The Yin And the Yang of Investing: Finance and Operations

06 September, 2010

After seventeen long and eventful years in marketing, consulting and general management/ operations, I joined the world of private equity almost two years back. The first question I started getting (and still get) is ‘why join a finance position after operations?’ or something like ‘isn’t it tough to understand finance after operations?’, and an even better ‘I never realized you knew finance as well!’

That got me thinking – I had joined the private equity business because I had an operating background (which was supposed to give me the license to ‘somewhat’ understand how businesses work on the ground, and judge managers for capability and integrity). Frankly, that was also the explicit reason why I had been recruited by my employer! NOT because I knew complicated finance terms and structures (I sometimes still struggle to read a financial statement!)!

A few months into the job, and after extensive interactions with a multitude of private equity funds, institutional investors, investment bankers, limited partners, and promoters, I have come to the conclusion that the private equity business has two distinct, complementary yet opposing parts to it – Finance AND Operations. And, the good private equity teams in business today are able to leverage their deep understanding and skill sets on BOTH these dimensions for success. I like to call these the Yin and Yang of investing – since while they are divergent forces, you need to have both for successful investing.

Finance professionals focus on finance (obviously!)

In my days as a business head, I used to have regular (sometimes too many!) interactions with the analyst community, who were trying to understand our business drivers and forecast earnings for the future. It was a very interesting experience indeed – most analysts were smart, young finance professionals – so they had a pretty good understanding of what was happening on the debt and overall balance sheet front. But, they had never ever done sales or marketing stints in the field, or even worked their way up in a large organization. They had never seen the grassroots of business, never ‘turned around the stones to see the worms and dirt underneath’! It used to be pretty interesting to see what kind of questions and conclusions they would draw from our discussions:

Question: How many people are you planning to add to your field force?

Answer: 500.

Assumption: Sales will increase by average salesman productivity multiplied by the number of salesmen.

Reality: Never happens that way – you take six months for recruitment (the talent market was pretty hot that time, and still is), you make mistakes in recruitment (initial attrition rates post recruitment tend to be higher than average), it takes a salesperson at least 6-9 months, or about 10 customer contacts to start getting any business at all from new customers (incremental sales actually start building only after that point), and finally, if you are adding new products in a new division, your chances of success are higher (since you can measure the new product sales etc), versus adding salesmen to an existing division (where accountabilities are somewhat lost)! Nobody asked about these nuances – which can fundamentally make or break a sales force addition program in the pharmaceuticals space!!

Lets now talk about private equity and investing professionals doing due diligence on a company for a potential investment. Nearly 70% of the focus is on understanding the financial books and numbers, current debt position, capital structure, market valuations, past track record on the P&L, audit reports etc. All this data is then used to populate a spreadsheet, which can then ‘tell you all the scenarios’ that can happen in the company over the next few years!

Only about 30% of the effort is really spent on understanding what is really happening at the operating level, speaking to the next line of managers (and the frontline people in sales, or in production), building your own assumptions on likelihood of implementation of various initiatives, what is really going on with competition, speaking to current and potential customers, competitors etc.

Many of the future plans laid out nicely on charts are not tested for ease of implementation, realism in terms of timelines, and in terms of impact on sales and profits. As a result, you will see that most plans that were built at the time of investment are nowhere close to reality after 2-3 years! Part of this bullishness stems from private equity’s hurry to exit an investment within 3-5 years (most try even earlier!) – in most situations, these are NOT realistic time frames to fundamentally plan and grow a mid-sized business, unless you have very strong tail winds in the sector, or you are plain lucky.

You need to be prepared for a longer haul – maybe 5-7 years. (We keep talking about a 10 year investment horizon for most funds, but I think people really factor that as a worst case scenario- or people don’t really believe that!)

Let’s now talk about institutional investors (the ‘Biggies’ – large financial institutions, with tons of money to deploy and move around on a daily basis): After building a basic understanding of a sector, these players could potentially commit millions of dollars to a QIP or an IPO after listening to a 30 minute power point presentation! Whatever happened to Warren Buffett’s advice – you always invest in a business you know well! Have you really understood the specific company well, rather than the macro industry!?

Re-focus on operations and understanding of the business

By no means am I suggesting that the investing professional should forget finance and focus only on operations – all I am saying is that you need a balance, and today the balance seems to be tilted too much on the finance side. A large part of the reason for this bias could be the background and ‘financial sector’ origins of the immense talent pool in the private equity business. The good news is that there are many simple ways in which an investment professional can get better at understanding businesses and operations – and indeed, many investment professionals already do this very well!!

In my next column, we will discuss some of my observations of habits of good investment professionals, and how they achieve this balance of the Yin and the Yang!!


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The Yin And the Yang of Investing: Finance and Operations

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