What do Ecobank, Fidelity Bank Ghana, Voltic and Petra Trust have in common? Other than being market leaders with strong brands, they have all, at some point, benefited from a private equity investment relationship. During the course of their engagement with private equity investors, most of these businesses saw a significant improvement in business performance, growth in market share, improved profitability and, in many cases, successful stock market listings that generated significant wealth for the founding shareholders. But how does this happen? What is it about the private equity relationship that gives these businesses the competitive edge?
Let us start with the basics. What is Private Equity? At a very high level it is simply an investment made in a company by buying shares or other types of investment that are not listed on any stock market. This means that, technically, a rich uncle’s investment in his nephew’s business is a private equity investment. However, in the finance industry, the term private equity, or PE for short, generally refers to those private investments that are made through investment vehicles (or funds) managed by professional investors called fund managers or general partners (GPs). The fund managers have teams of professionals whose job it is to identify promising businesses, make the investments and then, most importantly, work with those businesses over a 5-7 year period to increase the value of the business. Once the value of the business has been grown, the fund manager sells the stake in the business to “exit” the investment. Exit pathways typically include selling to the founding shareholders (the original owners of the business before the fund invested), another investor or listing the shares on the stock market in an initial public offering IPO. This all sounds very straightforward when presented in an article but a lot work happens between the share purchase date and the exit date. This value creation period is when all the changes and improvements are made to strengthen the business so it can leap forward as a market leader. Very often, private equity investors set challenging SMART goals and work relentlessly to achieve them to make for a more lucrative exit. These goals typically increase the value of the business beyond what the founders would have done without private equity involvement. For many profitable and reasonably successful businesses, this is the real reason why they consider private equity. Let us delve a bit more deeply into some of the factors that make the private equity model work.
The first success factor is the provision of capital and patient capital for that matter. One of the most significant challenges faced by growing businesses is securing sufficient capital to finance their expansion plans. Many profitable businesses are constrained to growing at a pace that can be financed from their retained earnings, meaning that actual growth is way below the actual potential of the business. Whether it is purchasing new equipment, launching a marketing campaign, releasing a new product line or hiring critical key staff, most businesses would benefit from having meaningful amounts of capital without the stress of repayments being demanded within 3 months of receiving the capital. There are many business owners who have developed strategies that could leapfrog them from, say, the 4th to the leading market position – only if they had enough money to pay for essential elements of their plans. A private equity investor provides the cash and the willingness to defer repayment as the business implements its growth strategy. Most entrepreneurs would agree that, all other things being equal, access to patient capital confers a significant competitive advantage to those businesses who can secure it. We have seen examples of this in sectors where a minimum regulatory capital is set by the authorities, for instance in banking and insurance. Those companies who fail to raise capital get acquired or they collapse.
The second and, probably, the central success pillar for private equity is the execution of a proactive and collaborative value creation process. As part of the due diligence process, professional investors follow a systematic process of analyzing all the drivers of business value to identify all the actions needed to achieve superior financial performance. Significant effort is spent to analyze value drivers such as revenues (e.g. product range, pricing, customer preferences, competitor action); costs (e.g. operating scale, capacity utilization, procurement practices, supplier selection); financial management (e.g. working capital efficiency, capital structure, internal controls); and corporate strategy (forward/backward integration choices, building/sustaining competitive advantage, corporate restructuring/acquisitions). This extensive analysis will usually result in a shortlist of the most critical actions that have the greatest positive impact on the value of the business. This shortlist will form the focus of the value creation plan to be implemented with the business during the private equity investment period. To illustrate the resulting benefits of PE investment, let us look at a very simplified real-life example from the banking sector in Ghana. In 2008, Fidelity Bank Ghana was ranked 11th out of 25 banks by return on equity (ROE) according to the PwC 2009 Banking Survey. There were two Ghanaian-owned banks in that year that were both ranked above Fidelity, with all three banks being 3rd quartile banks in that year. In 2014, Fidelity raised capital from private equity investors and by 2020 it had risen in the rankings to 3rd out 40 banks. In that same period, the comparable Ghanaian-owned banks had fallen or had remained in the bottom half of the rankings by ROE, representing an erosion of value for their owners. The private equity investment had effectively enabled Fidelity to accelerate ahead of its competition by evolving into a more profitable and respected Ghanaian-owned bank. Savvy entrepreneurs know that long-term business survival very often relies on being vel primus vel cum primis (either the best or among the best). A well-timed private equity investment can be the difference between life and death for a business.
