Value Creation the Private Equity Way (Part 1)

PLEASE NOTE: This transcript has been created using fireflies.ai – a transcription service. It has not been edited by a human and therefore may contain mistakes.

00:03
Dom Hawes
Welcome to Unicorny, the antidote to post rationalized business books. This podcast series reveals how senior executives in the world's best businesses are building value. Each episode is designed to give you an insider's perspective, so join us to find out how and why other business leaders make the decisions they make, how they create and measure value and importantly, what they see coming down the road. Today we're looking at the private equity business's approach to value creation to see what lessons you and I can learn, adapt and implement in our own businesses. I'm Dom Hawesand in my day job I'm the CEO of Selbey Anderson. We're a group of highly specialised marketing and communications agencies supporting tomorrow's leaders in finance, technology, industrial technology and health. We like the tough stuff. We help businesses operating in complex markets win the future. Over the past two years, I've interviewed dozens of senior business leaders for our various podcast strands. 

01:06
Dom Hawes
I've also attended conferences, roundtables and seminars. I've studied white papers, read as many books and devoured as much modern management theory as time would allow. I've networked discussed and debated with CEOs, CFOs, CMOS and many more execs. Basically, I've put the hours in and this podcast is the result of that work. So I hope you enjoy. At its core, marketing is how a business commercializes and exploits innovation that answers a defined customer need in your business and in my business, that's how we both create value. We take a product or service. We work out who needs it most, why they'll buy it, how much they'll pay for it, how to get it to them, how to make them aware of it, and of course, how to service them. And just like you have products in your firm, there's a class of business that sees your whole company as a product. 

02:01
Dom Hawes
I'm talking, of course, about private equity. Private equity, or PE, takes a bit of a bashing in the popular press, partly because the high profile failures are well, they're kind of high profile, but also the press loves to make a villain out of big business. But the PE industry and the people that I meet day to day in that business bear no resemblance to those paraded in the press. What I see is that private equity seems to be where the best and brightest business brains, head, post MBA. And it's a business that's super focused one thing too creating value. Right now, savvy CMOS and their teams are also focused on creating value and also in the short to medium term. their work might support long term brand building, but in this economic climate, it's all about value creation. And there's no better business at creating value than private equity. 

02:56
Dom Hawes
That's why today we're going to look at the private equity businesses approach to value to see what lessons you and I can learn, adapt and implement in our own businesses. Now, if you listen to the resisting recession series on marketing difference. You will remember Peter Russell-Smith. Today he is a straight talking, nonsense management consultant. But before founding the big business agency, he had three phases to his career. He started as a deeply technical engineer, then he moved into sales and marketing, and then he was a PE backed CEO himself. He's seen PEO, therefore, from all sides and has wide ranging experience, including both smaller private equity houses, but also some of the largest US houses like Vista Equity and TPG. And he's also worked with HG Capital in Europe. I'll put a link to his last episode and a full biography for him on the show Notes, which you can find at Unicorny.co.uk. 

03:51
Dom Hawes
And I thought a good starting point for today's conversation might be to understand that there are different types of private equity house. Peter explains. 

04:01
Peter Russell-Smith
So you've got seed, pre-seed A, B, C, etc. You've got a whole range of different categories where you are in your development. And private equity itself is divided into, I guess, tranches or buckets. So there's very small private equity companies that will take a particular size business, say if you put some numbers on it, five to 25 million revenue. There's another band of private equity companies that will concentrate on 25 to 100 million, and then there's a band above that. So certain private equity companies have to write a particular size check, which is mandated from how they collect their funds from their investors. So, their investor brief basically says, look, we're going to focus in these sorts of companies. We tend to have a three-to-five-year hold position. We'll exit the short-term position at five years and then we'll go and ante up and do it again. 

04:52
Peter Russell-Smith
So there's different levels of private equity depending on the stage of development you're at as a company. 

04:58
Dom Hawes
When I started out in business, and everyone who starts a business should have sight of what the exit looks like. When I started in business, exiting to private equity wasn't such a thing because there just weren't that many private equity firms. There are now loads, and I'm not sure how many of today's entrepreneurs clearly set in their mind that private equity is a good exit route for them. Is that something you think is changing? 

