Private equity 072013-digiversion

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A perspective devoted to Private Equity firms: to be successful they should adopt an innovative business model and control the richest parts of the value chain

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Private equity 072013-digiversion

  1. 1. perspective JULY 2013 private equity firms need to seek out successful business models, not just st andalone financial projections Alberto Calvo, Alberto Oteri
  2. 2. Private equity. Firms need to seek out successful business models, not just stand-alone financial projections Published by Value Partners Management Consulting via Vespri Siciliani 9 20146 Milan, Italy July 2013 Written and edited by: Alberto Calvo, Alberto Oteri If you would like an electronic copy please write to: cristina.goddi@valuepartners.com For more information on the issues raised in the report please contact: alberto.calvo@valuepartners.com alberto.oteri@valuepartners.com If you would like to subscribe or to be removed from our mailing list please write to: subscription@valuepartners.com valuepartners.com Copyright © Value Partners Management Consulting All rights reserved
  3. 3. CONTENTS PE firms need to seek successful business models, not just stand-alone financial projections 5 Considering the general “robustness” of the business model 7 case 1 / food & beverage: Focusing on customer preferences 11 case 2 / industrial goods: mastering technology to mitigate risks 14 case 3 / auto components: intelligent outsourcing of selected activities 15 conclusions 18 authors perspective private equity 19
  4. 4. Adopting an innovative business model and controlling the richest parts of the value chain are key to successfully navigate and ultimately succeed in turbulent markets. 4–5
  5. 5. PE firms need to seek successful business models, not just stand-alone financial projections As the current economic downturn is set to endure, Private Equity (PE) firms should focus on the rare “gems” of the market, which have been capable of developing unconventional, yet successfully proven, operating models. The three business cases we present throughout this perspective are of different sizes and belong to different industries, but have built their core strengths around three main pillars: technological innovation, a consumer focus and a savvy understanding of when to ‘buy’ and when to ‘make’. These three pillars have enabled these different businesses to successfully navigate, and ultimately succeed, in their respective and occasionally turbulent markets. perspective private equity However, these have not been the sole reasons for their success; their competitive advantage has also been driven by an ability to position themselves well within their respective value chains.
  6. 6. Exhibit 1 Billion USD, US Buyout deal value 1980-89 1990-99 2000-07 CAGR 2008-12 600 400 +40% 200 -6% +59% +18% 0 83 84 85 86 Source: Dealogic. 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
  7. 7. considering the general “robustness” of the business model It has been four years since the peak of the financial crisis in 2009 and stock markets, especially those in Europe, are only now beginning to return to their pre-crisis levels. In comparison, the Private Equity industry has proven to be a cyclical industry capable of recovering quickly (sometimes at a compound annual growth rate as high as 20-60%) after stages of significant economic downturn (e.g. in the early ‘90’s and 2000-2001). (See Exhibit 1) However, the pace with which the PE industry will be able to grow over the next cycle is still unclear. Indeed, despite the encouraging signs from non-European stock markets (e.g. USA, China and Japan), such a turn-around is yet to fully emerge. While Private Equity grew significantly in North America from 2011-2012 (23%), it remained steady in the Asia-Pacific region (-3%) and decreased both in Europe (-19%) and in the Rest of the World (-33%) over the same period, maintaining a consistent level of investment (excluding 2009) since 2008. (See Exhibit 2) perspective private equity Within this challenging and uncertain economic context, Europe seems to be suffering the most; in 2012, the level of investment of PE firms in buyouts and growth-development-capital (approx. €32 billion) was equivalent to the value in 2004 yet was almost half the value of 2007 (approx. €62 billion).Furthermore, despite a 50% reduction in the level of transactions from 2007-2012, the number of firms involved in PE deals increased from 1,650 to 1,900, demonstrating both the overall scarcity of resources available as well as the overall potential of the industry. (See Exhibit 3) In a market characterized by a growing number of deals and a scarcity of debt financing, the PE industry is focusing more on growth transactions and start-ups rather than turnaround and secondary buyouts. This is driven by the growing complexity and risk of traditional operations of the latter, such as the damaging effects that refinancing may have. In fact, LBO specialists understand that in the coming years yield could be increasingly driven by profitability improvements and organic growth rather than through financial engineering.
