Chapter 5: Private Equity & Value Based
Investing
Is there a room for «Value-Based Investing» in the PE
industry? To answer this question, let's first rapidly define the concept.
The notion was first introduced by Columbia Professor Benjamin
Graham in his classic «Security Analysis» text where he developed a
method of identifying undervalued stocks, meaning stocks whose prices were less
than their intrinsic value. This became a cornerstone of modern value
investing. Also, Graham approach was to focus on the value of assets such as
cash, net working capital, and physical assets.
But this approach has since evolved under the philosophy of
investor super guru Warren Buffet. Indeed, Buffet modified that approach to
focus also on valuable assets such as franchises and other intangible assets
that were unrecognized by the market at that time. Here are the principal
elements of Buffet investment philosophy:
1- Economic reality, not accounting reality: Financial
statements prepared by accountants conformed to rules that might not adequately
represent the economic reality of a business.
2- The cost of the lost opportunity: Buffet compared an
investment opportunity against the next best alternative, or the marginal best
alternative in more economic words; that is the «lost opportunity».
3- In value creation, time is money: Buffet assessed
intrinsic value as the present value of the future expected performance and
that book value is meaningless as an indicator of intrinsic value.
4- Measure performance by gain in intrinsic value, not
accounting profit: The gain in intrinsic value could be modeled as the
value added by a business above and beyond the charge for the use of capital in
that business. It is a measure that focuses on the ability to earn returns in
excess of the cost of capital.
5- Risk and discount rates: Discount rates used in
determining intrinsic values should be determined by the risk of the cash flows
being valued. The more the risk, the higher the discount rate. The conventional
model for estimating discount rates was the CAPM, which added a risk premium to
the long term risk-fee rate of return. Buffet developed a philosophy against
Beta in computing the cost of capital by arguing the fundamental principle:
«it is better to be approximately right than precisely wrong».
6- Diversification: Buffet disagreed with conventional
wisdom that should hold a broad portfolio of stocks in order to shed company
specific risk.
7- Investing behavior: Buffet believes that investment
behavior should be driven by information, analysis, and self-discipline, not by
emotion, fashion or «hunch».
8- Alignment of agents and owners: Buffet believes that
to do the best investment, one should think that he is investing his own money.
Now that «Value-based investing» as Graham and Buffet
conceived it, do PE funds believe in it? Apply it? And is it applicable to PE
transactions.
My answer is yes. In my opinion, the majority of Venture, General
and Buyout PE funds follow the philosophy of value based investing. And I do
believe that PE among other asset classes is the one that embodies at best the
lessons we had from Graham and Buffet.
If I go along the eight points developed by Buffet and listed
here above, I would confirm that yes PE funds are good in «value-based
investing» at an exception of one criterion: the use of time as a valuable
asset in «value-based investing». Indeed, because of the timeline
defined in the LPA's, PE mangers are almost obligated to return all the
proceeds from divestments in a time fashion that do not exceed 10 years. This
make them often forgo a valuable part of the excess returns a portfolio company
is making but selling under time strain. Their strategic power of
«buy-to-sell» as we explained in chapter 3, is good at making
phenomenal returns, but also bad at making the «maximum returns» an
investment can bring.
The concept of value based investing was first developed to
address the investment behavior in the US stock market by institutional,
private, and mutual funds investors. Yet, there is something that strikes me if
I go back to my private industry and small business experience. All the
principles here up exposed and developed by Buffet also perfectly apply to
small businesses, in the way that they are common sense of wise and aware
entrepreneurship. So if the concept applies to publicly traded stocks, closely
held companies like those in PE funds portfolio, and also to small businesses
as I mentioned here, does this signify that the concept is transversal and
universal? I believe yes. Even if a valuation exercise applies to the most
sophisticated investment opportunity in Wall Street, I really believe that a
valuation process based on «value-based investing philosophy» is a
common sense of how to do business wisely and not following emotions or
fashions. In that sense, valuing GE or a Delaware based small business follow
the same principles, even if the proportion of data to collect and the tasks to
undertake hugely differ in terms of volume; in that case it is more a matter of
scale than of valuation philosophy.
Back to PE, Robert F. Brunner, a Distinguished Professor at
Darden Business School, University of Virginia, presents a case study in his
book «Case Studies in Finance - Managing for Corporate Value
Creation» (Mc Graw Hill, 2007) that deals with a growth stage Private
Equity investment. The reflection process held by Louis Elson, Managing Partner
at Palamon Capital Partners, a generalist UK based PE fund, when dealing with
the acquisition of TeamSystem S.p.A., an Italian based accounting and payroll
software company, perfectly matches what we described as the «Value-based
investing» philosophy. Here are some extracts illustrating our opinions.
