Do companies actually want to grow?

I have discovered in my work with business owners and private equity, that many owners do not want to grow their businesses. I found this wonderful twenty minute conversation between P. Bruce Hunter and Robert Gold invaluable. 
Robert is an accountant for many years to owners. He is himself an entrepreneur and business founder. Bruce drives a TEC group where he is to fire up Canadian business owners on the key issues. Bruce knows the right questions to ask - you know the ones, you do not want to think about them, never mind discuss them with someone like Bruce who is familiar with issues. I suggested to Bruce and Robert that they make this a weekly podcast conversation because they have a great chemistry. Here's Bruce about his podcast:

My recent interview with Robert Gold and Andrew Brown can be heard at BusinessCast.ca, the world's pre-eminent podcast for Entrepreneurs. I understand from Robert that it is the number one podcast on the Financial Post podcast page as of today. The subject of how to drive

BusinessCast - The Podcast for Entrepreneurs businesscast.ca

The iTunes-featured BusinessCast is the best business podcast for entrepreneurs developed to help small and medium-sized businesses.

Identifying Best Fit with Your Firm

U.S. PE funds can provide a compelling financial offer while also bringing relevant industry experience. As business owners, an investor that is able to gain a firm grasp of your business concept quickly is advantageous. Otherwise, the investor can be a costly drain on your time.

In selecting a best-fit investor, your needs as a business owner must be aligned with the investor you select. There are a wide variety of PE funds, tailored to a variety of business owner’s needs. Will the PE fund add identifiable value?

A lot of PE funds simply supply the capital injection and remain a passive investor for the term of the investment. Others are much more focused in providing a team effort with management to kick-start the growth plan.  If applicable, a PE fund can also assist with U.S. expansion.

I encourage business owners to ask for the track record of PE funds. Canadian companies should opt-out or avoid being the test case for a fund’s first Canadian investment. “What is the fund’s track record in Canada?” Call up the list of CEOs the PE fund has worked with in the past. They can shed light on the relationship and experience.

Evaluate the fund’s total strategy and investing style for compatibility. There is a huge diversity in the U.S. realm of PE funds. Funds typically vary in size of investment, industry focus, preferred stage of investment company, ownership of investment, and board participation to name a few. PE funds invest in late stage growth where products already exist and there is a revenue stream. Large investments can be up to $100 million USD in equity or as small as $10 to 15 million USD. With their equity stake, some funds may prefer a control or minority ownership position.

Typically PE funds reside on the board of the investee company as either active or passive board members. Active is good, but not undermining management, which often can be a slippery slope. The degree of diversity of investment professionals is also important as business owners should be looking for board members who provide expertise in a wide range of business areas. Maturity of the fund is also imperative as the stage of the fund’s life will dictate the timeline of investment. 

Chinese Stock market down 22%

We had a very busy week in Ontario. There was a 5.0 earthquake, with the epicenter 61 km north of Ottawa. The earthquake could be felt from Montreal to Toronto. A tornado touched down in Midland and now we are enduring the G20 Summit Lockdown in Toronto. I saw Goodluck, the Nigerian leader, get into his limo and spoke to Kola, one of the Nigerian guards. They have been enjoying the warm weather and are impressed with how clean and quiet Toronto seems. The streets are empty and it seems like a scene from Zombies in the City.

While this was happening around us, the markets were also enduring a very rough week pulling the returns for the month and the year back into negative territory. Year-to-date the S&P TSX Composite is down -.65%, the S&P 500 is down -3.77% and the Dow Jones is down -2.92%. What you may not know is that the Chinese stock market is down -22% year-to-date and other international indices are also in negative territory. The markets are currently in a trading range and we have gone back to touch the 50-day and 200-day moving averages. With more and more economic indicators coming in below expectations even the most ardent commodity bull has to step back and assess at least the near-and intermediate-term landscape. 

Private equity is awash with cash - for now. In two years time, the tides will have receded though. For business owners, entrepreneurs and CEOs, now is the time to look seriously at private equity partners. There is no market mood to affect your valuation of your business and you get experts putting their thinking caps on to build your business. Right now, we all need all the help we can get.

Jacoline Loewen, expert in private equity and family business and author of Money Magnet: Attracting Investors to Your Business which is now a text book at Ivey Business School.