05:19
Peter Russell-Smith
Definitely. I think the extent to which private equity is on the exit path has dramatically increased in the last ten years, particularly in software and IP based businesses, because the traditional IPO or exit or trade sale is still very relevant. But the IPO market has been very difficult over the last few years, particularly given the sizes of some of the IPOs. So private equity has filled that void extremely quickly and is now, I guess, one of the preferred methods of exit. 

05:50
Dom Hawes
Private equity versus a trade sale, from an entrepreneur's point of view, is extraordinarily attractive because you're basically getting cash up front. No three year earn out. Obviously there are strings attached, but it can be a lot more wealth enhancing, I think, to exit to private equity than it can be just to make a straight trade sale. 

06:05
Peter Russell-Smith
Yeah, and it depends on the stages you go through. So, if you're growing your business from ten to 25 million, you'll get a particular type of private equity investor will come in. Then they call it swapping sponsors. It's where you go from Team A to team B to team C. So, you're making your way up that value chain, up that food chain as you go along. As an entrepreneur, you're taking money off the table as you go through that process, depending on the sequence and depending on whether you're actually what they call the platform in the investment or whether you're a bolt on. So how private equity think about this when they're looking at businesses? Is, is this a platform I can add and acquire businesses and join up to, or should I join this organisation's capability and capacity up to my existing platform? So depends where you're at in that cycle. 

06:55
Dom Hawes
Today we want to talk about marketing and marketing's role in value creation, but particularly with a private equity lens. So, we started out with like the macro cycle, which is where are you in your business's lifecycle and therefore what? Private equity is the right size for you? But private equity firms, typically, unless they're an open-ended investor, most of them run in closed end funds, so they have an investment cycle of somewhere between three to five years. And within those three to five years, they're going to put you through a playbook. Talk to me about playbooks. 

07:22
Peter Russell-Smith
If you think about PE's value creation, it's really got three parts to it, right? The first part of it is they focused on EBITDA and they're focused on the ability of the business to generate cash in order for it to be loaded up with debt. In order that the business can take on good quality debt, then they can withdraw their funds and move on to the next investment. So it's all about making sure that there's sufficient EBITDA there in EBITDA. One of the things that you want to make sure you've got is recurring revenue, right? So it's very hard to have a consistent EBITDA position if you've got a project based business. So lots of private equity companies looking for businesses with recurring revenue, so that's a very attractive model. The third part of it then is, as you said, is they have these playbooks. 

08:03
Peter Russell-Smith
How the three of those components work together is that they want to increase the EBITDA, they want it to be recurring, so they'll make changes to the way you offer the market, your services. In making those changes, they want to lock in contracts and they want those contracts to have automatic price increases. And when you're an entrepreneur and you're moving into private equity for the first time. They're really difficult discussions, right? Because you've had a customer base for ten years, for five years, you probably haven't put your prices up that much. And incomes a private equity investor and the first thing they do is they look at your customer contracts and they change them. And so there's a marketing activity around how you introduce those price changes. And that can be very stressful for the business. But once you through the other side of it's very, very logical. 

08:51
Peter Russell-Smith
So increasing EBITDA, increasing enterprise value through recurring revenue and then getting the business ready to take on investments and getting the business ready to acquire. So how all that plays out in the playbooks is that in order to increase EBITDA, one of the things they often do is to reduce the experience and knowledge of the people in the business because they're cheaper, right? So if you're paying someone $150,000 or pounds a year, if you can get someone else to do the job for 60,000 pounds a year, but with a very specific playbook that they need to follow, you can bring people from outside the industry into the industry who will follow the playbook. So part of the playbooks and part of that is that you're actually taking out a lot of the market intelligence, but it has to be embedded in the playbook. So once you've embedded that in the playbook, what you then need to do is you need to find people to fuel that. 

09:48
Peter Russell-Smith
And once you've standardized and once you've productized that playbook, then you want to go ahead and automate it. And so that's where you see CRMs like HubSpot and those sorts of companies, they come into their own because they automate from one end of the process to the other. In the process of automating it. One of the issues is that because you've taken out so much of the skill along the way, because you've downsized the experience level financially, you have to make sure your playbooks work. And if your playbooks don't work and there's exceptions to the playbook, then that's when management gets involved to make decisions, those sorts of things. So it's a very complex set of changes that need to occur in the business. So you're changing the relationship with the customer contractually and you're changing the nature of how you go to market, you're changing the nature of how you sell. 

