Investing in private equity? Back management teams not sectors.
2 April 2019
When investing in private UK companies, "hot" sectors are exciting, but strong management teams running sound businesses can create value in any industry.
It’s a given that when you invest in private equity you want to back a "winner" - but what does a winner look like? So often, in the press at least, there seems to be an obsession with “disruption” to define hot sectors and “unicorns” to measure success. And while there’s clearly a place for investing in such life-changing or industry-defining ideas, hoping to find the next Google or Amazon, they can be hard to monetise in the real world.
As we saw in the Dotcom era, some will eventually see stellar growth after round after round of investment, but many won’t. My mantra for private equity investment is: “Back the management team, not the sector.”
A good management team will spot and capitalise on opportunities to grow and add value whatever industry they are in. That’s why at Connection Capital we are sector-agnostic. But it’s also one of the reasons why we invest in UK SMEs which are more established, rather than start-ups or early stage companies. Potential for value growth may be more modest, but with the management team bedded in and profitability already demonstrated, prospects for a successful outcome and a capital gain without multiple rounds of investment tend to be better.
So, what are we looking for in a good management team? For me, the top priorities are:
1. A strong CEO
As the leader of the management team, the CEO is the lynchpin to organisational success. There’s a huge amount of expectation of (and pressure on) a CEO, so they need a well-rounded set of skills and attributes.
We recently outlined some of the things that make a good CEO in a previous article, but in the context I’m talking about here, I look for a CEO who can articulate their vision clearly to everyone in the company in such a way that they understand and commit to their role in delivering it.
That includes setting out the steps that will need to be taken along the way, and how they will be achieved, getting all staff to buy-in to that journey. If they can articulate that vision to me as a potential investor, I’ll be confident they can communicate it effectively throughout the business.
2. No "I" in team
That said, we don’t want to see the cult of personality. Individual charisma is all very well, but the CEO needs to have soft skills such as the ability to listen and be approachable, to be open to internal challenge from his or her senior team (as well as external challenge from investors).
Private equity investors should ask: how does the team dynamic operate?
Is it a collaboration of people working well together, where individuals’ views and ideas are shared and given consideration and skillsets are complementary?
Or is it a collection of minions implementing demands from the CEO? Just as businesses shouldn’t be too dependent on one customer, over-reliance on one individual is risky too.
3. Mind the gaps
Any gaps in the team’s skills and expertise need careful attention. In the sorts of lower mid-market UK SMEs we back (i.e. £10-75m turnover), management teams can be small and may have limited experience in depth below the board and, so any weaknesses are easily exposed.
All parties involved in a private equity financing transaction need to consider whether new roles need to be created (such as a Finance Director if there isn’t one) and how best to deal with individuals who may not have what it takes to keep up with the business as it undergoes rapid change.
A particular challenge at the moment, with the number of ‘cash out’ deals we see (whereby owners look to realise a portion of the wealth tied up in their business) is the strength in depth of the team that remains.
Have they been in the business long enough and do they have the leadership to fully understand what’s required? If not, their intelligence, drive and ambition may not be enough.
In these circumstances we work with the management to supplement the team with key recruitments and by adding wider skills and experience via one or more non-executive directors from our extensive network of private equity investing clients and contacts.
4. A realistic business plan
We often find that SMEs seeking private equity investment over-sell what they can achieve. They promise investors big things because it’s what they think we want to hear and because they have been asked to support the vendors’ best-case scenario forecast (presented in the Information Memorandum prepared by corporate financiers to generate the best possible price).
That’s understandable, but even though the forecasts may be based on assumptions which individually appear to be reasonable, is it realistic to expect all of them to come to pass in an ambitious timetable? Management teams have to remember that the price paid and the structure devised is often based on these numbers and this can put intense pressure on the company post-deal.
We then have to cater for this over-optimism by adjusting the funding structure with the realism brought by years of private equity investing experience and expertise, which shows that ambitious Information Memorandum based forecasts are rarely achieved. I prefer a more balanced view, and we often ask management teams to present two forecasts: one outlining a ‘stretch’ outcome, and the other a base-case view, so that we know what the realistic range is.
5. Private equity investment works best as a partnership.
There is huge mutual dependency, so honesty and trust is vital. Management teams must feel they can be open with their private equity investors, and likewise investors should be able to be open with management, whether minority or majority equity holder.
Connection Capital is comfortable being either and we have the same partnership style approach in both circumstances so we do not see ourselves as the business owners, who decide on what comes to pass in glorious isolation. This does not mean that we are passive, we have to make sure issues are raised, so that they can be addressed constructively and quickly and opportunities can be maximised.
This relies on effective communication, from the first meeting, through the investment process and throughout the investment life. In all our private equity investments we introduce as good an independent Chairman as we can find to the company. Their role is not to look after our investment (that is our job), but to run the board, help the management run the company and help us all make better decisions taking in to account all stakeholders’ perspectives.
Chasing the “next big thing” might deliver the “unicorn” that dreams are made of, but as anyone sensible investing in private equity knows, there are also very high risks involved.
Not to mention the prospect of a series of highly dilutive investment rounds, each one of which is meant to be the last, but rarely is.
Selecting solid UK SME businesses run by ambitious - yet realistic, driven - yet open-minded, management teams is the most reliable route to making good investment returns in the UK private equity industry. Sector, schmector: it’s all about people. That’s our strategy and it’s one that’s served us well.
Leadership no-no's: what sets alarm bells ringing:
- Inability to explain the business plan or communicate vision
- Inadequate knowledge of what customers want and how to deliver it
- Unrealistic forecasting – it only benefits vendors
- Leaders that won’t listen or who won’t be challenged
- Lack of understanding of what makes their business valuable, beyond an increase in scale
Bernard Dale, April 2019
Bernard is a Managing Partner and Head of Connection Capital's Private Equity team. He is an experienced investor in UK SMEs and has worked in private equity for almost 25 years.