If you’re following Steve Jobs’ advice, you must know the risks to growing

A business owner was happily engrossed by his business and making a great deal of money. Inspired by a speech by Apple founder, Steve Jobs, however, his dream became to grow the company more. This CEO knew that he had the drive but worried about putting so much of his personal money at stake. He could not afford to take the risk, but nor could he go to the public markets at that stage. To help his company evolve, the CEO sold 75% of the company’s shares to private equity partners. They helped build up the staff, create systems, and identify acquisitions. Ironically, his 25% share ownership ended up giving him more financial return than if he had kept 100% to himself. How incredibly satisfying when the difficult course turns out also to be the best! Of course, if you’re following Steve Jobs’ advice you must know the risks to growing. One additional point—Jobs may have lost his spot at Apple for a decade but he says the company made it through that period due to the private equity financial partners in place.

Risk is relative. A medical device company wanted to launch a new product. As the owner knew it would cost $5M to bring to market, he weighed the risks. “Right now, I’m profitable. If all goes well, the product will grow my $10M company to $30M, with a cash flow of $1M. If it does not go well, I’m in the hole for $5M and it will take me five years to break even and get back to where I am now.”

Pass!

But private equity partners will be lured to the possibility of growth. They catch a glimpse of the big fish in the dark water and appreciate the gleam of its scales; they will pick up the harpoon and take on the struggle, bleeding from holding the line, facing unbelievable adversity to bring home the fish others can only admire from the shoreline. That medical device company’s CEO settled on admitting to the conservative nature of his personal and financial goals. “I built this business in my garage and now it has to fly without just me. Let’s get in partners and share the risk.” He got enough cash off the table to cover his retirement and compensate for all the hungry years, but he was still able to stay around to enjoy the new growth with the partners who brought valuable new skills—vision, contacts, and patient capital through the storm.

How to Take Advantage of American Capital Flooding into Canada

In terms of American private capital investors, the U.S. based industry is broadly comparable around the world. The typical private equity structure is 2/20, which means that the fund is structured as a 10 year partnership. The committed capital is provided by an institutional investor such as the Harvard Endowment. The fund managers draw down a 2% fee (used to keep the lights on) and are expected to obtain a 20+% gain over the threshold. In light of the Great Recession, the fee structure has been under much debate.

U.S. funds are able to leverage their U.S. industry experience to help Canadian companies expand their business footprint and help launch them into a market close to home before tackling the worldwide stage. Through an American fund’s U.S. pedigree, a fund can leverage their experience in the American markets to pick out the consumer market nuances and help Canadian businesses expand south of the border.

Many Canadians currently reside in the U.S. as professionals in the private equity industry. With Canadians on the inside of the U.S. based PE funds, there is a natural orientation to help out fellow Canadians and their companies by bringing capital to Canada. However, business owners beware; funds in Boston or Chicago are probably more likely to invest than funds in Houston and cultural fit is a factor that cannot be overlooked. 

What Do Canadian Entrepreneurs Have to Offer?

When the flow of credit to companies dried during the credit crisis, large companies cut expenditures in their Research & Development budgets and hoarded cash. Now that the general economic outlook has eased and companies are starved for innovation, business owners and management are now looking at ways of obtaining growth.

Canada possesses a legacy of strong returns and successful deals. Also, boasting the largest announced leverage buyout of our time.

As Canadians, we live in what is often called the “Great White North”.  Our neighbours to the South and the rest of the world have a common perception that there is less competition in Canada. This is a commonly accepted truth for private equity funds as the U.S. has a greater number of funds with larger capital base. However, there is currently no known analytics verifying the perceived lower level of competition.

Currently, Canadians can also boast about the strength of the Canadian economy. No banking system is fundamentally as sound as ours. Our education system and clusters of innovation across the country provide us with a talented and high calibre workforce. Our legal framework is also well developed to facilitate the growth in private equity. And with the continual “Brain Drain” to the U.S., we have Canadians working on both sides of the border.

As an added bonus, Canadian investments are not counted in “foreign” concentration limits for PE funds. Typically, in a PE fund’s investment mandate, the Limited Partner (“LP”) list restrictions in the types, size, risk level, etc. of investments. Such restriction may include the amount that a fund can commit to one investment opportunity (not >25% of entire fund capital) or foreign investments (not >25% of capital committed overseas). The advantage for Canadian companies is that North America is not treated as “foreign”. 

