The Yin and the Yang of Investing: Finance And Operations (Part II)

18 October, 2010

In a previous column, we discussed the importance of getting the right balance between BOTH the elements of great investing skills – knowledge of ‘finance’ (capital markets, financial concepts, etc), and knowledge of ‘operations’ (understanding what enables execution, strategy, customer orientation, talent retention etc in a company/industry). In my observation, the best investors (and I speak now specifically for the Private Equity industry) demonstrate a strong understanding of both these aspects. However, on the average, the PE industry tends to over-focus on financial aspects, sometimes ignoring the operational realities in business.

In this column, I lay down some observed behaviors of successful PE investors that enable them to understand operational realities of business better than others. We could stretch the thought here to say that these could be possible ‘to dos’ for investment professionals wanting to get better on the operations front!

1. Allocate most of your time and effort with promoters/ industry managers. Much of the management guru industry today urges businesses to ‘get close to their customers’. In marketing/sales, the general thought is that for peak effectiveness, a sales person should be spending at least 60% of his time with customers, either understanding their needs, making a sale, or ensuring post sale service! Common sense, right? Many years back when I was a consultant, we studied the actual time spent by the sales team with their customers for a client – a very simple analysis of their calendar and actual schedule over three months. The analysis shocked us (and the client as well) – the sales team was spending less than 5% of their time with customers. The rest went into administrative work, waiting time, travel, presentations, internal meetings, training etc.

Similarly, people at senior levels in an organization are urged to spend adequate time with customers – just to ensure they remain ‘outward’ focused. This is critical at senior levels, when it’s very easy to start seeing life from your ‘ivory tower’, and viewing reality from the eyes of your internal team’s biased reports.

Good organizations use various techniques to encourage this ‘outward focused’ behavior – I remember Unilever used to mandate at least 2-3 days of field/consumer work for ALL managers, in my earlier job we mandated at least 5 field working days per month for ALL managers, set aside to meet customers (doctors in this case) by working with the sales team. The results were fantastic – enabling much better understanding on what was working (or not working) at the grassroots level, apart from other collateral benefits of the sales force being on their toes and all charged up! 

In the investing context, I would assert that time spent with promoters and operating managers is the BEST utilization of time for a PE investor today! That is the time where you understand industry nuances, engage in operational issues, understand the operating team’s point of view and constraints etc. It also can get you ‘proprietary deals’ as collateral benefits! However, I can bet that this activity gets less than 10% of an average PE manager’s time allocation.

I also think that, on average, most private equity managers spend excessive time with Investment Bankers and  colleagues in the capital markets/ PE industry, and attending various investing conferences. While these are important activities for deal and talent sourcing, they do little to build your operations muscle.

My observation is that the best investors ensure they spend a large part of their time (probably as much as 40-50%, though there is no rule of thumb here) with industry managers. They can be seen spending time with promoters, at various industry conferences, with personal friends in industry etc. They know that other networking meetings are important, but your real ‘customer equivalent’ is the promoter or the industry manager! As a simple next step, I urge my friends in the PE industry to do a simple analysis of their calendars over the last three months – How much of your working time have you spent with promoters and/or industry managers? Is the allocation looking like 40-50%, or is it worryingly lower? 

Another nuance to this behavior is the ability of high quality PE investors to build and manage their own PERSONAL network of operating managers. The key words here are ‘personal network’! It’s important to note that these have to be people who are true FRIENDS, not just professional associates. The PE space in India is a very small, closed space – everyone seems to know everyone. And probably that is true. Everyone claims they are friends with everyone! And that is definitely NOT true.

I find that there is little effort made to make real personal friendships, especially with industry practitioners. And that can really help understand an industry! Only a personal friend will tell you the reality in a company/industry the way it is. A casual acquaintance (who you think is a ‘friend’) will say all the right things, but never tell you the gory details on what really happens at the operating levels in an industry.