  8. 8. Exhibit 2 Billion USD, Buyout deal value 0% +5% -5% -3% -9% -19% +10% 186 182 +2% -5% 188 186 +23% 73 2008 2009 RoW Asia-Pacific 2010 Europe 2011 2012 North America CAGR (08-12) CAGR (11-12) Exhibit 3 Europe, 2012 Investments Billion Euro (Buyout and Growth investments only) 62 Companies financed # of companies 1.400 1299 1161 1.200 45 994 1.000 40 36 32 775 800 881 878 2011 2012 783 593 600 18 1047 932 615 400 348 200 2007 2008 2009 Source: Dealogic, EVCA. 2010 2011 2012 0 2007 2008 Growth 2009 Buyout 2010
  9. 9. Previously, the availability of low rateliquidity from 2004-2007 enabled many funds to engage in significant LBO activities. However, this level of risk would no longer be sustainable today, given the economic stagnation within Europe and the difficulties emerging as a result of high capital market rates. Typically, growth operations and startups occur in industries with fewer comparable benchmarks and less available market information (though specific company analysis remains crucial), whereas turnaround and buyout opportunities are typically associated with more ‘open’ market sectors. For this reason, when assessing the attractiveness of a potential deal, PE firms should primarily consider the general ‘robustness’ of the business model in question and the firm’s positioning within the value chain, rather than stand-alone economic projections that might not reflect the true potential of a firm. Based on our experience as industrial advisors for the major PE funds, when evaluating the potential of a number of target firms, it has emerged that if properly explored, some industries have succeeded in developing innovative business models, which have strengthened the whole business case even in those markets characterised by a high level of competition and an uncertain outlook. perspective private equity In this perspective, we will discuss three different cases in which, by leaveraging their business models as a source of competitive advantage, companies have been able to excel in their respective, albeit different, markets. More specifically, these firms have built their competitive advantage through: • Centrality of the end customer – capturing preferences and trends by having direct control over the last part of the value chain and leaving the burden of investing in assets for production to firms operating at the top of the value chain • Technological exclusivity – offering products and solutions that are technologically unique and hard to substitute • Outsourcing opportunities – evaluation of potential advantages through a prudent analysis of the “make-orbuy” business decision
  10. 10. Exhibit 4 Wine, Consumption, 2011 # of countries Stable* / in contraction (122 MLH) market share 9 cagr 2006-2011 top countries (MLH) -1,5% 24,9 24,7 21,1 14,0 10,2 • Argentina • Japan • Portugal • S. Africa 5,3% • China** • USA • Russia • Australia • Canada • Brazil 38,7 27,3 11,6 5,3 4,8 4,4 • Netherlands 4,2 • Belgium 3,1 • Switzerland 3,0 • Sweden 1,9 • Norway 0,8 n.a. 50% • Italy • France • Germany • UK • Spain 9,7 8,6 4,9 3,6 • Chile • Mexico • India • Thailand • Turkey • ... RELEVANT (227 MLH) growing markets (105 MLH) WORLD 244 MLH MARGINAL (17 MLH) 11 43% ~175 7% * Countries with a yearly growth <1%. ** Data influenced for more than 50% from fortified wine and wine not from grapes. Exhibit 5 Wine, Volumes, Mlh, 2011, Top 10 exporting countries 24,3 22,3 14,1 ~ 25% of world export 7,0 6,6 4,2 4,1 3,6 3,1 3,0 Italy CAGR 2007-11 % EXPORT ON PRODUCTION Spain France Australia Chile USA +5,2% +10,3% -1,9% -2,8% +2,1% -0,1% +3,9% +3,4% -3,6% -3,5% 57% 67% 28% 63% 63% 22% 43% 37% 20% 39% Source: Euromonitor International, Global wine compendium, Value Partners analysis. Germany S. Africa Argentina Portugal
  11. 11. Case 1 / food & beverage: focusing on customer preferences The wine industry is characterised by a stable level of demand concentrated in a few selected markets. (See Exhibit 4) Recently, a growing number of new wine-producing countries (e.g. South Africa, Chile, Australia) have successfully entered various global markets, managing to offer differing taste-profiles, yet high quality, at a competitive price. (See Exhibit 5) Traditionally, Italy has produced a wide variety of wines and remains the major global wine-producing exporter (approx. 