Some entrepreneurs have been known to invite private equity investors into their business, not for the money but for the fresh ideas and operational discipline. In their view, partnering with a PE investor is akin to having a personal trainer to help you stay fit. In the same way that the best personal trainers have built experience helping hundreds of clients transform their bodies, PE investors analyze thousands of businesses to diagnose problems and identify opportunities for improvement. This makes the PE investor the ideal partner to brainstorm alongside an entrepreneur to transform their business from good to great while creating value for both parties. When the value creation plan is designed, it includes clearly defined targets for the overall business. These targets are filtered down to targets for individual senior managers and further down to targets for the entry-level employee. A high level of accountability is demanded of everyone in the business with bonuses and incentives designed to encourage high performance at the individual and aggregate level. Results are rewarded and there are consequences for not meeting targets. The rigorous impartial and regular reviews of performance of all (including the managing director) against targets greatly increases the probability of success for achieving the objectives of the value creation plan. It is a tough but effective process which protects value for the company owner and for the investors in the PE fund. Yes, PE investors do have a responsibility to return capital to their own investors such as pension funds. This operational discipline can be uncomfortable for some company founders who have not had to operate in this manner for years and some of them have been known to accuse PE investors of being overbearing or “taking over their business”. Similar to the example of the fitness instructor, in the moment, nobody enjoys being pushed to do more exercise reps when already tired or to stop eating tasty but unhealthy foods. However, we all welcome looking fantastic, feeling healthier and receiving positive comments from our friends.
Beyond improved operational discipline, some company owners actively pursue PE partnerships as part of their succession planning. There are many business owners who have built their companies over decades, have achieved significant success, and are nearing retirement age or just want to take a step back from the daily operations of the business. Their personal involvement has become so integral to the day-to-day running of the business that stepping away could be risky without careful preparation and planning. In many of these situations, the children of the founder may not be resident locally or may not be interested in running this business. Partnering with a private equity investor can be beneficial in these circumstances due to the in-built focus on strict corporate governance, defining a succession plan for management, and carving out a clear distinction between ownership and management. This is achieved, amongst others, through careful selection of professional board members, hiring of an accomplished management team, implementing an effective performance management policy, and regularly assessing the performance of the board against goals set by the owner. The enabling environment needed for this type of restructuring is characterized by an institution of checks and balances and the ability to step back and dispassionately analyze one’s own business from the perspective of a rational professional investor. One could argue that a business could simply pay a consultant for this service, but a PE investor would have their own capital at risk and would therefore be more motivated to ensure that the new ideas actually generate a return on investment. The result? By the time the PE fund is exiting, the business would be transformed into a formalized institution that is designed to run independently of its owner while still paying out annual dividends to the owner. By opting for the PE partnership in a timely manner, the owner would play an integral role in restructuring the business, would be able to safely reduce his/her day-to-day involvement and rest safe in the knowledge that the business has a fighting chance of outliving the founder.
In sum, it makes sense that beneficiaries of private equity consider this form of financing partnership as their “performance booster”. This might be why not many of them openly announce that they have benefitted from PE capital. The combination of patient capital in a context of capital scarcity, the ability to leverage that capital to secure market leadership and the expertise of professionals whose sole focus is to maintain your company’s leading market position makes a compelling case for private equity. Even for a company that believes it is “doing fine”, these potential benefits make it worth taking a serious look at private equity as an investment option.
In future installments we will talk about commonly asked questions about private equity. These would include: How would a private equity firm value my business? How do I decide which PE firm to partner with? How do I prepare myself for a private investment process? What does the due diligence process entail? Until then, keep pushing to build value in your business.
****** About the Author******
Jerry Parkes is CEO of Injaro Investments, a firm focused on using smart capital to help SMEs to realise their potential as drivers of Africa’s economic growth. Operating from offices in Accra, Abidjan and Port Louis, Injaro manages vehicles that invest responsibly and with the goal of spreading economic benefits broadly to the majority of Africa’s people. Jerry is a Ghanaian national, holds a MEng. Electrical & Electronic Engineering with French from the University of Manchester and a MBA from the Wharton School, University of Pennsylvania.
****** About the Fund Manager******
Injaro Investment Advisors Limited is an investment advisory firm licensed by the Ghana Securities & Exchange Commission and is part of an international fund management group that manages investments across Sub-Saharan Africa. Injaro has expertise in the areas of private capital, corporate finance advisory, asset management, management consulting and project management.