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Title: The PE Toolkit Date: 2023-03-04 Modified: 2023-03-04 Tags:private equity Slug: petoolkit

book cover

deal sourcing

not a lot of guidancex on sourcing

1 in 100 is normal odds for selecting a deal to pursue

focus on the process not the interim outcomes

go deep on an industry

proprietary transaction = not well known in the market and its just you

PE theoretically should be better in bear markets as shareholders seek financing

Disruptors, applying strategies from other sectors, replicating deal structures in new geos

thematic deal sourcing

Identify a sector theme and build an investment thesis Go through supply chain to find sub sectors

Conduct an in depth analysis of the selected industry Elaborate by mapping out key players operating in the industry Build a network of experts and company execs to fill knowledge Establish a long list of deal targets Rank the companies and approach 2-3 targets at a time Go visit to convert to real transactions

#3 opportunistic deal sourcing

Most deals are done this way - network with intermediaries, analyze pitchbooks, attend company meetings and write offer letters

PE problem: info is easy to get and everyone is connected

Best way to compete is to 1) stay top of mind with your key contacts and 2) reviewing only relevant deals

Develop a POV about the deals you want to target

Articulate messge about your mandate

Team up wth intermediaries who add value

Add new relevant connections to your network

Build a strong brand

Apply creative thinking to supplement your opportunistic deal flow

Setup a tech platform to manage your originations workdlows

Establish a team devoted to deal sourcing

#4 eliminating the wrong deal

For every 100 opps considered, investigate fewer than 25%, sign an LOI for 14 and close only 6.

You’re really there to eliminate deals

You need a process that will debias your judgement

Thinking Fash and Slow

Most firms to 10-15 transactions in any one fund

Setup instant deal breakers (10 or so) as first screen Comply with your mandate - LBO or growth? Deal structure, sector, geo. Challenging geo - suppliers, customers, legal, labor force Industry - subsector must be good for 10-15 years, avoid structural issues, no pricing power, few barriers to entry, in a permanent decline, going to stay small or niche Small - no small deals Investment stake Reputational risk Too little time Too many things need to go right

Second screen - standard approach and use same investment criteria

#5 ID the right deal

Second screen…

Transaction dynamic what does the seller know that you dont? is there a good reason for selling?
Market Larger growing markets allow for errors and dont need to be dominant. there should be a barrier to entry, not too much supplier/buyer base, have pricing power and be in the right part of the value chain Red flags - over capacity, product commodiation or obsolenscne Resilience - changes in reg, commodity cycle, sector innovation, interest rates/foreign exchange dont matter
Business model and competitive position - MOST Important How do they make money? What does the customer buy and why? What is distinct? What’s its share, cost and quality compared to comp? Moat - own intangible that is valuable? tightly integrated with customer business process producing high switch cost? network effect? cost advantage that cant be reproduced easily?
Management team
financial performance - only the essentials at this stage sales growth, gross margin and ebitda in %, maintenance CAPEX, EBITDA - Maintainence capex for FCF and net debt existing asset base and expansion capex
ESG
investment thesis and value creation measures why this business? what is the source of the market dislocation that makes it good? are you a logical owner of this business? what value do you bring? sample value creation - increasing sales, buy and build or roll out strategies, entering new markets operational improvements - supply chain, better procurement, waste reduction, IT , overhead reduction financial levers - elininate value destroying capex programs, working cap improvements, rengoation key contracts, change up balance sheet
valuation and structure
exit and return
risk and reward

#assessing the top management team

meeting management way more often than deal closings/exits

PE owned businesses have better management bc og higher debt - more monitoring, efficient people managmenet, greater delegation of authority

They get skin in the game - hope for A reward A and achieve A with incentives oly for A

Good managers:

Make decisions earlier and faster
Drive results and align people around them on the plan
Adapt in a rapidly changing climate 4.Consistent on follow through - make corrections when they need

For a PE CEO:

track record
over communicator
deliver in fast paced environment
operational agility
think like an investor

How to assess

Meetings and interviews - discuss investment, industry, company, value creation plan, team dynamic, howd they get there, how long they work together
Strengths finder
references - keep talking past their script

#7 reviewing the business plan

You need to know the operating challenges and opportunities not just the numbers

You know why the company exists and convinved it needs to exist now and in the future
You know the industey and compettiive dynamics
You can explain how the company makes money and understand the economics of its business model
You know what operational imrpovements and growth initiatives will be done during investment horizon
You have an operating model and set of projections with sensitivity analysis
You have ID’s a list of key assumptions that need to be verified and validated during the due diligance process

Top issues: inflated projections and unrealistic assumptions unrealistic timeline idealistic perception of company’s capabilities missing costs and investments lack of competence in capital allocation and cash flow management

You have to poke holes - break down business in to blocks and basics

Answer these questions:

what does the company do? Does it need to exist?
what macro factors will affect it?
what do i have to know about the industry to put the companyu’s business plan in to context?
what are the key building blocks of this companu’s business model?
how is this company pisitioned at present compared to its competitors?
what do they do well now and what does it do badly?
how have they done historically?
what 5 year projections am I underwriting as an investment case? what are the key sources of value creation during my investment hoiroj?
what are the risks?
does it all add up?

