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The private equity edge, especially for unlisted family-run businesses

Comments / {{hitsCtrl.values.hits}} Views / Wednesday, 6 December 2017 00:00

The success of the large number of privately-held/family run businesses could be viewed as a catalyst to the long-term inclusive economic growth of the Country. Hence, guiding and nurturing these “un-cut gems” is a nationwide requirement. 
In most of the privately-owned/family run companies in Sri Lanka, strategic management decisions are taken based on a “firefighting” scenario. The management would be disturbed only if the “fire” irrupts, as long as that does not happen most of the privately-held/family-run businesses would not mind ridding the high waves (the good days). Hence, they would put less time and effort to restructure business operations to be more strategic thinking.
In light of the above, I would like to touch on a few critical factors; that I consider would contribute, in large measure, to the success of a privately-held/family run business.

1.Budgetary discipline followed up with a 3-5 year strategic plan 

In most instances what I have noticed is, budgeted costs would be a mere average of the P&L (Profit and Loss) line items. Further, the revenue would be a mere a 10-20% increase of the previous year as sales target, and no variance (difference between actual and budgeted figures) calculations are done at end of the period. 
All key functions of the business (viz. Sales & Marketing, Production, Finance, HR and IT) should work together to come up with the specific budget ceilings. It brings in ownership and hence responsibility to adhere to budget ceilings. Further, my advice is to establish a quarterly system of check and balance (before a year-end review) of the budget and actuals. Ascertaining whether it is moving towards a positive or a negative variance is important. Always a negative variance needs to be scientifically analysed and corrective measures brought in. Hence, as you can see this is an organisation -wide discipline. 
Most organisations would fail to look at the sales targets scientifically. A mere 10-20% increase is very superficial and anecdotal. Let me elaborate on a few key points that need to be looked into; 
  • Understanding of the overall Industry growth. Zero-in on specific geographies, business segments that are fuelling the growth. 
  • Understating of the strengths of the company in the above. If lacking, what would be the strategies to acquire the strengths (it could be organically done or via Merger and Acquisition)
  • Minimum growth rate required for maintaining the company market Share. The industry could be growing at 20-25%, whilst company concentrates on an internal growth target of 10-20%; invariably resulting in market share erosion. 
  • Understating of the break-even sales quantity levels. 
  • A clear dialogue on the penetration strategies, which would give a better picture of the required Sales and Marketing costs for the sales targets. 
  • A pragmatic approach to the above situation would be to look at a month on month budgetary process for 12-24 months and take it up on an annual basis thereafter. The annual process could extend for another 2-3 years. This entire exercise could well be a part of a detailed strategic plan. 
  • A Strategic Plan is a long-term road map for a company. It should underline the key strategies to enhance economic value addition of a company (Shareholder Value)
  • I propose a two-prong shareholder value creation approach, 
  • Increasing value through pure business operations 
  • Increasing value by achieving the right debt to equity mix for project expansion.
  • Increasing value through pure business operations; should come through increased profitability margins by way of,
  • Increase sales through sales price margin increase (premium pricing through differentiation) or increase sales volumes through strong Penetration Strategies as opposed to the same Cost Base. 
  • Profitability margin improvements via operational efficiency improvements; basic asset efficiency. 
  • Few strategies that would support the achievement of the above factor;
  • Marketing and branding strategies to enhance sales volume, market share and sales price premiums.
  • Revisiting the value chain to improve operational efficiencies.
  • Improving labour efficiencies through various mechanisms (which I would address in the ensuing section of this article) 
  • Value creation via Mergers and Acquisitions, other than organic measures of shareholder value creation. Never fear to increase value through mergers and acquisitions. 
A key factor that the management should keep in mind is to include a comprehensive action plan. The action plan should articulate all key personnel/departments who would be taking up responsibility to achieve the strategies.
As a precursor to the above, it is compulsory that the company carries out a diagnostic analysis covering the internal and external environment. 

2. Performance rewarding and a review mechanism

There is very little value in articulating the most enterprising strategic plan, if the actual implementers of the process do not believe in the said philosophy. 
Key management initiatives that could attract the employees, 
  • Involvement of each level of staff from all the key functions (directly or even group wise) in the strategy deliberations. 
  • Instil in the minds of all staff that once the company benefits from the said exercise; it will invariably trickle down to the economic benefits of all employees. 
  • Exposure of the staff to a clear “succession plan”, in terms of career progression, along with an incentive mechanism in line with the company financial progress, a logical profit shearing mechanism could be implemented. 
I discourage excessive incentives based on commissions, mainly due to staff not developing an ownership culture, but developing a very highly selfish commission based attitude. 
Along with the different performance rewarding mechanisms, as set out above, it is of paramount importance to introduce an evaluation mechanism as well. Each employee scope should have an in-built Key Performance Indicator (KPIs) for the purpose of evaluation. What is important is that each individual/group KPI should link up to measurable company goals, set out in the strategic plan. 

