Star Ingredient to Success
“Before investing in a particular company, we need to identify whether it has the potential to grow, and in doing so, we look for certain characteristics or factors in a company. These include the market, the company’s historical performance, as well as the quality of its management team.”
— Mr Wei Zhu, Managing Director and Head of Greater China,
Standard Chartered Private Equity Limited
Standard Chartered Private Equity Limited (“SCPE”) is the private equity and venture capital arm of the Standard Chartered Bank, providing professional shareholding partnerships for companies across a wide range of industries that are in their growth or matured states. SCPE partnered with companies that require equity funding for expansion or to finance changes of ownership, such as acquisitions or management buy-outs. The firm typically invests from USD 25 million to over USD 100 million in a single transaction and also takes the lead in substantially larger transactions, with the objective of seeing value and liquidity returns delivered within a five-year period. Once funds are invested, SCPE participates in the business as a board member, as well as takes an active role in strategic initiatives such as acquisitions, Initial Public Offering (“IPO”) preparation and leadership development. More often than not, it acts as the catalyst in identifying areas for improvement or opportunities to make businesses even more successful.
As the Head of Greater China, the Managing Director of SCPE, Mr Wei Zhu, shared his views on the relationship between maximizing the value of the firm’s investment and Corporate Performance Management (“CPM”).
In Search of the Right Ingredients
It is as simple as how the quality of ingredients dictates the taste of a dish; just about every successful investment story begins with a search for the right ingredients – opportunities that are worth investing in. However, it is almost an art to identifying such opportunities in an ever-changing market, where there is often an information overload.
The market – the prospects for the market in which the company operates is one of the most important macro factors affecting the growth and development outlook of a company. A company that is operating in a market with tremendous room to develop is certainly more attractive to investors.
Performance and history – it is commonly acknowledged that an understanding of the past is fundamental to an understanding of the present. The performance and historical facts of a company provide a unique insight into the current state of a company. In general, investment managers turn their attention to the key value drivers, which include revenue, earning quality (such as operating cash flow), and financial ratios (such as the accounts receivable-to-sales ratio). The analyses of these value drivers also form an essential context for evaluating the future growth potential of a company.
Management team – the competence and ability of a company’s management team along with a sustainable business model are some of the most important micro characteristics investors focus on when evaluating the prospects of a business. “It is also important that the management team is motivated by the opportunity to grow its business,” Mr. Zhu said.
Behind the Scenes
Private equity firms generally receive a return on their investments via one of the following channels: IPOs, merger and acquisition, or recapitalization. As a firm that mostly recognizes the return on investments via the IPO channel, SCPE’s strengths lie in partnering with the existing management team of a business, and becoming actively involved in improving it. The ultimate objective is to see value and liquidity returns delivered within a five-year period. But how exactly does the magic work behind the scenes, in other words, how does the chef transform these ingredients into a tasty dish?
A healthy relationship between the stakeholders always works as a catalyst and is crucial to success. One has to recognize that the existing management team is often resistant towards having external investment managers acting in management roles in their business. It is only natural for them to feel uncomfortable, and a sense that they are under scrutiny. However, the last thing investment managers want is to be portrayed as is ‘imperial envoys’. “We usually participate directly as board members by acquiring a substantial minority position in a company, and work very closely with the existing management. It is important that the relationship is built based on the foundation of trust, and it works best when the parties see each other as business partners or even friends,” Mr. Zhu said. There is no unified equation to conjuring up these relationships, but a good understanding of the background of both the entrepreneur and the existing management team always helps in shaping the right communication style and approach when working together.
There is certainly more to the key to success than pure healthy relationships. Adopting an investment and being able not just to turn it around, but also to double its value in a three to four year time frame, as well as achieving an industry average of 25% internal rate of return (“IRR’) is no easy task. The cycle of encountering and overcoming obstacles appears to be a daily routine for investment managers, and this ability seems to pave the way to inevitable success. “The three major challenges I have seen in managing the growth of my portfolio companies from a management perspective include: sub-quality financial management, inadequate cost control, and inefficiency of operations,” Mr. Zhu said.
Sub-quality Financial Management
Enterprise Resource Planning (“ERP”) systems may sound alien to many business owners, especially those in China. It is typical to see the finance function of a company relying solely on traditional spreadsheets (such as MS Excel) to support its day-to-day duties, resulting in a tedious financial management process and unavailability of timely management reports. Moreover, members of the finance team generally come from bookkeeping or equivalent backgrounds and do not possess the necessary skills for financial management. They are often pigeonholed, and commonly thought to be too preoccupied adding up numbers, while failing to observe the bigger picture. These factors can seriously impact the foundation of quality financial management.
Inadequate Cost Control
“I would not be surprised to see the cost margin of a business floating around the 80% mark when we first step-in… cost control is crucial to a business, especially during economic downturn,” Mr. Zhu said. When the market is highly competitive, a business can only be living on very thin margins, unless it is able to distinguish its products to the extent that the market is willing to pay more for the brand premium. A method of lowering cost, which is often adopted in China, is to increase the scale of production to achieve a greater economy of scale. However, Economy 101 dictates that the lowering of costs through achieving greater economy of scale generally results in a diminishing marginal return in terms of the cost being saved. The market’s ability to absorb the supply increase is also limited. Let us not forget also the inverse relationship between the supply and price of a product in a competitive market. “Most of these costs are related to the procurement end,” Mr. Zhu said, “including the cost of raw materials and logistics, and therefore the management has to be very sensitive to aspects of vendor management.” Establishing the right strategic sourcing strategies while achieving a balance between supply risk and cost can only be beneficial to the performance of a business.
Inefficiency of Operations
From customer development to revenue collection, there are countless ways a business can possibly suffer from inefficiency within its operations. From another perspective, there are just as many ways a business can enhance efficiency within its operations. One example was shared by Mr Zhu with regard to prioritizing customers.
Prioritizing customers is a concept that is almost unheard of in the business world in China. Often a business devotes relatively the same amount of resources to serving each of its customers, which can result in wasteful and inefficient utilization of resources. To enhance its efficiency in serving customers with the aim of improving performance, a business may apply the 80/20 rule – around 80% of its margin or sales volume comes from about 20% of its customers, and therefore more resources should be focused on serving the top 20% of its customers. More time in dealing with customers with the highest margins and sales volume not only enhances business relationships, but also helps with accounts receivable collections because of the relatively huge portion of sales these customers are responsible for. In addition, it can also provide more opportunities for sales penetration within these high-value customers.
Business operations can also be enhanced through other channels, including a reduction in working capital and improvements to cash flow, control and optimization of costs, as well as the management of operation risks.
Private equity firms maximize the value of the firm’s investment by applying CPM measures to its portfolio companies. The benefits of implementing CPM measures can continue even long after the firm has stepped down from management roles within a company. There is not a one-size-fits-all approach to CPM; however, the key is to adopt an adaptive mindset to implementing relevant CPM measures that are beneficial to the business at the time. After all, cooking with different ingredients requires different techniques and tools, but an adaptive cook who can unite these ingredients with the right cooking techniques almost always promises a mouth-watering dish.