Sustainable Profit Improvement: Building Great Businesses
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 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.
But how do you know if a “good” business can become something more? While there are many theories and paradigms on this subject from all manner of authors and pundits, Carpedia International’s experience through 16 years consulting across more than 300 North American organizations through approximately 250,000 hours of real-time observations is that companies with the potential to sustainably close the gap between actual and potential profit performance – and thereby become exceptional businesses – share the following attributes:
- A management team which is open-minded to a collaborative partnership that empowers and significantly rewards their success, while being humble but driven to improve the business;
- Identifiable productivity improvement opportunities which can be achieved in a timely basis through tangible changes in processes, products, planning systems, and management’s behaviours, focus and discipline;
- A substantial backlog whose delivery can be accelerated as increased productivity expands the company’s available capacity to handle orders; and,
- A sales organization which can be invigorated to exploit the newly freed capacity and capitalize upon shorter lead times, improved quality and delivery to generate additional revenues and increase the company’s profit growth rate.
The presence of numerous of these attributes contributes to our ability to believe in the Company’s potential to sustainably improve their profitability.
The absence of any one of these attributes is a cautionary note requiring particular attention to understand, while the absence of two or more of these attributes is a red flag.
Conclusion: The degree to which a “good” business can become exceptional, as demonstrated by sustainable profit improvement beyond base levels, is strongly correlated with how favourable private equity investment returns prove to be and the actual degree of investment risk. Therefore, we focus our investing efforts on fundamentally strong businesses which can achieve sustainable profit improvement through the Carpedia approach to building great businesses.
What’s Next: How we create alignment and incentive to achieve the goal of sustainable profit improvement will be the subject of our next blog.
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