Unlocking Value: The Six Essential Attributes of Exceptional Businesses in Private INvesting
In the intricate world of private investing, the first step of any investment—deciding where to invest—might seem straightforward, but it is far from simple. Exceptional private equity returns result from a complex choreography that includes identifying high-quality businesses, acquiring them at favorable valuations, and driving operational improvements before the exit. This article delves into the six key attributes that mark a great business and outlines how these factors guide our investment decisions.
1. Core Offerings
Companies that provide essential products or services are indispensable to their market or industry, ensuring resilience through various economic conditions. The mission-critical nature of these products or services often stems from their position in the value chain and their small component of the customer's overall cost structure, where factors other than price become most relevant.
Key Questions to Consider:
· What is the essential purpose of this business?
· How have the main product and value proposition changed over the last ten years?
· How does this product or service integrate into the customer's overall needs and processes?
· How is the industry expected to evolve over the next 10 to 20 years?
2. Strong Market Entry Barriers
High barriers to entry are crucial because they mean a business cannot be easily replicated, and the risk of substitution is low. These barriers can include high replacement costs, operating efficiencies from scale, brand value, logistical advantages, and customer switching costs.
· How challenging and costly would it be to replicate the business or undermine its competitive position?
· How does our investment valuation compare with fundamental metrics such as the replacement cost of capacity?
· What barriers prevent existing competitors and new entrants from adding capacity to the industry?
3. Market Position
Companies with high market shares often enjoy substantial advantages, including cost and service benefits from large-scale manufacturing or extensive distribution networks, translating into pricing power and margin realization. In contrast, market laggards frequently suffer from underinvestment and losing market share to competitors.
· What attributes define the company or its products/services relative to its peers?
· What are the competitive implications of the industry's concentration or fragmentation?
· What is the competitive environment—regional or international?
· How do the company's returns on capital compare with those of its peers?
4. Reliable Cash Flow
The ability to generate stable, unlevered cash flows across market conditions is a critical indicator of business quality. We seek to invest in businesses where we have confidence in the durability of free cash flow and our ability to enhance outcomes through operational improvements, acquisitions, or capital structuring. Stable businesses are easier to finance and sell in all market conditions, making investment returns less dependent on economic or commodity cycle timing.
· Is there an opportunity for organic growth, and what investment would be required?
· Are there substantial restructuring costs or extraordinary items each year?
· What maintenance-related capital expenditure would be required?
· What is the return on capital, and is it sustainable?
· What is the price elasticity of the customer base, and how easily can the company pass through input cost changes?
5. Sustainable Competitive Advantage
Businesses with durable competitive advantages maintain defensible market positions that strengthen over time with a low risk of substitution. These advantages drive value creation by allowing companies to generate high returns on capital and maintain or expand industry-leading positions.
· Does the business create value through organic growth and/or acquisitions?
· Is the industry likely to experience long-term secular demand growth?
· Can the business increase margins over time?
· Does management execute a repeatable business integration and value creation playbook?
· Is the company able to increase cash flow with minimal additional capital expenditures?
6. Scalability
We aim to acquire businesses with large-scale operating leverage so that operational improvements significantly impact cash flows and the value realized upon exit.
· What level of effort and risk is involved in achieving profit margins?
· Does the quality and scale of the business attract top-tier management?
· Does the company require significant investment to boost revenue and EBITDA?
· What have been and what are expected to be the returns on invested capital for these additional investments?
· Is the risk/reward balance favorable?
Assessing Value and Operational Improvement Potential
In evaluating potential investments, we not only understand what makes a business great but also filter transactions based on whether we can acquire for value and deploy an operational approach to enhance returns. Our business quality assessment is comprehensive, and a deficiency in any one area can make an investment unworthy of pursuit. However, a great business does not always equate to an attractive investment. Overpaying or misapplying leverage can turn a low-risk business into a high-risk investment, undermining the potential for target private equity returns.
Ultimately, the combination of quality, value, and the ability to drive operational improvements creates an attractive investment opportunity. Our operational approach, honed over years of experience as long-term business owners and operators, allows us to identify great businesses with durable, predictable cash flows and entrenched competitive positions, and make them even better.
Conclusion
Identifying high-quality businesses is a nuanced process requiring a deep understanding of various attributes and their implications. By focusing on essential products or services, high barriers to entry, market-leading positions, stable cash flows, durable competitive advantages, and large-scale operating leverage, we increase our chances of finding and acquiring businesses that can deliver superior returns. Our comprehensive analysis and opportunistic approach ensure that we make informed investment decisions, ultimately creating value through our ownership period.