10:41
Peter Russell-Smith
And what it puts a much greater emphasis on is marketing. So the sophistication of your marketing messages and your understanding of your core value propositions and the messaging that your buyers will react to becomes far more significant. 

10:57
Dom Hawes
So this is getting right to the heart of what I wanted to talk about today. Because whether you are private equity backed or not, and private equity obviously encompasses anything that isn't public I e family office, a traditional PE house, venture capital where you could be completely privately owned. Of course, that also is a weak kind of private equity. But whether you are mandated to do it by an investor or not doesn't matter because you can still take elements of the playbook that private equity uses to create value for yourself. And I think the focus that they put on value creation is really useful to any business right now. 

11:33
Peter Russell-Smith
Completely agree. So if you're preparing for investment and you want to increase your enterprise value, you do what the PE is going to do to you. So you focus on EBITDA. You reduce your costs, you make your revenue recurring. You put annual price increases not linked to inflation. Give you an example. If you're a zero user in the UK, every three, six months you get a little email from zero that says it's gone up four quid. In itself, it doesn't mean much. It's like, okay, another four pounds a month, who cares? But when there's 750,000 users and they all get four pounds a month and it's raw profit, so now it's real money. Anyone at any stage of their lifecycle can get ready for private equity and can get ready and add a significant amount of value in their own organization by writing their own playbooks, by making sure their messaging is clear. 

12:25
Peter Russell-Smith
By making sure their customer contracts have got automatic price increases in them, by beginning to look at what are the mechanisms that you would use to acquire other businesses? Because the ability to acquire and grow and buy and build is a significant value creation piece. It makes your company more valuable if you can acquire other companies. Elegantly. 

12:52
Dom Hawes
Okay, I just want to comment on a section from the first half of today's show, then we'll get right back to the interview. Now, at the top of the show, Peter identified three key components in creating value EBITDA, revenue, quality, and playbooks. EBITDA is the cornerstone of value for most businesses. Unless you're a unicorn where the laws of business gravity don't apply, your enterprise value, the thing that keeps your CEO and your CFO up at night will be based on EBITDA. Most likely. The other value drivers he mentioned are really shorthand for the quality of your business. They're two of the things that dictate the multiple applied to your EBITDA to create enterprise value, and they are the quality of your contracts and the quality of your playbook. So if you're looking at creating value and you should be focus on those things, you can directly impact that drive value at the business level. 

13:45
Dom Hawes
Profit and quality, let's unpack those. If you're going to impact EBITDA, think about price, think about cost of customer acquisition. Be on top of both your pipeline conversion ratios and your pipeline velocity, and think about your customer lifetime values. These things allow you to get a tight grip on your own contribution and frame it to the business in quantifiable value. Next up, let's look at quality of contract. How can you adapt your product or service to increase the amount of recurring revenue in your business? What about your standard terms and conditions of business? Do they allow you to raise prices automatically at will or are you locked in for the contact duration? These things all create value, and as the voice of the customer, I kind of think you should be all over them. Now, PE houses focus on recurring revenue because that's what supports their leverage. 

14:40
Dom Hawes
But there are other ways too of measuring account quality and they may add value to your business. Things like how well are you targeting in your market? Do your customers share common needs? And if they do, can you package them up and productize a solution? Are they in a definable market in which you can build like, meaningful market share? Because a scattergun approach to market is less valuable than a focused approach. And so we come to playbooks the documented systems, processes, policies and procedures that systemize your business. Playbooks allow you to capture, test and refine your methods. They add value in three ways. They help you increase consistency, they help you increase effectiveness. And they're one of the most easily identifiable marks of quality that will ultimately help justify your enterprise value. We're going to dig into Playbooks in a little bit more detail now and later in this show. 

15:37
Dom Hawes
Peter also gives me the number one reason most projects to automate processes fail. 

15:44
Dom Hawes
So we're going to unpack the cycle a little bit now. So we do quite a lot of work with PE backed businesses as well. And, well, you will know because you've done the coaching, but you've coached me on different elements of the cycle, specifically around recurring revenue, quality of revenue, all that kind of stuff. But I want to start at the beginning. So our observation normally is when a company first comes into that PE house, there are two things they're looking at. One is my brand good enough? And is my value proposition strong enough to resonate to the market I need to sell to? Because I'm about to go through hypergrowth. And the second thing they go through is, am I digitally enabled enough that I can automate some of my process? And those are the first two things that we see most companies think about. 