Private equity--Use it or Lose it

Use it or lose it. That is the choice faced by some buyout firms sitting on piles of capital they have raised but not invested. The firms are unlikely to give it up without a fight. That was the message I heard while visiting Boston last week and speaking with a large number of private equity firms. They definitely are stressing about finding good companies as the American market is over-served and seen to be saturated. The funds had been counting on Europe but now that is a big muddle. Australia is too far and the time distance burns out the teams. So that leaves Canada. 

The Wall Street journal's JOHN JANNARONE  explains the increased pressure in private equity investing which is good news for Canadian business owners.

A fund-raising arms race last decade was followed by a sharp slowdown in investments, leading levels of dry powder to surge. Such undeployed capital stood at a record $280 billion among U.S.-focused buyout firms at the end of 2009, according to research firm Preqin.

The catch is that firms generally agree to invest capital within five years or return it to investors. For some, the deadline is fast approaching. U.S.-focused buyout funds have $51 billion that must be used before the end of 2011, Preqin says. Another $213 billion needs to be invested by 2015.

Raising new money isn't that easy anymore. So, the worry is that firms will lower the bar on the quality of investments to ensure existing funds are put to work. One risk is that firms begin to chase after deals and overpay. 

Why Private Capital?

One of our clients was a Canadian domestic company with large margins and a solid customer base of Canadian banks was looking to enter the public markets.  This would have been a nightmare. The public market option is typically not ideally suited for mid-market companies, often lacking liquidity as investors lose interest after the initial public offering.

In addition to the high initial costs of an IPO, business owners must pay annual fees for audited financial statements and supply quarterly reports to their shareholders. There is often the conflict of interest in meeting short-term expectations with long-term growth plans. The initial sacrifice of payout to the investor should be rewarded with later value from the realized growth potential of the firm.

Furthermore, the lack of privacy of confidential information, once a company goes public, may decrease a company’s competitive edge as margins are disclosed to competitors, suppliers and customers, among other strategic information.

Private capital has the flexibility to meet a wide range of business owner needs, while providing privacy of confidential information and a long term outlook in realizing growth potential. A PE fund provides strong financial expertise to complement the management team. With no short-term external reporting requirements, management is able to better focus their capital on growth opportunities that add value to existing shareholders. PE funds assist in improving business operations through efficiency or by supplying expertise in exploring new markets for growth.

PE funds are also able to leverage their existing relationships with banks and lawyers to provide the business owner with access to a broader base of financing options than they had before. American private capital investors in particular are able to use their relationships with banks and lawyers south of the border to support investment opportunities in Canada. This provides a much larger pool for Canadian business owner’s to dip their toes in and Canadian business owners are no longer restricted to the kiddie side of the pool.

In amidst all the talk of PE funds building equity value, let me  emind the business owner that there is a lot of hype around adding value and that there is often the need to cut through all the clutter. Some PE funds are able to add tangible value to building the business through growth, others are more focused on cost cutting, and others are all about the hype.

It is also important to consider the decision making process as PE financing entails the addition of a partner. It is important to retain the rapid decision making that exists prior to the PE fund investor while incorporating the additional expertise of the board members.

An example of a “Homerun” investment for the Monitor Clipper Partners entailed a small Canadian investment in 2004. The founder owned 70% of a truly amazing business model and wanted to diversify holdings. The fund was able to dissuade the owner from listing on the public markets for the reasons listed above. Instead the individual sold half of his equity position to private equity investors, effectively taking money off the table. With the injection of working and growth capital, the business growth rate was accelerated. The 35% ownership structure and additional capital to turbo charge growth and expand the business footprint into the U.S., grew to become 75% of what the initial business value was, upon exit, three years later. For Monitor Clipper, this was their highest IRR on a three year investment and a Canadian investment to boot!

What Do Private Capital Investors Look for?

The private equity industry really got going in the 1970s when, Kohlberg Kravis & Roberts (“KKR”), one of the present day PE titans, was founded. The industry has flourished in goods times while being hit hard during the Great Recession. The fundamental framework though has always remained the same regardless of whether the economy was at the peak or trough of the business cycle. The criteria for evaluating investment opportunities are uniform globally.

The international criteria for what constitutes an attractive investment consist of solid industry characteristics, meaningful competitive differentiation, strong management with equity ownership, and business growth potential. PE fund investors look for a compelling reason to invest and love growth stories where the business owner is looking for capital to excel the current growth of their business.