This kind of networking takes effort and time (imagine trying to build a true friend across 20 industry sectors – that will take time!), but could build you your most important network for the future.

2. Go deeper in the organization when doing due diligence to understand how a company is being run. While a CEO/ promoter will have his perspective, and so will his senior team, you need to get to the next two layers of management (at least), and definitely meet the front line sales people, and the manufacturing people (if relevant). Remember, what really determines execution is the quality of the team on the ground, and their clarity of understanding business priorities! Ask them about their frustrations, their successes, and how they spend their time.  Speak to their customers, competitors and competitors’ customers! Understand why customers are buying from this company over others.

Unfortunately, given today’s ‘deal making’ environment, I have seen PE investors seldom going beyond the well-marketed Investment Memorandum (IM) document, and meeting the senior management/promoters of the invested company. Nearly all the remaining due diligence is ‘outside in’ on the company and industry. There are some odd cases of deploying consultants to understand the high level strategy/ industry dynamics, but almost NEVER the desire to meet the actual working managers in the company! How strange is that?

There is sometimes the assumption that given the competitive nature of the deal, promoters and I-Bankers may discourage you from reaching too deep into an organization. Well, my basic point is that if they are doing that, they must have something to hide! Most good promoters who want value added capital would welcome potential investors speaking to their teams, and you will be surprised how many would agree to opening up their organizations to the right potential investor!

3. Insist on detailed project timelines and gantt charts – understand ALL the steps towards the various initiatives and plans stated by the management over the next two years – quiz management, and try to build in the steps by yourself if details are not provided. You will be surprised at how surprised the management sometimes is on realizing the many steps they may have forgotten or skipped. It will give you a realistic measure of likely implementation, and an appreciation of the time frame you need to underwrite your investment for! Question – do you have a rough gantt chart on critical projects that are important for value creation in your portfolio companies? Did you create at least a draft of these at the due diligence stage?

I am not suggesting fancy MS Project stuff here – never let fancy technology cloud issues. You need very simple ‘common sense’ steps on initiatives – like setting up a plant, ramping up of sales, ramping up of the talent team etc. Good investors have simple, conservative thumb rules on how much time it takes for some of these things to happen, and they use that knowledge when investing! 

4. Learn from your invested portfolio companies. Unless you are a first time entrant to private equity, you will have the luxury of an existing portfolio of companies – and that is a great starting place for rich and easily available information on operations! The best investors spend a lot of time learning from their invested portfolio companies! In fact, you could easily become an expert by working really closely with your portfolio – on not only specifics of the industry that you invested in, but also general points on execution and talent management.

Unfortunately, we see few PE investors really working closely with their investments – with the net result that they are sometimes not even confident to speak on all aspects of the company/ industry that they invested in! While most investors are active at the Board level, they seldom are aware of the issues at the operating level, losing a great learning opportunity! Do you know the front line people in your invested portfolio companies, or even people a couple of layers below the senior managers? Have you attended any operating review meeting, just to get a sense on what challenges the company faces at the grass-root level?

If possible, attend lower level operating review meetings (which should be happening at least monthly, maybe more frequently – else they will be too high level and not very useful for this purpose). The idea is not that you start interfering with their process, but to at least learn about what is working, and which part of your investment thesis is not – and why? You can use that learning elsewhere, if not in the same company.

I would like to end this article with two parting comments – firstly, these four behaviors that I mentioned above are my observations, and I am sure these are not comprehensive – there could be many more things you could do to improve operational ‘awareness’ while investing. I would be happy to hear what others have tried successfully to improve in this area!

And finally, I would caution ‘over correcting’ on the operational side. Knowledge of finance and operations BOTH is critical to investing success. If you over correct on the operational side, you run the risk of getting ‘emotionally attached’ to your companies or to industries. Having the right balance between the Yin and the Yang not only enables strong understanding, but also objectivity in investing. Maintain that balance! 

 


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The Yin and the Yang of Investing: Finance And Operations (Part II)

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