Why private equity investors are building ‘value machines’ - whether they know it or not
It is often helpful to give labels to new concepts which otherwise stay fuzzy. The problem with fuzzy concepts is that they are hard to visualise, communicate and work on. Armed with (previously invented) labels like ‘brunch’, ‘laptop’ or ‘webinar’ we make it quicker to define an option for socialising, distinguishing between computer variants, and agreeing how to learn on-line. Investors do the same thing: ‘EBITDA’ was invented in the 1970s to make leveraged buy-outs easier to justify to debt providers. ‘Value creation’ is a more recent label created to group together a whole range of ideas and actions.
Activities
In that context, I’d like to suggest a label for a different strand of activity which PE investors dedicate considerable time to but usually see as unconnected actions. However, defining what shared purpose connects them all makes it easier to judge whether collectively they are likely to achieve their goal. So, let’s examine the activities, their joint purpose, and consider a new label which might capture the essence of it all.
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From the very start of investor contact with a management team, both parties are looking for signs that a healthy, medium-term partnership can be created. That is multifaceted but involves trust, compatible decision-making styles and a shared vision of the future. Formal processes like due diligence and shareholder agreements may deepen and concretise that sense of partnership, but much of the essence is created informally, well before exclusivity. When revelations about personal relationships within a team, or CEO financial arrangements, appear (as they have done on a couple of recent Catalysis projects) that can put everything else in jeopardy.
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Board and governance arrangements can take time to agree. Who from the executive team should be in the boardroom? Which investor is the right person to become a director? What sort of Chair (or other NED) would best fit the requirement and how is that decided? Where do board decisions end and executive ones begin? These can all be considered as extensions of the core management-investor partnership.
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Strategic objectives and financial expectations emerge in early form as the partnership is defined, evolve during the period of exclusivity and are then passed to the board for refinement and translation into action post-deal through 100-day activities, value creation planning and strategy process. Those objectives and expectations, like another concentric circle or Russian doll, build on the partnership and governance framework.
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The final activity - which is meant to translate intentions from A, B & C into on-going action – is team & organisation strategy. Who is being backed – and being held accountable – for execution of the strategy? What degree of resourcing and other support is available to underpin scaling and value-add initiatives? How can the management team most effectively use those resources to deliver results?
Shared purpose
The four activities cover an apparently wide range of topics. However, without their permanent presence, value creation plans (which constitute the nuts-and-bolts aspects of C) have little chance of succeeding. A fragile partnership; a board producing confused governance; unreasonable or misaligned expectations; inadequate team & organisational arrangements: all can block value creation. By contrast, when A, B, C and D are in place, they provide a foundation and system which allow the conversion of intentions into effective action and positive effects.
A new label
My suggestion is that the deployment of the four activities by investors can be helpfully labelled as a ‘value machine’ for two reasons:
They are fundamental to value because any economic outcomes are essentially determined – positively or negatively – by their presence.
Looking at a dictionary definition of machines (‘an apparatus using mechanical power and having several parts, each with a definite function and together performing a particular task’), this label meets the requirement of involving multiple parts, with definite functions, and collectively performing a specific useful task. It is true that the apparatus is driven by human not mechanical power.
Perhaps more important than the definition is the implication that investors need to (i) design and operate their value machines with clarity of purpose, (ii) keep an eye on how well each individual component operates and, (iii), check how aligned they are.
So, how do you feel your machine building and handling skills are working?
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