16:26
Dom Hawes
Can you talk to me around those issues? 

16:28
Peter Russell-Smith
Sure. The first one is really important. What tends to happen as you grow is you go off track, you experiment with different things. And so were very successful at doing A. We've got some nice cash flow there. There's good margin, good profit. Let's go and do B. Now, sometimes B works, sometimes it doesn't, because it's a stretch in the organization. You haven't funded it properly. There's a whole host of reasons why you're playing in the wrong market. So the very first thing is, as around your brand, your proposition, your unique value, your selling proposition is to revisit it, to keep revisiting it, to keep focused on it. There's a reason you're in business, and the reason you're in business and the reason you're growing is you've got product, market fit. Lean into it. Find other ways to lean into that market to solve those business issues. 

17:18
Peter Russell-Smith
So that's the first thing. First thing is to stick to your knitting, know what you're good at, know why you're good at it, and just do more of it, and how you expand and grow with that. There's various different models that you can use, whether it's a market development, a product development, a penetration strategy. There's a number of different ways that you can enhance your growth. One of the wake up calls you can give yourself is to understand your total addressable market. And that takes a fair amount of work to understand. How much of my market have I actually got? And most organizations, when you go through this process with them, right up till they're about 80, 90 million pounds, they've got less than 1%. So is there a bit of headroom? Oh yeah, we can grow. We can grow just doing what we're currently doing. 

18:01
Peter Russell-Smith
So the first thing is, around that brand, around those messages, around that unique value proposition, kind of double down on it. 

18:08
Dom Hawes
And then you need the systems, the processes, the support mechanisms to be able to handle not just new clients and an increase in volume, but potentially to make yourself a platform for acquisitions. Talk me through the system process, the digital transformation piece. 

18:22
Peter Russell-Smith
It's a fascinating topic. Where most companies under 100 million go wrong with automation is they start with the system. So they go and buy HubSpot or they go and buy salesforce. They go and buy some Rev, Ops, CRM thing, and off they go, and they put it in. And in putting it in, what they haven't done is to create their playbook. You can't automate a process that you don't understand, that not everybody understands. The links in the chain. So you can't understand that. So the very first thing you have to start with is, so you've done your brand, you've done your go to market, you've focused your messaging and unique value proposition. Now you instinctively know because you're already doing it, right? You know how to market to those people. You know how to get them in your funnel. You know how to close them. 

19:06
Peter Russell-Smith
You know how to deliver the solution. You know how to manage them. But what doesn't happen in organizations that are running quickly is nobody's documented it, nobody's communicated it. And so everybody works in a whole range of different ways. There's a client of mine at the moment I'm working through, and I call it their Rinse cycle, right? They've put in salesforce. They've got a shop, a web shop. They've got orders from customers. They've got standing contracts. And so basically what they're doing is, in trying to automate all of that is, they've realized that in the middle of all of this automation, there's this rinse cycle that they have to go through around stock and what's this and what's that. So they've got multiple spreadsheets, multiple internal meetings, and they've already spent the money on the technology. So what I'm doing with them now is just taking a step back and saying, right, so all the tech's there and ready when we're ready for it, let's step through creating your playbook. 

20:02
Peter Russell-Smith
Who does that? Who does this when that occurs? And so it's a full sales and marketing playbook from quote to cash right the way through the entire process. Then how do you get them from awareness to quote on the marketing side? So the playbook becomes really important. And the better the playbook is and the more easy it is to understand and the more widely it is communicated, the technology can then work with a marketing lens. 

20:32
Dom Hawes
One of the challenges, I think, is that if you take it back to, like, Michael Porter's value chain analysis, take it right back to kind of Basics 101, people think about core activities and what they can do with the core activities. But actually it's the support activities and automating those support activity that then gives you the capacity to grow at scale. 