Strong management with a meaningful equity stake in the business is a crucial criterion for investors. Often, if an existing owner is looking for a complete exit, this is a sign of worry for the investing party. PE funds like to create partnerships and can help owner managed or family businesses acquire ownership if they don’t have it initially. Funds can help take some cash off the table initially but with the continued presence of management and a capital injection from the investor, grow the equity stake remaining into a larger pie.

The alignment of growth plans between investors and business owners needs exist for the growth phase for the business to bear fruit. The due diligence process prior to investment from both parties ensures there is a strong alignment initially.

 Increasingly, entrepreneurs and business owners are competing on a global platform. Like companies, private equity funds are becoming more multinational. The Harvard Endowment invests capital in locally based Canadian private equity funds such as Torquest and Birch Hill Equity Partners. Private equity is an alternative asset class that allows institutional and high net worth investors exposure to a different risk-return scenario. Some mid-market and virtually all large cap funds are multi-national and as funds follow the attractive returns, increasingly they are moving to Asia.

Some PE funds are quite diverse in national or ethnic origin of personnel. You’ll be hard pressed to find many native New Yorkers working on Wall Street these days as Jacoline Loewen, author of Money Magnet can attest to. Broad similarities among private equity firms are evident around the world. The big differences lie in a firm’s strategy and culture and their ability to operate effectively internationally -- the litmus test for U.S. funds. 

You can't be for jobs and against business

Business has taken a beating and capitalism questioned this past two years. Common sense is beginning to flow back into the media as journalists hear from business owners that they might as well sell their companies and get a union job. 
Our business owners need to know they are appreciated and that their service to business, usually at the cost of family time, is recognized. Private equity takes on these same risks as the owner, putting at risk their own capital, unlike a bank. Private equity is also getting a beating as the American tax laws change to show that their risk taking will not be seen as equal to the business owner.
With the increasingly negative rhetoric about business, I was pleased to read Thomas Friedman's article on the best gift to a graduate -- a start up. Of course, encouraging start ups requires many elements of the business environment to work together. Above all, the knowledge by society that founding and running a business takes enormous effort is the most critical. Otherwise, taxing those who make jobs will push their incentives down. 
Here's Thomas Friedman:

We owe our young people something better — and the solution is not that complicated, although it is amazing how little it is discussed in the Washington policy debates. We need three things: start-ups, start-ups and more start-ups. 

Good jobs — in bulk — don’t come from government. They come from risk-takers starting businesses —  businesses that make people’s lives healthier, more productive, more comfortable or more entertained, with services and products that can be sold around the world. You can’t be for jobs and against business.

 I asked two of the best people on this subject, Robert Litan, vice president of research and policy at the Kauffman Foundation, which specializes in innovation, and Curtis Carlson, the chief executive of SRI International, the Silicon Valley-based innovation specialists.

Carlson said he would begin by creating a cabinet position exclusively for promoting innovation and competitiveness to ensure that America remains “the world’s new company formation leader.” “Secretary Newco” would be focused on pushing through initiatives — including lower corporate taxes for start-ups, reducing costly regulations (like Sarbanes-Oxley reporting for new companies), and expanding tax breaks for research and development to make it cheaper and faster to start new firms. We need to unleash millions of entrepreneurs.

Litan said he’d staple a green card to the diploma of every foreign student who graduates from a U.S. university and push for a new meaningful entrepreneurs visa (the current one, the EB-5, requires $1 million of capital that few foreign entrepreneurs have). It would grant temporary residence to any foreigner who comes here to establish a company and permanent residency if that company generates a certain level of new full-time jobs and revenues. One of the best moves we could make, adds Litan, would be a long-term budget deal that would address the looming Social Security/Medicare payouts for baby boomers. Proving to the bond market that we have our long-term fiscal house in order would keep long-term interest rates low and thereby “encourage private investment more than any tax cut.”

Nevertheless, I’d also cut the capital gains tax for any profit-making venture start-up from 15 percent to 1 percent. I want our best minds to be able to make a killing from starting new companies rather than going to Wall Street and making a killing by betting against existing companies. I’d also impose a carbon tax and balance that with a cut in payroll taxes and corporate taxes. Let’s tax what we don’t want and encourage what we do.