3.A diversified board of directors/advisory panel 

A fully-fledged Board of Directors may not be an absolute requirement for a start-up private company, however, for an established company (even being a family run business) a diverse BOD complements all what I have discussed so far. 
Even from a minimalist standpoint, there needs to be governance established to oversee all aspects of the company. Never, fear to obtain the professional services of lawyers, strategists, financial economists, industry leaders, etc. The ensued discussion, does not in any way advocate to bring in a whole gamut of professional representation to the board at once, but advises the private company leaders to expose their businesses to professionals at a BOD level. 

4.Never undervalue an audit process 

Stemming from the above factor of good governance and control, an audit process is of paramount importance. 
Companies, most often, do the audit only to fulfil Inland Revenue requirements. They do not use the audit as a tool to improve companywide controls. To make matters worse, some small-scale audit firms do not properly advice the company management the true benefits of an external and internal audit process. 
The company management does not understand to use the Audit process to;
  • Improve company-wide financial and non-financial systems and controls
  • Identify fraud, and mismanaged processes
  • Establish proper set of financial accounts for a better decision making 
  • Woo investors by portraying that the companies checks and balances are well looked after by top grade auditors

5.Preparation of intelligent management accounts 

According to my experience I have mostly seen a P&L and Balance Sheet produced utilising a widely used accounting package, claiming it as management accounts. These reports would give the management no idea of the current position with the historic trend or give any plausible indicator of the future. 
Hence, I would advocate the following to be also a part of a more elaborative set of management accounts (though it is not an exhaustive list)
  • If the company has many divisions, the requirement for segmented accounts 
  • Historic trend in sales price and sales volume data in comparison with current 
  • Historic trends in cost lines in comparison with the current
  • Identifying key value drivers for the company, explaining sales and specific cost lines as a unit of each value driver
  • Key Ratios entailing – Profitability, liquidity, leverage and efficiency for each segment 
  • A cash flow for each month. One of the biggest deterrents in the management accounting process is the lack of a cash flow. The management will never understand the liquidity movement of the company just by looking at profit and loss and the Balance Sheet. 
  • An analysis of the raw material movement through the production floor, from purchase to finished goods. This would explain, wastage at each stage and work In progress build-up at each stage. 
  • New projects/acquisitions to be evaluated based on economic value addition rather than mere accounting profit increase. 

6. Understanding the pulse 

of an investor 

For an entrepreneur, I consider it is paramount to understand the pulse of a potential investor. Even at a point of fund raising (whether it be debt or equity) or exiting the business, knowing the investors mind set is vital for better investor pitch. 
Hence, I would like to state below (a non-exhaustive list) briefly the key areas a potential investor would look at. 
Debt raising:
  • Firstly, whether the capital raising would be fully or partially secured. If so the quality and the recoverability of the security. 
  • Any possible credit rating done by reputed credit rating agencies. 
  • The Repayment Capacity of project. The basic liquidity strength would be looked into.
  • A further analysis would be the fluctuation of the historic trend in sales and how successful the company has been in the past in achieving targets. 
  • Possibility of external credit enhancements and the quality of the guarantor
  • The ability of Roll-Over, if the debt raising is structured as a “Plain Vanilla” bond where the capital repayment is a bullet payment at the end.
  • Quality of the management/BOD.
  • Equity raising:
  • The initial screening would be; the stage of equity raising (e.g. seed level/concept level fund raising – more suited for angel investors, pre commercial level, growth investing, matured level). Depending on the risk appetite of the investor, he/she would be willing to look each scenario differently. 
  • The Valuation Methodology used to derive the value indicators. Basic relevance of the methodology would be dependent on the nature of business, its stage in the life cycle, etc. 
  • How successful has the management been in achieving historic forecast and budget targets, are they always too optimistic
  • If it’s a new company/concept how true is the forecast numbers based on the macro environment 
  • Quality of the management/BOD to achieve the targets 
  • The Current governance measures adopted (whether they being big or small), basically the openness to proper governance 
  • A Financial and a Legal Due Diligence by a third party if it’s an existing business. 
  • One of the key factors that the probable investor would look in to is the exit mechanism for him/her in the future. The method he/she would utilise to harness the value.

7. Open for Research and Development 

I am well aware that depending on the place of the lifecycle, the R&D function would be a little farfetched for certain companies, basically due to the effort and cost factor. What is stressed upon, at this moment, is the R&D culture, and inculcating the culture of learning through research. For instance, earlier in this article I mentioned about a scientific approach to creating sales targets, one could first get a market survey done to understand the actual market share and consumer trends. Now the world is moving towards “Big Data analytics” to unearth unseen consumer trends and be the first to exploit before competition. This is moving towards a learning culture, and not just accepts what the sales team says. Whether one would require retaining his/her own unit or outsourcing the matter is a secondary issue. But what is important is creating the craving for development through a learning/research process. 
Concluding remarks 
The long-term vision of value creation should not be mired. Every private equity leadership should look at a concept called “value unlocking” as a long-term target. Value unlocking is monetising the long-term value created within the company.
(The writer is a Chartered Financial Analyst. He is a member of the CFA Sri Lanka society. By profession he is a Strategic & Financial consultant and a Lecturer for the Chartered Financial Analyst Program in Sri Lanka. He could be contacted via samweera83@gmail.com.)

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