20:51
Peter Russell-Smith
Correct? The issue with the marketing side of that is that you have some attribution. You know where you're going, you know what your value proposition is. So how do you digitally automate that? How do you digitally reach more? How do you increase your market share? And so understanding how that plays all the way through the sales cycle, all the way through the delivery cycle, and then all the way through the customer support cycle, you shouldn't leave it to chance. And that's what private equity are extremely good at. They're extremely good. They've got in most large private equity organizations, they've got internal operational partners. And their job is to come and help you get good fast and be able to then put more through the machinery. So they establish the process there. And what they bring with them is their version of a playbook. Now, you might have one, but they've got their version. 

21:42
Peter Russell-Smith
So they walk in, they open up metaphorically, they open up a big book and they say, here's page one, let's start there. And they work their way right the way through the process. Because they've done it so many times, they're actually really efficient at it. But in preparing for investment or impairing for, as you would call it, hypergrowth, you can do that yourself. 

22:00
Dom Hawes
So I think from a marketer's point of view, the thing I would like them to take on board and Professor Ritzen, Mark Ritzson would kill me for this. He's a countryman of yours, the most famous marketer in the world. So he hates anyone adding P's to the four P's, right? And all the marketers know about product price, place, promotion, but people process physical evidence is what we're talking about, right? It's about if you're a private equity company, your first stage you're in the cycle is to get all that stuff sorted, is to get automated, because what comes next is acquisitions. So from a marketer's point of view, what role do you think they have in the acquisition process? 

22:37
Peter Russell-Smith
Well, I think it's critical the identification of what you acquire normally falls to this corporate development group, which normally has a couple of senior dudes in it. And they go out and look at the market and they do their research, they find a couple of people they like, they have a few dinners they work through whether there's a relationship there and whether they could work together on it goes. Marketing plays an incredibly important role in that because if you're acquiring capacity, you have to have the playbook in place to make sure the capacity is utilized. If you're acquiring capability something new, you have to understand from a marketing perspective how you incorporate that into your offer, how it materially changes your offer because it does, and then how you don't kill the value of what you're purchasing when you bring it into your organization. So marketing is and should remain at the front of those discussions. 

23:30
Dom Hawes
So marketing has a very active role to play in origination, obviously, but also in due diligence. Where would you focus a marketer's attention when it comes to due diligence? 

23:40
Peter Russell-Smith
I would focus very much on existing customer relationships first. And I know that kind of sounds the back end, but the quality of the existing customers and the quality of the journey they went through to become customers is something that an acquiring marketing team should get a very good handle on. Once they understand the quality of the contracts and the quality of the customer relationships, then they can work their way back up the cycle to understand how they did that. How does this company we're acquiring, how do they end up with such good quality contracts and such good quality customers? So that part of the diligence should happen in concert with the financials, with the code checks, with all of those other things that go on, because that informs the investor. As to the value. 

24:31
Dom Hawes
Well, there you have it. Or should I say, there you have half of it. Because next week, Peter comes back to the studio to deliver the rest of the interview, looking at how marketers can learn from private equity's approach to value creation. But what did you think of today's show? You can contact me on LinkedIn or on the website at Unicorny.co.uk, where you can leave a text message, you can even leave a voice message. And you can also follow this show there by putting your email address in and pressing register. By the way, I've also got a newsletter running on LinkedIn. If you look my profile up, I'm Dom Hawes and scroll down. The newsletter is called Marketing Difference, and in that newsletter we discuss the contents of this and other podcasts. It allows us to engage directly with you about content. Now, as usual, I'm going to be putting detailed show notes at Unicorny.co.uk abridged show notes are going to appear under the graphic of your favourite podcast platform. 

So I want you to imagine that you are the investment director at a private equity house and you just acquired the business that you are working in right now. So what are you going to do in the next hundred days to drive real value in the business? You can record answers at unicorny.co.uk. You can send me a message there or on LinkedIn. And if you do well, I'm going to try and read out or play the best ones in part two of this podcast, which is coming up next week. So don't waste time. If you want to get in there, if you want to get on air, please do it right away because we've got to have time to edit it. 

I'd like to leave you with this.

Be like PE. 

Build a machine, but make the machine work for your people. Don't make your people work for the machine. 

We would love it if you would rate, review or refer us. Reviews and referrals are how shows like this one grow. So please take a little time right now to support the Unicorny project. If you're interested in joining our community, please register at Unicorny.co.uk, where you can also ask questions or leave comments. That's all for now. I'm going to head back into the forest and find more inspiration for Unicorny next time. 

See ya