Private Equity investors, as a rule, have a propensity for looking before they leap. Known for their discipline and attention to detail, PE investors rarely reach for a dime without conducting a fair amount of due diligence. Most potential PE investment activity has within its foundation a document known as the investment thesis – essentially, the private investors’ “white paper,” outlining in detail how value will be created and a return made on the investment within the target exit timing.
Often the primary drivers of this thesis are restructuring costs – fixed overhead, asset deployment and operating expense. Another driver relates to the sales force – in particular, whether an addition of headcount or selling tools would drive more sales, and increase effectiveness.
Although it varies by investment, in some cases a missing lever in the thesis is a thorough understanding of the market potential for the company. Unlike the internal cost and internal sales operations, the market potential relates to the external view of the marketplace in which the company competes. As valuations in some verticals have marched upward recently, this emerging piece of the puzzle has gained favor in thesis development, as it can help justify a higher purchase multiple and ensure a return.
Whether you are a PE investor, a portfolio company CEO, or a non-PE CEO, your company could likely benefit from a hard look at the market potential thesis for your company. Here are four questions that can help you gauge your company’s market potential:
1. Is your company doing business in growing categories?Answering this question requires you to look beyond your own company’s revenues – instead, observing the financial performance for all companies in your market space. It is amazing how many companies don’t bother to take this step. Think of it this way: If you do business in a category growing at 10 percent, all you have to do is stay even with competition, and your company will grow at 10 percent. Profit will likely grow at a higher rate as the higher revenues spread over your fixed costs. Of course, if you are doing business in an industry that is declining at 10 percent, you will have to gain share – likely at high expense and lower margin – to grow.
One of the biggest consumer products companies in the world subscribes to this simple principle, and actively manages this mix. When they encounter particular slowing growth in a slow profit category, they exit that category over time. Conversely, the company enters new categories where they can leverage their expertise and enjoy growth above the company’s average benchmark to ensure consistent revenue growth.
Here’s a recent example of a company that’s embracing this kind of strategy: You may have heard that Wal-Mart is in talks to acquire Humana. Now, you may be wondering, what does retail store operations have to do with healthcare delivery? Wal-Mart is subscribing to the “growing category” principle. Classic retail is not growing – it’s getting harder for Wal-Mart to grow, and its profitability has declined over the last three years as they have to spend more and more in their classic space. Humana potentially offers more trips to buy health care products at the Wal-Mart store, and a higher transaction size. The jury is out on this deal – but Wal-Mart is trying to expand into a faster growing space. We will see if it works.
On the opposite end of the spectrum, Unilever just divested its slow-growth margarine business for the same reason. The margarine business is large, with virtually no growth and flat margins. It was holding back the whole company. Unilever got a decent price from a private equity firm and sold it. Getting rid of this business in one stroke helped to increase the company’s growth rate on a smaller revenue base.
2. What is your point of difference?
Think of this as a “moat” built around your company to help drive both sales growth and margins. The “moat” exists because you have established a preference versus competition for your company and its products and services. The “moat” does not necessarily have to be built via the latest high-tech innovation, although that works, too.
As an example, Texas Instruments sells a school calculator designed 20 years ago. You would think it would be “toast,” given all of the technology advances of the last two decades – but that is not the case. Their calculator is a low-cost tool that addresses basic computing needs for elementary and junior high school students. And it doesn’t hurt that it is the only “device” authorized to be used by students when they take standardized tests. Check your iPhone at the door, but come on in with your TI calculator. Simple, cost effective – and no real competition.
This “moat” isn’t theoretical. Companies with a “moat” have better sales and profit, which means they grow faster than average, hire more employees, and promote the employees they have, because they are needed to lead a larger business.
Companies that don’t have a “moat” become commodities and face margin pressure, which in turn drives cost reduction and, unhappily, offers far less opportunity for their employees to grow.
3. Do you know where you are going?
The famous phrase says if you don’t know where you are going, any path will take you there. A random path to anywhere is not likely to drive consistent growth or profitability. Think of your own company. If I talked to a few employees, would they be able to tell me in their own words how the company is going to grow? You would hope they would answer, “Yes, we are going to add service X to our existing service in our existing customers.” Or, perhaps, “We are going to maintain our current customers, but expand into vertical Y by leveraging our technology A and operating expertise B.”
Obviously, the strategy has to be built on insights, and go deeper than I am describing. But the highest-performing companies have a clear view of where they are going, and where they are not going.
4. Are you operating with data and milestones?
If you decide to enter into a growing category and leverage your point of difference with a clear strategy, that is great. But how will you know it’s working? If the strategy is to expand a new product or service into an adjacent category, what are the milestones that need to be achieved to be successful? What is the step-by-step plan to get it done? If 10 new customers are being targeted, what is the selling story? What is the contact plan? What are we targeting to sell them? And, what are the revenue and profit targets? Again, it’s amazing in the mid-cap space how many companies do all of the homework, then fail in execution.
So, what next? Step back and go through these four questions. Are you in a growing category? Is the ocean rising, or falling? If it’s falling, fix it by adding higher growth categories, or exiting slow ones. What is your “moat”? Why is what you do different and better than other companies offering a similar product or service? Can you say what your strategy to grow is in a sentence or less? Can your employees say it? And, finally, how do you know you will be successful, what do you expect and by when? It’s worth the time to drill down on these questions. Do it right – the company grows, employees are happy, and you, the CEO, are the hero! Don’t do it, and you could literally endanger the company and culture you have worked so hard to build.