25% of total global export), with hundreds of small and medium-sized firms ranking at the highest level for quality on the international stage. Through our work, we have observed three major business models being adopted by the major Italian producers (See Exhibit 6): 1. Classic model – firms that are fully integrated throughout the value chain, from viniculture through to the commercialisation and sale of wine (asset-heavy) 2. Commercial focus – firms mainly focused on ageing the wine and commercialisation (relying extensively on outsourcing – asset-light) 3. ‘Chain director’ – firms that focus exclusively on wine commercialisation and control the entire value chain through specific partnership agreements (asset-light) Empirical evidence demonstrates that it is vital to have direct (i.e. proprietary) control over the entire production chain for the premium and super-premium segments, whereas for the medium/ medium-high-value segments the primary success factor is the ability to understand and address end-consumer trends and tastes. (See Exhibit 7) perspective private equity
  12. 12. Exhibit 6 ASSET-HEAVY BUSINESS MODELS OF WINE INDUSTRY CLASSIC MODEL “FROM GRAPEVINE TO WINE” VITICULTURE WINE PRODUCTION AGING BOTTLING SALES & MARKETING PARTIAL OUTSOURCING IN SOME CASES COMMERCIAL FOCUS ASSET-LIGHT MAINLY OUTSOURCED “DIRECTOR” OF THE SUPPLYCHAIN Source: Il Mondo, Cerved, Value Partners analysis. No investments Activity performed internally
  13. 13. Flavour specialty, wine innovation and attractiveness of the bottle are also key success factors within the medium/ medium-high-value market segments. For the majority of non-Premium winemakers it appears then to be more appropriate to adopt an agile business model with no territorial and asset constraints (e.g. vineyards, casks, etc.), a greater ability in understanding and addressing consumer preferences, the use of advanced marketing and a proactive management of the main distribution channels. HIGH MARGIN Exhibit 7 TYPE OF ACTIVITY Sales & Marketing Aging LOW MARGIN Wine production Viticulture Bottling LOW HIGH INVESTED CAPITAL Source: Value Partners. perspective private equity Recently, a very smart player has in fact created value in the sector through the use of a more nimble business model where the company has been able to maintain direct involvement within the final stages of the value chain. This has permitted the targeted distribution of hundreds of labels geared towards international markets which makes up to 70-90% of domestic production, without committing large capital in land and equipement, thus reducing risk. PE funds that are willing to invest in such opportunities should evaluate, with the assistance of industry experts, not only the product portfolio of targeted firms, but also the solidity and smartness of their business models.
  14. 14. Case 2 / Industrial goods: mastering technology to mitigate risks The filtering of food ingredients and derivatives is a niche market, yet dynamically evolving, characterised by continuous research of technological performance and cost optimisation. However, significant barriers to entry exist as a result of the required skills and expertise related to the employed technology in use. These barriers are further strengthened as the required knowledge varies depending upon the specific fluid and the associated production process, ranging from fruit juices to wines. Technology is thus key to protect profitability and competitive position. In this sector expertise is considered a strategic asset which enables firms to develop a fruitful business relationship with the major bottling companies or food processing specialists. As the industrial advisor of a PE fund, Value Partners has appraised the innovative operating model of a leading firm in this particular industry which has built a globally recognised expertise in a variety of different market segments (including beer, wine, fruit juice, etc.). Albeit very small in size, the firm uses a proprietary technology to build a solid and well protected position in a very complex value chain. This has prevented so far an uncomfortable position as second or third tier supplier, and has ensured a direct relationship with the final decision makers at clients. 14 – 15 However, this competitive advantage is not easy to maintain. It requires continuous investment in innovation, also through partnerships with universities, research institutes and industry unions. PE funds willing to invest in these technology-centric industries should consider the ability of a target firm to nurture these core capabilities as well as to ensure that they have necessary resources to deploy in on-going research and development.
