Warren Buffet and other adherents of value investing believe that that the key to successful investing is in finding businesses with sustainable competitive advantages. Long-term competitive advantage is generally derived from a business’s scale, proprietary technology or processes and customer captivity.
This approach is useful in both public market and private equity investing since the presence of sustainable competitive advantage is strongly correlated with economic profits (i.e. profits higher than its cost of capital). For Indian companies, there is another source of competitive advantage - the quality of the entrepreneur (or ‘promoter’) or the senior management team of target investee companies.
Most PE transactions in India are structured as minority investments and the PE investor does not have the power to replace management teams. Even if the PE investor had such rights (say, in a control transaction), the lack of available senior talent in the market makes it challenging to implement wholesale changes to management teams. All these factors highlight the importance of management assessment in the due diligence process.
Assessment of management skills is difficult due to some unique attributes of the Indian market. First, many Indian promoters are first-time entrepreneurs so there may be no past track record of building and exiting other successful businesses.
Second, most firms which tap the PE market are entrepreneur led and ‘pre-professional’, so its not realistic to expect a fully professional management at the time of investment. Instead, investors may seek entrepreneurs who demonstrate a proclivity for progressive governance and professionalizing the business in the future. Finally, Indian entrepreneurs are naturally skillful in the art of courting western customers and investors, so be cognizant of the impact that the entrepreneur’s charm may have on your investment decisions.
My due diligence checklist focuses on the following aspects of the entrepreneur’s abilities and attributes 1) integrity, 2) strategic vision, 3) commitment to professionalize the business.
Integrity – Given the tight grip of the top management on the financial affairs of their companies, honesty is probably the most important attribute in entrepreneur that investors should look for. One may get a sense of the entrepreneur’s integrity by speaking to the company’s customers, suppliers, business associates as well as current and former employees.
Strategic Vision - Indian entrepreneurs generally possess strong operating skills and good cost discipline, but some of them pay scant attention to their competitors and in positioning their business for long-term success. In contrast, successful entrepreneurs have the ability to see a few years ahead and anticipate market trends. These are the people you want to invest in.
Commitment to professionalization- Prior to making the investment, investors may test an entrepreneur’s commitment to progressive management and governance by discussing specifics such as the size of the issuance of ESOP’s, proposed budget for hiring professionals, and the potential composition of the company’s Board. The specificity and thoroughness of the entrepreneur’s response may allow you to determine if the entrepreneur actually cares about such matters, or is just telling you what you want to hear.
Also, spending time with the entrepreneur in different types of situations over multiple meetings can be highly instructive. You may try to observe how does the boss act with customers and suppliers. How does he behave with junior employees? Do the employees respect the CEO or do they fear him?
Subsequent to the investment, the investor’s task is to guide the company through its various stages of growth. Sunil Mittal of the Bharti group has talked about the four models of management, which correspond with the four growth stages of the Indian companies: 1) entrepreneur-led and entrepreneur-promoted, 2) entrepreneur-led and professional-supported (most mid sized businesses fall in these two categories), 3) professional managed and entrepreneur-supported (e.g. Wipro/Bharti) and 4) professional led and professional supported (e.g. Infosys/ITC/most MNC’s).
Post investment, the challenge (and opportunity) for PE investors is to help their entrepreneur led companies (first and second stage) transition to professionally managed firms (third and fourth stage).
Indian entrepreneurs possess a tremendous amount of ambition, optimism and creativity. India’s entrepreneurial energy, when combined with a professional approach to management, may lead to favorable outcomes for private equity investors.