Monday, February 18, 2008

In building value in business, the whole is not the sum of the parts

Private equity firms often seem mesmerised by DCF analysis and financial models. This emphasis is counterproductive to their notional requirements and even proper risk analysis of the project. Theoretically PE groups want a credible business plan in a framework of three to seven years that is going to generate double digit returns. This is inevitably dependent on future earnings multiples. They move into the business to finance strategic acquisitions to generate these earnings multiples and get them to their exit strategy. Some deals work well, some less so as events evolve.

Admittedly the industry needs high returns to build and keep their investor base and to compensate management in their role in the business. Yet nominal returns on projected earnings are little more than a snapshot based on estimations that change rapidly according to market conditions and forward revenue forecasts. Making good projections requires considerable skill and instinct, but this just scratches the surface. Building value in a firm that generates attractive earnings multiples is a complex job.

Harvard Business School recently sent me a prospectus for a new course they are developing on this subject. The headings are useful in illustrating that DCF analysis means little in itself. Management plays the key role. Starting, developing and executing a business plan that generates healthy earning multiples is not a simple accounting exercise. There are a lot of intangible factors. Fundamentally, it all begins with vision and commitment.

As a case study, Quintana - a successful start up in the dry cargo market - would not even have got off the ground without the vision and leadership of Corbin Robertson, the founder. Clearly his client relationship with First Reserve and position as a US-based commodity trader played a big role in the evolution of this vision, but he did not start investing in vessels because of DCF figures. He had a vision and he committed himself to go into the dry cargo sector. The market prospects were not all that clear when he funded the first vessel acquisitions back in 2005 in a volatile, choppy freight rates environment.. In effect, he led the investors into the business with an initial personal commitment and the returns evolved as the business took form. First Reserve, the PE firm concerned, would never have done this on their own. This is fundamental aspect of any business
Lets consider below a few of headings in HBS course summary, which clearly demonstrate that good earnings multiples and successful business performance is anything but a simple mathematical number crunching game:


  • Providing energy and vision for the corporation

  • Overseeing the selection and recruitment of the company's corporate-level and potential leaders

  • Managing the ongoing professional development and career advancement of all corporate executives

  • Understanding the role that succession plays in an organization's corporate strategy


  • Designing and managing the business- and country-unit portfolio to add value, while developing and managing business growth based on cross-unit or entirely new activity
  • Creating effective corporate-division relationships
  • Overseeing the organic development of new businesses
  • Managing mergers and acquisitions to ensure that they contribute strategically to the company's overall mission


  • Funding strategic initiatives and managing both access to capital and cost of capital
    Understanding balance-sheet structure, the pattern of earnings, dividend policy, resource allocation, and relations with financial markets
  • Meeting the special financial challenges associated with multinational activity


  • Maintaining productive relationships among owners, managers, and other stakeholders
    Leveraging the role of the corporate board to ensure accountability, responsibility, and ethical business practices
  • Evaluating the impact of governance structures on compensation and incentive systems

Note how little emphasis HBS gives on those dogged DCF calculations over which PE partners so often dwell over in cold call road show presentations. Too often they flood you with questions on minute details that overshadow the basic critical issues in the business guidelines that you are eager to discuss with them and exchange views! Most of the emphasis in the HBS course is on the human element and relationships, which is central in business where quality of relationships is critical to financial results.

In reality, businesses grow and prosper as they evolve. Asset investments to get into the market place for initial positioning may actually have nominally mediocre returns. These first asset investments are simply stepping stones in an overall strategy. A lot of initial effort in business development goes into positioning and building of relationships with customers, banks and investors. Also very important is building viable infrastructure for good execution that ensures customer satisfaction. This requires organizational development skills to find the right people, keep them motivated and provide them the means to perform well in their jobs. Commercial power in the market place is a factor of market position and scale. It grows over time as the business develops and reputation spreads, opening new opportunities that are not necessarily visible or accessible at outset.
In short, what actions you take today bring results tomorrow. You have to be willing to learn to walk before you can run. Those attractive earning multiples that PE firms adore cannot necessarily happen instantaneously nor do DCF calculations really tell much of the story. This is why vision and commitment in business are such important elements of success. You may well have to sacrifice today in taking risks and committing yourself to a lot of hard work to get those impressive results down the line that seem in retrospect so obvious. There is no free ride here.

The challenge for PE firms is to provide the support and effective financial engineering for the business to grow. They need to make more effort to know their clients and understand their business guidelines in deal formation. Conversely since they hold majority share generally, it very important that there is good match for the prospective client and a mutual understanding of the business risks involved in the transaction so as to facilitate the underlying commercial relationships in the project.

No comments:

Post a Comment