Why you are spending more time dealing with non-financial issues (and why that is likely to continue)

It is not surprising, that with so much going on in the news at the moment, we tend to stay focused on coping with the short term disruptions we are faced with: a second wave of Covid, the messy economic environment and the unpredictable implications of Brexit (and the US election). But thinking about longer term trends is also worthwhile, especially where those trends have been accelerated by the pandemic. The obvious example is the shift to remote working with the risks that bring for commercial property and hospitality – and the opportunities it has created for multiple tech businesses.

But give a thought to another long-term trend which affects private equity even more directly, namely the growing amount of time spent on non-financial issues as opposed to deal-making, creating financial structures, refinancing, fund-raising etc. Instead, as long-term private equity investors - like Tim Farazmand – observe, more time is now being dedicated to working with investee companies to build value. Specialist advisers like Andros Payne of Humatica note that this trend is driving growth in demand for their services. The pandemic has only made this more acute: one portfolio director reckons that the time spent on each investee has almost tripled in recent months.

What is driving this?

There appear to be two main reasons:

Firstly, the investment environment has changed significantly over the last thirty years. Gareth Whiley remembers that, in the early part of his career, investors could more or less pick and choose between a range of opportunities presented to them by advisers – what he calls ‘farming’ as opposed to the ‘hunting’ which is required now. Another investor remembers producing more than 3x returns in the 1990s with much less effort than 2x might involve today. Chris Harper blames this in part on the huge proliferation of investors in the UK market which has competed away easy returns. In parallel, the use of leverage has become more conservative while benefitting from major multiple arbitrage scarcer than it used to be. Consequently, the private industry has needed to find new ways of creating economic value.

The second big reason is that the corporate environment has also shifted significantly, especially as it affects mid-market investors. 30 years ago, the bread and butter for many investors was buying out unloved subsidiaries from over-extended corporates. As those have become rarer, they have been replaced by investments into younger, often founder-led, companies who are exploiting niches and looking to scale up. These bring entrepreneurial vim and ambition but often lack knowledge of management practices and processes and so need to undergo an organisational transition before they can safely scale up. It is consequently more difficult for investors to just back an incumbent team and leave it to them and a Chair to set their own strategy and then manage its execution. Instead, investor directors have become more active contributors to key board decisions.

Private equity houses have responded to these twin challenges in various ways over the last decade. Operating partners were introduced by larger houses. Value-adding teams have grown in number. Chairs have been expected to become more engaged than previously. Formal value-adding frameworks have been adopted with varying degrees of success (see the Seven Sins of Post-Deal Strategy document here for a painful exploration of where they can go wrong).  

The trends which have driven the increased importance of non-financial involvement by investors show no sign of diminishing and are being exacerbated by the evolving recession. The implications for individual investors are that competence in corporate finance disciplines only represents a diminished part of the overall ‘curriculum’ required to work as a value-adding investor director, even if there are supportive colleagues, Chairs and advisers who can help on certain aspects of the role. The knowledge to be mastered covers psychology, governance, strategy, organisation development – and as many of the 1001 tricks of the trade in building companies as possible.

The stories below illustrate the difficulties of making judgements when these various elements need to be weighed against each other... and against the seductive arguments of financial models.

Mid-Market War Stories

The sensitive tough guy

The investor was pleased: following my interview with the CEO (let’s call him Greg), he had received a call to say how much Greg had enjoyed the conversation. We had spoken about how he had grown the specialised services company (‘ABC’ from bootstrapping beginnings, built a national team, harnessed the web for sales and achieved gross margins of about 70%. Competition was growing but there seemed good prospects to build the business further. He came from a tough background, loved very masculine sports and was very proud of what he had achieved across his ‘empire’ of interests.

A couple of weeks later, the tone had swung to the other extreme. Greg was spitting with anger and couldn’t believe the investor could work with someone as unprofessional as me. Apparently, I had carried out such a hatchet job on him. Although there were other economic reasons involved too, the cessation of the discussions over this off-market opportunity was clearly not helped by Greg’s disillusionment with the diligence process. What had gone wrong?

