Direct Investments: Creating Value for Our Investors
Our Kensington Private Equity Fund is a unique hybrid of investments in other North American private equity funds, and direct investments in small-to-mid-cap companies. Both require the ability to assess management teams, their track records and the likelihood of future success. However, we take a much more active approach with our direct investments where we work closely with management teams to build shareholder value. While good financial engineering can enhance returns, in order to deliver value for our investors in our target market of smaller niche manufacturing and service businesses, we focus on three things— buying well, growth, and selling well.
Buying
Buying well means we look at a lot of investment opportunities and say “no” far more often than “yes”. We are disciplined investors who focus on understanding the key value drivers of a business. Through thorough due diligence, we evaluate numerous factors including a company’s growth prospects, product/service advantages, managerial talent, industry dynamics, competition, potential risks, etc. Ideally, we are trying to identify what Warren Buffet described as an “economic moat” — those competitive differentiators that allow a company to fend off competition and sustain long term superior economics.
These competitive advantages could include highly engineered products, valuable intellectual property, low cost position, unique process know-how, and so on, and are usually manifest through high operating margins aka profitability. It is at this stage that we are looking to define our investment thesis — why is this an attractive opportunity and what is the strategy for driving value.
Growing
The growth phase is critical to driving value and stems from what we learned in due diligence. Working with small cap companies has its advantages in that they tend to be more agile, require less capital to grow and change can be achieved more quickly. However, we see a number of obstacles to achieving growth that are fairly typical of smaller companies including limited managerial depth (often in the finance function), customer and vendor concentration, narrow product/service lines, inadequate ERP systems, lack of working capital, etc. We work closely with management to remove or mitigate the impact of these obstacles and focus on providing the resources required to achieve the forecasts.
Speaking of forecasts, we are big believers in rigorous budgeting & planning, and alignment of interests. There is an old saying that “what gets measured, gets done”. This is particularly true in running a business. Many smaller companies have fairly informal budgets and rely more on management’s “gut feel” for the direction of the business. We typically help management develop three year revenue, EBITDA and capex targets based on the strategy. We encourage management to acquire a meaningful equity position in the business through direct investment, as well as through option plans that we establish at the outset of our investments. In this way, interests are aligned and management participates significantly in the upside they create.
Selling
Selling well is the final step in realizing value. Ideally, through the growth phase, we have helped build a business with management depth, solid growth prospects and sustainable margins that will be attractive to both industry and financial buyers. As with most things, timing is key as its far easier to exit in a favourable economic environment characterized by liquidity and an upward trend in the industry in question. Without sounding too obvious, we have found that the best time to sell is when someone wants to buy. Our best exits have occurred when we have been approached on an unsolicited basis. That being said, we believe there is great value in using a sell-side advisor to conduct a process, either broad or targeted, to help create “competitive tension” and achieve the best return. The best advisors have deep, relevant industry knowledge and personal relationships with the decision makers of the logical buyers both within North America and abroad.
It seems that valuations and sellers’ expectations today in many industries are at or above the high end of the range where we are comfortable buying, so we are being patient. We have instead been looking to exit investments where opportunities have presented themselves. In the meantime, we remain on the lookout for attractive businesses led by excellent management teams where we can bring our experience in the small-to-mid cap market to bear in driving superior investment returns.