Palamon Investment Process:
Palamon's investment process began with the development of an
investment thesis that would typically involve a market undergoing significant
change, which might be driven by deregulation, trade liberalization, new
technology, demographic shifts, and so on. Within the chosen market Palamon
looked for attractive investment opportunities, using investment banks,
industry resources, and personal contacts.
About TeamSystem S.p.A.:
TeamSystem was founded in 1979 in Pesaro, Italy. Since its
founding, the company had grown to become one of Italy's leading providers of
accounting, tax, and payroll management software of small-to-medium-size
enterprises (SME's). Led by a cofounder and CEO Giovanni Ranocchi, TeamSystem
had built up a customer base of 28,000 firms, representing a 14% share of the
Italian market.
Palamon's search generated the opportunity to invest in
TeamSystem S.p.A. In early 1999, before Palamon's fund had been closed, Elson
had concluded that the payroll servicing industry in Italy could provide a good
investment opportunity because of the industry's extreme fragmentation and
constantly changing regulations. History had shown that governments in Italy
adjusted their policies as often as four times a year. For Palamon, the space
represented a ripe opportunity to invest in a company that would capitalize on
the need of small companies to respond to this legislative volatility.
Industry Profile:
The Italian accounting, tax, and payroll management and software
industry in which TeamSystem operated was highly fragmented. More than 30
software providers vied for the business of 200,000 SME's with the largest
having 15% share of the market; TeamSystem ranked number two with its 14%
share. All of the significant players in the industry were family-owned
companies that did not have access to international capital markets.
Analysts predict that two things would characterize the future of
the industry: consolidation and growth. Consolidation would occur because few
of the smaller companies would be able to keep up with the research and
development demands of a changing industry. As for growth, experts predicted 9%
percent annual growth over the period 1999-2002. That growth would come
primarily from increased personal computer penetration among SME's, greater
end-user sophistication, and continued computerization of administrative
functions.
The Transaction:
After TeamSystem pas performance and the sate of the industry,
Elson returned his attention to the specifics of the TeamSystem investment. The
most recent proposal had offered EUR25.9 million for 51% of the common shares
in a multipart structure that also included a recapitalization to put debt on
the balance sheet.
Valuation:
To properly evaluate the deal, Elson had to develop a view about
the value of TeamSystem. He faced some challenges in that task, however. First,
TeamSystem had no strategic plan or future forecast of profitability. Elson
only had four years of historical information. If Elson, were to do a proper
valuation, he would need to estimate the future cash flows that TeamSystem
would generate given market trends and the value that Palamon could add.
His best guess was that TeamSystem could grow at 15% per year for
the next few years, a pace above the expected market growth o 9%, followed by a
6% growth in perpetuity. He also thought that Palamon's professionals could
help the CEO improve operating margins slightly. Lastly, Elson believed that a
14% discount rate would appropriately capture the risk of the cash flows. That
rate reflected three software companies' trading on the Milan stock exchange,
whose betas averaged 1.44 and unlevered beats averaged 1.00.
The second challenge Elson faced was the lack of comparable
valuations in the Italian market. Because most competitors were family-owned,
there was very little market transparency. The nearest matches he could find
were other European and U.S. enterprise resource planning (ERP) companies and
accounting software companies. Looking through the data, Elson noticed the high
growth expectations (greater than 20%) for the software firms and
correspondingly high valuation multiples.
Risks:
Elson was concerned about more than just the valuation, however.
He wanted to evaluate carefully the risks associated with deal,
specifically:
- TeamSystem management team might not be able to make the change
to a more professionally run company. The investment in TeamSystem was a bet on
a small private company that Elson hoped would become a dominant, larger
player. Its CEO had successfully navigated the last five years of growth, but
had, by his own admission, created a management group that relied on him for
almost every decision. From conversations ad interviews, Elson concluded that
the CEO could take the company forward, but he had concerns about the ability
of the supporting team to deliver in a period of continued growth.
- TeamSystem was facing an inspection by the Italian tax
authorities. The inspection posed a financial risk and therefore could serve as
a significant distraction for management.
- The company might not be bale to keep up with technological
change. While the company had begun to adapt to technological changes such as
new programming languages, it still had some products on older platforms that
would require significant reprogramming. In addition, the Internet posed an
immediate threat if Team System's competitors adapted to it more quickly than
TeamSystem itself.
Finally, Elson wanted to make sure that he could capture the
value that TeamSystem might e able to create in the next few years. Exit
options were, therefore, also an important consideration
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