Building Great Businesses That Are Worthy of a Higher Valuation
When Carpedia Capital considers investment opportunities, we always frame the potential for returns against the magnitude of risk (recall our definition of risk as the likelihood actual realized returns are lower than those required over a reasonable time period and the potential for permanent loss of capital) we are taking to ensure this relationship is appropriately balanced.
In our opinion, the primary determinant of investment returns and risk in private equity deals is how “good” the business is today and how likely it is to become exceptional during our holding period than it is likely to become the converse. Consequently, we spend the bulk of our time assessing businesses against these two criteria when deciding which companies to seriously pursue. After making the investment, our attention hones in upon the “how likely” qualifier to ensure our odds of success are “highly probable” as opposed to something less certain – with strategic focus, capital allocation, management development and risk mitigation being key tools to ensure the likelihood of strong investment returns remains in our favour.
Building Great Businesses That Are Worthy of a Higher Valuation: Profit level and applicable valuation multiple are, in our opinion, the two primary drivers of business value. Each is of significant importance and changes in profit level often cause directionally similar shifts in valuation multiple. Given that our approach to operational improvement of profits is well-discussed in earlier thought pieces, this article addresses the means through which we contribute to investment returns by building great businesses that are worthy of a higher valuation multiple:
- Strategic Focus (or, Why & Where Management is Focused): Businesses that consistently demonstrate growth and improving competitive advantage, each resulting from intentional action rather than mere serendipity, are highly valuable. We invest significant effort to develop, with management, a strategic plan to focus their time and effort upon the right initiatives that will grow the business with a return on capital in excess of capital cost, with good margins, while diversifying its customer base, expanding its market position and strengthening its competitive advantages in quality, delivery, cost and innovation. We also intentionally seek, as part of the strategy, to grow the outright scale of the business through both acquisition and organic means – as larger businesses, typically those with $5MM to $10MM of EBITDA, are inherently more valuable on a multiple basis than those with <$5MM of EBITDA.
- Capital Allocation (or, Where Management Lays the Shareholders’ Chips): Businesses that earn strong returns on incremental capital invested are highly valuable, as they have materially more growth potential and, also likely, a higher degree of profit sustainability than do low return on capital businesses. We invest significant effort to develop and vet capital plans for material new opportunities – be they of equipment or software or the acquisition of an entire complementary business – that accelerate the strategic plan.
- Management Development: The ability of a management team to execute growth and operating plans, on time and within budget, is highly coveted. Good, hard-working, intelligent, self-motivated but humble people are rare assets which must be further developed, trained, recognized and rewarded to bring about their maximum value. The team must also have depth to it and a well-defined succession plan, properly tied to development and training plans.
- Risk Mitigation: Businesses with inherent stability are more valuable than those subject to the vagaries of significant external risks. Through various hedging and natural matching strategies, we mitigate exposures to input cost, interest rate and currency rate volatility. We also often seek to reduce inherent business risk by expanding activities within non-cyclical end markets and with blue chip customers, typically under long-term contractual agreements, as strong and expanding market positions in these areas are highly coveted and by themselves serve to mitigate risk.
Conclusion: While we never bank on multiple expansion as a premise upon which to make an investment, we do devote significant effort towards building great businesses that will ultimately be worthy of a higher valuation than we paid – because the returns enhancement and risk mitigation benefits of doing so allow us the opportunity to exceed the business case upon which an investment was premised.
What’s Next: The right and wrong way to approach determining the value of a business will be the subject of our next blog.
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