  15. 15. Case 3 / auto components: intelligent outsourcing of SELECTED activities The global mechanical gear market is worth approximately €20 billion with around 60% of it controlled by non-OEM integrated, stand-alone manufacturers (though this may vary depending on the technology used, final application and volumes produced). (See Exhibit 8) Typically, OEMs (Original Equipment Manufacturers for cars, trucks, boats, etc.) do not run all of their product’s associated operations and activities in-house, but rely on external suppliers and assemblers for the provisioning of components and peripherals. (See Exhibit 9) A common misunderstanding is that the process of outsourcing is only used for standard and low value components: it may occur also within other more complex or demanding processes as well. This outsourcing of complex components is often managed through external business partners, as they have unique technologies and know-how. Such partnerships not only involve the communication of technical requests to suppliers but also the sharing of expertise to improve and simplify solutions designed by the OEM. Exhibit 8 World, Gears, Revenues Gear Business Billion Euro, 2012 Expected growth of addressable gear market Percentage points 20 bln (100%) 60% +5% 100 107 113 118 122 2014 2015 2016 40% Total gears Captive* Addressable** Source: Value Partners analysis. perspective private equity 2012 2013 * OEM, Tier 1 ** Tier 2, 3, ... CAGR 2012-16
  16. 16. Exhibit 9 Example of supply-chain AUTOMOTIVE AGRICULTURE CE • Technical specification OEM • Final production • Assembly of all components TIER 1 TIER 2 • Detailed specification definition of each component • Supply of finished / semi-finished components • Production of assembled components • Production of individual components COMPONENTS MANUFACTURERS TIER 3 • Production of individual components TIER ... • ... ... Note: CE = Construction Equipment. Source: Value Partners.
  17. 17. For suppliers, opportunities for value creation often resides in the parts of the value chain in which large OEMs have a small direct presence and economic interest, enabling more specialised firms to operate and develop technologically advanced solutions. As a matter of fact, these opportunities have resulted in new technologies being introduced by indipendent suppliers in many specialised applications (e.g. gear oil pumps for braking systems) with new materials (e.g. plastic), replacing iron and steel in many components (e.g. electric windows). A number of leading firms have cleverly positioned themselves within these long supply chains. One such firm, a global gear producer, was able to accompany the major OEMs throughout their internationalisation processes by developing innovative technologies and solutions which were customised to their client’s needs. Such a partnership, which involved the joint engineering and development of some components, enabled the firm to contribute to the success of the OEM, and share with it the value generated perspective private equity To mitigate against business volatility (and the underlying cyclical nature of the automotive, construction equipment and agriculture industries), the firm also entered a range of new and diversified markets such as power tools and gardening equipment. For PE firms, a careful analysis of each segment in OEM’s value chain is required to assess these types of businesses.
  18. 18. Conclusions In a challenging and fast-changing economic environment, PE funds should focus on targets that not only have success brands and products, a competitive cost position and a proven commercial strength, but also on those that are able to build real competitive advantage through a winning business model. As a consequence, PE funds should also consider investing in more specific industry analysis, to understand relevant demand drivers and critical value chain dynamics rather than focusing on the financial engineering details within a transaction. 18 – 19 This new focus for PE firms has two major implications. Firstly, the competencies and resources destined for investment screening and industrial analysis should be reinforced and sharpened. Secondly, it is important that PE firms have the capabilities and expertise to support growth at their targets through relevant industry skills, contacts and know-how.
  19. 19. AUTHORS Alberto Calvo Partner, Milan Office alberto.calvo@valuepartners.com alberto oteri Associate, Milan Office alberto.oteri@valuepartners.com perspective private equity
  20. 20. About Value Partners Value Partners is a global management consulting firm that works with multinational corporations and high-potential entrepreneurial businesses to identify and pursue value enhancement initiatives across innovation, international expansion, and operational effectiveness. Founded in Milan in 1993, Value Partners’ rapid growth testifies to the value it has created for clients over time. Today it draws on 25 partners and 280 professionals from 23 nations, working out of offices in Milan, London, Istanbul, São Paulo, Buenos Aires, Beijing, Shanghai, Hong Kong and Singapore. In 2007 Value Partners acquired Spectrum Strategy Consultants – a leading UK company specialized in publishing, broadcasting, entertainment, IPTV and mobile – thus further strengthening its international presence. Today Value Partners is a leading advisor in the telecom, media and technology sectors worldwide. For more information on the issues raised in this note please contact the authors. Find all the contact details on valuepartners.com Milan London Istanbul São Paulo Buenos Aires Beijing Shanghai Hong Kong Singapore Value Partners has built a portfolio of more than 350 international clients from the original 10 in 1993 with a worldwide revenue mix. Value Partners combines methodological approaches and analytical frameworks with hands-on attitude and practical industry experience developed in an executive capacity within each sector: telecommunications, new media, financial services, energy, manufacturing and hi-tech. Copyright © Value Partners Management Consulting Limited All rights reserved

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