key shareholders and management in a room, taking stock of where they are on the journey. The past 18 months, though, have been extremely testing for some, while presenting huge opportunities for others. Mobeus has seen both sides of that story in its portfolio.
One investment is ATG (Active Travel Group), which has had a “pretty interesting” 18 months, says Maltz euphemistically. “But it’s a really good business that’s already starting to come back quite strong. So, we’re looking to make acquisitions to build it up. Even though the business is currently behind on the original plan due to COVID-19, we still have a very positive long-term view of the value we can create, and have confidence in that and our management team.”
Adapting in a crisis
Another Mobeus company is customer experience business Ventrica. “Pre-pandemic, we had tiptoed around the idea of having people working at home and actually the blocker was largely the clients,” says Blackburn. “During the first lockdown, Ventrica’s management team did a phenomenal job, essentially virtualising that business in the space of about two to three weeks. Now, we’re running a hybrid, which has completely changed how that business delivers effectively for its customers and supports its people, as well as making significant cost savings.”
Obviously, there must still be value creation opportunities for the acquirer when selling a business. “You need to be able to demonstrate sustainable momentum in the business,” says Blackburn. “Future value creation opportunities have much more impact if you’ve already started a pilot that shows they work. You need to be able to clearly articulate that to the next owners.”
Maltz says that despite the much-heralded wall of private equity money, most recent Mobeus exits have been to trade. He counsels: “Trade very quickly sees through anything that’s not a real, deliverable opportunity. Getting the right corporate finance input often helps us understand the value drivers a trade buyer will look for in our business to justify paying a higher multiple – we start focusing on that early in our investment period.”