master list of value creating activities…

achieve operational and financial efficiency

better financial reporting and transparent decision making and control
incentivize management and be clear about responsibility, make changes
reduce operational complexity to get to industry best practice
reduce head office costs and redundant processes
question all costs through supply chain - automate, use IT, nenegotiate key contract,s form partnerships, outsource or insouce
reduce waste
reduce slow moving inventory and get better payment terms from suppliers
dispose of underused assets, explore alternative financing of fixed assets
eliminate capex unless it has a clear hurdle rate
focus on cash and cash profit focused KPIs

##optimize existing customer value prop

improve product perception- brand, clarity of existing offer
revenue optimization - challenge the current product mix, review sales drivers, grow average transaction values through sales incentives, loyalty, ancillary servies or product bundles, enhance features and introduce greater price discrimiation
reduce churn through better service
eliminate uneconomic product related activities…eliminate bad marketing spend, locations, non core divisions, unprofitable product lines

##pursue profitable growth

only once efficiency and product are optimized
expand to new customer segments or geographies
intro new products - test and launch new servies, locations, formats
grow through acquisitions

-dont attempt all, just what can be done in 5 years

try for operational efficiency during first 6-18 months, 2-3 items in customer proposition fist 24 months. revenue growth is the most important source of value creation

#valuation

3 things - value of business, headline price, cash consideration paid by the investor

value in business - growth, exisitng cash flow, exisitng asset base, comeptitove advantave, operational improvement potential, option or access to assets, value in control to make decisions,

the price is influanced by motives of seller/buyer, market sentitment, industry outlook, negotiation skiss, options of both parties

cash paid - depends on non cash, structuring options like rachets and earn outs, post closing amendments based on existing cash, working capital.

valuation metrics - all are misleading in isolation

check the outliers and the averages review multiples over a full cycle to see if market is too hot use bases like historic, forwrard, 12 months and run rate

remove one off windfalss, charges,etc… look for window dressing

EV to Sales

EV to EBITDA

EV to OpFCF

Industry benchmark - price per bed, etc…

P to BV

PE multiple

Comps

liquidation value - sets floor

cyclical valuations - whats driving the cycle? demand? prices? whats your plan for a down cycle

PE method - can you hit your IRR needed given a price and your leverage?

From value to price…dont do unless value to buyer is more than value to seller

You need a desperate seller

#deal structure

capital structure, management incentives, risk mitigation

typically have to fully repay existing debt - so start at clean slate

LBOs give tax advantages and motivate management

Senior debt is the cheapest- and may be organized in tranches and can be prepaid at par

Equity - what return will generate 2.5x-3x of invested capital over 4-5 years

management plans - only incentiveze those who can drive financial performance

earn out - good for bridging the entry price gap between seller expectatin and buyer…make the payment contingent variable and linked to a range of outcomes

escrow - make the seller put some saide for a known, quantifiable, highly probable risk being resolved in near term (a claim)

vendor note - seller financing; can be used with escrow too

#10 deal execution - transaction proess and due dil

most deals die at least once

prelim discussions - deal teaser 2-10 page doc, no access to mgmt. you know its proprietary deal if its less prescriptive and there’s more meetings

review of high level info and first round bid - NDA and CIM signed, you may need to request financial data if there’s none

talk to management to learn model, ask questions, eval management. you come up with an investment thesis, generate a diffenritated deal angle and valuation range for the first round bid. you want your financing set.

subsequent bidding - get access to more info, site visits, management time. determine priority areas of due dil,

Seller reveals buyer and exclusivity period

10 principles of good due dil:

get good advisers 2.brief them
be clear about what you require from them
any due dil not by your team is suspect
do due dil in phases - front load with most critical, dont do detail until exclusitivyt exists 6.agree on format from due dil team
control due dil costs with fee caps, phased work with separate pricing, budgets
they are human
you are human
keep the big picture in mind business model, does thesis still stack up, is business plan achievable in horizon , are financials good?, what liabilities are we buying, how will change of control impact this business and model? will company be desirable at exit?

due dil should reveal strengths and weaknesses

workstreams - business, financial,operational, legal, insurance

#deal execuction - legal

you need provide input during legal negotiations

you need to translate due dil gindings in to legal clauses

deal team is there to 1) explain main risk areas to lawyer 2) check every number

always volunteer to take responsibility for first draft - get the first draft advantage

non binding vs definitive agreements - if the deal is unlikely, pull out early from drafting definiteive agreements. do you have initial drafts of key docs going?

risk management - indemnificatioins let you get payments from a counterparty when there are losses, reps and warranties compel the parties to state a specific fact and make a commit on the fact, convenants are promises of future behavior

narrow vs wide definitions - your rights should apply in broad scenarios, your obligations in narrow ones. pay attention to scope of definitions.

expect the best plan for the worst - needs to support your desired risk leel, time horizon and preferred exit route

main docs:

NDAs engagement letters with advisors offer letters to sellers - great differentiator from other buyers. sound upbeat, desire to move quickly, sale purchase agreement articles of association

#12 adding value through active ownership

Use a Value Creation Plan 100 Day Plan for momentum Setup governance an reporting Warning signs

Approaches: Apply new operating procedures aimed at benchmarking and improving sales, product, support, G&A Do a turnaround and bolt on acquisitions

basics: revenue growth, margin improvement, overhead reduction, capital efficiency

the basics need specific steps that create a path to value

focus on where upside can be captured quickly, address most pressing needs, set clear priorities

most plans operate on a 5 year clock

different routes for different companies is normal

others - better supply chain practices, eliminate procurement waste, customer chirn. sales closing, build avg transaction values, capture adjacent segments

value creation plan

challenge the status quo through culture of performance and accountability
over invest in early wins in first 100 days of ownership
pursue profitable growth through new markets/products
strengthen existing capabilities
consolidate success and exit

You make the plan with management, with milestones, KPIs and link to the investment base case Work with experts on procurement, sales, working capital mgmt, tech

do the plan between signing and closing - you know the base case and opportunities to cut costs/inc revenues from due dil

this is the time to teach management about cash management and capital allocation

derisk as soon as possible - generate cash quickly to cushion from risk, pay down debt, or deploy more capital toward business growth

every company should:

assess their IT gaps - customer tracking, purchasing, getting BI data, automating supply chains and optimizing logistics
optimize product pricing- increases in pricing are better than savings in variable costs
look for outdated price lists, situations where customer pricing is too uniform, loose discounts and rebates,

if profitability varying by customer type or product: do experiments to see price sensitivity segment better upgrade product features to differentiate improved product mix

-grow the moat:

dont just focus on shortcomings, allow management to 2x on strengths

make a whale chart and rank customers, products, locations by profitability

split in to quartiles - what’s special about the top quartile

the transaction hits max momentume in the first 100 days

-management has to communicate to employees about future expectations -make org chart changes -link comp to individual performance -assess and improv efinance function -dont target everythign in the plan within 100 days - just what’s critical -low hanging fruit - working capital changes, IT upgrades, supply chain improvements and purchasing arrangements, redeploy unproductive assets and spare capacity

-put target dates, DRI, actions, success criteria, milestones, KPIS and dollar targets to each iniativie

program office - the new management team can’t watch the lists…they have to run the business, sop setup someone to track progress, put in tools to track, and do updates

rewards - do a bonus based on executing plan

governance

-small boards, more time commit than public board, someone has daily interaction with management during 100 day plan -support and challenge the portfolio compnay - be the steering committee for critical decisions -do not want to foster reliance on the board and any CEO will prevent that -budget, changes in management, acquisition/disposal, straetgy, operations and investmetns must be approved by board

-scorecards: financial, customer, internal business ,and innovation/learning

-board tracks performance against base case and the value creation plan, need data of budget to forecast for KPIs and leading indicators, know risk and controls, and be presented a wholistic view of the business

look for warning signs: -distracted management -filtering info -too risk prone -quitting

#exiting

-funds have 10 year horizons -quarterly valuations are nice, but its all about the exit and the profits

-you must choose when, how, and how to maximize the eixt

Are multiples good? Is the business ready?

You exit when the majority of the value creation story is visible, not yet fully exhaused -dont wait for maximum performance -time is the enemy -you can time the economic cycle so you sell when multiples are expanding -funds early in their life may mean shorter holding periods since PEs want to return cash to LPs to start fundraising -funds late in their life mean longer holds since they need fatter multiples and want to boost their carry

most sales are to strategic or financial buyers

smaller companies mean more strategic and sponsor to sponsor

strategics are looking for strong brand, defensible market pisitions, attractive geos, or delivering snyergies to their business most deals are to strategics corporates look to M&A as the easy way to get organic growth the target should position itself by showing its exclusive market segments, unique expertise, outstanding serviee, or better commercial exeuction premium prices for cross selling or cost savings that create synergies they do less industry due dil - so the deal is faster dont do LBO style purchases

financials are lookign for levers that can be pulled to support LBOs

selling to another sponosor/financial buyer…

only if they see growth will they buy

investment thesis track record debt paydown market position value creation plan you have to show unit economucs, working capital cycles, cash generation, ROI from prior capex

##alternative exits You can also refi original axqiisiton debt and give it to the investors sell a minority stake or majority stake

Dont botch the sale by not oaying attention to the business operations…

start early - know your likely exit before transaction completion, and revisit every 6 months
package 24 months in advance - no spikes in earnings or cash as they may be deemed unsusstainable. settle taxes, sell bad inventory, collect bad debts, dispose of non-operating assets, do PR and get management to attend trade shows. Market within the industry.
get management on board - make sure you have a full team to offer
split the duties for the management teeam - one team for ops, the other for sale
create the story
target an uneventful DD process, have a VDD report
maintain competitive tension - keep all exits open

Dont overmarket or provide exclusicityu to one buyer

conduct the final round of bidding…