There’s an old saying in poker. “If you can’t spot the sucker in your first half hour at the table – it’s you.” In private equity terms, there is often a temptation to see the deal environment as a gladiatorial forum which necessarily throws up winners and losers.
But in current market conditions, the oft-used cliché of ‘win-win’ – where vendors, management teams, private equity investors and, of course, limited partners all take something from the transaction – is more appropriate than ever.
An investment strategy based around considering different scenarios for operational and strategic improvements, offering vendors participation in the upside generated after the change of control and involving an open and long-term relationship with management and seller will work effectively across all stages of a cycle.
Faced with rapidly changing economic conditions, private equity firms are increasingly modelling a variety of different investment scenarios and applying probability to them wherever possible to enable debt to be serviced in a variety of potential different futures and returns criteria to be adjusted without placing undue stress on the company or the investor.
Effective scenario modelling also allows for flexibility in a portfolio company’s balance sheet to seize upside opportunities as they come along. These might include strategic one-off situations such as acquisitions, new product development and new market entry, or simply the possibility of more rapid growth through improved markets.
The conditions to seize opportunities for operational improvement or strategic repositioning are dependent neither on a company’s ability to raise debt on favourable terms, nor on economic growth in the economies where the company operates.
But an investment strategy based on transformative value creation does entail some essential ingredients. Firstly, a valuation is agreed between seller and buyer based on a business plan involving improvements to a tried and tested strategy carried out by management. Additional upside opportunities are often merely remote possibilities at the outset of a transaction and difficult to price in, but should nonetheless be considered in a transparent way by all parties.
Secondly, that a management team is in place that is capable of not only running the company in its current state but also identifying value creation opportunities, seizing them and stewarding the more complicated and substantial companies that often result from this activity. We look out for managers who are overqualified for their current roles.
And thirdly, that the company’s flexibility to take advantage of opportunities that present themselves is not constrained by prohibitive debt structures. If the price of lowering the cost of capital by a few percentage points is a management team entirely focused on servicing that debt, it is not worth paying.
An open and trusting relationship will survive far more external shocks than one which is based on playing cards close to the chest. One advantage of a transformative value creation strategy is that, if convinced, a vendor will often find it attractive to participate in it and indeed would expect to make a substantial amount of money from their participation.
With vendor participation in a deal, cash price upfront is no longer the only issue and a more multi-faceted relationship based on trust is established where both sides are rewarded for their openness and fairness in dealing with one another.
There is also a requirement that anything a potential investor says should be absolutely reliable, particularly in a market where the ability to raise debt for a buyout is regularly scrutinised in the media and elsewhere.
Private equity investors need to ensure that banks lending to a buyout vehicle are also clear and open about their situation. It is of no use whatsoever to either potential acquirer or potential seller if the acquirer has persuaded his banks to overstate their readiness to lend to the deal. The habit sometimes encouraged by vendors’ advisors of submitting crazy first round bids in order to get in the second round of an auction, simply serves to make that auction process unreliable, which is bad news for seller, management, potential acquirer and indeed advisers on all sides.
Returning to our poker table, in an environment where there are an increasing number of “forced sellers’’ in need of liquidity, it’s tempting for private equity investors to identify these parties as the ‘suckers’ from whom value is transferred.
But this would be a mistake and one that is contrary to the culture of Stirling Square. Investments where all parties can legitimately feel they have come out with a good deal, including perhaps an opportunity to participate in the value being created, are ideally suited to all points in the economic cycle.