In reality, ABC was like lots of companies that had grown from an entrepreneurial force of nature into a business needing to make its transition into a mid-market company. It still had plenty of energy, opportunity and lots of room for an investor and Chair to guide it to a larger and more valuable future (Greg was keen to hit a value of £100 Mn. in five years). Systems and processes were weak; regional operations ran things differently; people management was rudimentary; KPIs were lacking; strategic thinking was mostly absent. None of that was (or is) especially unusual, though, and could all be addressed under sensible private equity ownership.

What was more problematic was that Greg couldn’t separate the glossy image of success he wanted to project externally from the mundane realities of growing businesses. The steady linear growth he talked about was characterised by wild swings up and down. His perception that he was a people person seemed limited to enjoying recruitment rather than managing managers or providing a sense of priorities for the wider business. The high rating ABC had received from a Best Companies analysis was based on filling in staff feedback forms for them – and disappeared when they were allowed to do this themselves. Greg wanted to remain ‘100% involved’ in the business but only came to the office a couple of days a week and was often distracted by his other interests. He admitted that the figures he presented to the press and in interview were strongly influenced by ‘artistic licence’ when compared with boring facts.

Even these issues could have been addressed with a dose of self-knowledge and flexibility. Instead, Greg couldn’t bring himself to consider bringing in an MD to bring order to the increasing chaos. An experienced manager who had described serious flaws in the telephone system at the centre of their call centre operation – in some detail - was forced to deny the topic had ever been discussed. The contradiction between a desire to further grow profitability at a time when the business lacked sufficient staff and essential overhead was dismissed. 

In retrospect, Greg found the raising of issues too personally painful to deal with and his plan to get some cash out had to wait until another investor bought up ABC as part of a sector consolidation a few years later. Greg was not involved with the leadership of the new business. His story provides an illustration of how good partners for private equity bring not only confidence and optimism – but also enough humility to acknowledge unsolved problems and when they might need help from others.

Money versus psychology

The discussion was nothing if not colourful. Everyone our MBI candidate (let’s call him Steve) had ever worked with was clearly a disappointment to him: ‘idiot’, ‘pig-headed’, ‘abrasive scouser’, ‘nightmare as a boss’, ‘greedy’, ‘dregs of society’, ‘didn’t like us... quite bitter’ were just some of the descriptions used. Even his wife got a verbal kick. Afterwards, the investor with whom I was carrying out the 2-on-1 interview and I sat down with the head of investment to sort out what we now knew. The business in question was about as simple as one could imagine – a distribution business with a stable set of clients and no major competition. The pricing was sufficiently attractive that a good return could be made with fairly incremental growth. The vendor was happy to provide an extended handover period so there was time for Steve to polish up his product knowledge. Other parts of the team were experienced and didn’t need much change. 

As for Steve himself, he had plenty of relevant experience, including an apparently successful stint in another PE backed company. It is true that he had been in semi-retirement for four years but the demands on his skills would not be major and he was happy to invest his own money. Steve was taking this on because his retirement pot had shrunk due to difficult public markets and he wanted to top it up before retiring for good. Based on this set of circumstances it certainly seemed sensible to proceed with referencing.

Steve’s previous investor rated him a solid and other referees confirmed his basic truthfulness and competence. No-one spoke warmly about him and it became clear that he had a very transactional view of other people – they existed to do their jobs and help him make money. But a clear consensus also emerged that he was so highly motivated by money that he would likely do what was needed to make his new role a success. On a balance of odds calculation, we all concluded that it was worth taking the risk on this cold fish of a man.

Within ten days of Steve’s arrival, I had a call from the investor. Steve had quickly concluded that the incumbent team and the vendor were all idiots and major change would be needed. The team disagreed and threatened to resign en masse; the vendor was outraged. The investor had to choose a side and fired Steve. A more humane replacement was identified and did a decent job of executing the conservative plan. 

So where did we get our judgement wrong? In retrospect, we didn’t give more proper attention to the degree to which Steve was suffering from a ‘hardening of the attitudes’: his pre-existing lack of human empathy had mutated into a toxic disregard which was no longer able to flex even enough to gain the money he craved. The evidence was there in the interview but we had hoped that classic incentives would be enough to compensate.

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