Private Equity: The Consolidation Play and Due Diligence - John Poerink, Linley Capital

you alright thanks for that I haven't done anything yet so I don't know exactly why you're clapping but I'm going to try and make this very interactive okay so ask questions whenever you want raise your hand or just ask questions I'm going to be focusing on due diligence but I'm going to take a very broad approach to the whole concept of due diligence so this is not going to be an accounting class because I would fail miserably in that but ready take a broad approach to due diligence in that and try and explain to you guys how we look at companies and how we go through the whole due diligence process in evaluating what is a good investment pros investment and what is not I'm going to be doing that on the basis of a investment that we made in a retail business before I do that let me let me give you a bit of them a bit of my background in addition to what the professor just mentioned and I kind of came into this business in a fairly unorthodox way I spent many years working for the Benetton family and then later also for a gentleman by the name of les Wexner who is the founder and majority shareholder of the limited brands that owns all of these apparel and consumer good companies and I was exposed to kind of the whole ma sector by doing transactions in a corporate setting so we did a whole slew of transactions when we were in the Benetton group where the Benetton decided in the early 90s to start diversifying and we bought all sorts of businesses including infrastructure deals we bought in northern Italian road networks which still is in the hands of the Benetton family today we made investments in telecom we made investments in consumer good companies and then similarly the the limited brands was involved in the similar capacity in a number of fairly large transactions and I got a lot of exposure to buying these these companies that were typically kind of middle market companies so anywhere between let's say a hundred to a billion dollars in revenues and and the complexities and issues that we dealt with in incorporating these businesses into the larger corporate setting so then later I went into private equity after I went back to business school and to this day I continue to be in this business and I have to say that I actually love what I do it's a it's a tremendously fun and interesting business and multifaceted business and I just have to figure out how this thing works here we go all right so I told you a little bit how and what we're going to be doing today and I'm going to talk a little bit about private equity core competencies and then really go into due diligence I'm going to try and stay away from kind of the technical stuff with respect to the technical accounting stuff they're ready conceptually try and explain what we do on a day to day basis when it comes to due diligence on the basis of a transaction that we did now this transaction that I'm talking about is a small transaction it doesn't matter however because it had all sorts of interesting aspects to it that regardless of the size you'll deal with in a private equity context before I start who is who has any experience in private equity has worked in a private equity firm ok quite a lot of you guys and in just just Fran what what kind of context were you working in private equity so I was working a curriculum in Spain ok it's a meet mom calling ok I will reduce from 200 million to a hundred million okay welcome what were you doing that so I was an asset so basically I was in terms of operating models or in the real world never sitting depths with works okay and helping the the priest out in directing the consultants in the in the market on stage ok ok good well let's start then with and we'll go through this very quickly quickly what what is it that we do on a day to day basis I mean so we're private equity men and women we work we have a lot of capital that we're backed with and what is it that we do on a day to day basis and in our offices I mean so we all talk about doing deals it's not as easy as that right so Daniel what is it that we do on a day to day basis where does the whole process start I didn't find potential targets require advise you believe popular okay so identifying potential targets to require okay so how do we do that we usually contact some different bands for firms that have been approached by my firm but to say the company yeah although an IPO and okay so investment banks right so we depend on what else what else do we rely upon from finding interesting investment opportunities Network what networking your colleagues your friends your family you try to reach as many people at potential investors and business owners accessible and this is how you ensure a certain deals local potential beautiful okay so go ahead consulting reports just worthy look at the company business and where they see the companies from cash flow one my friends well position to the industry okay right so we we source deals do Tom Morris in hire by said broker if you want to target a particular segment over eyestrain women advisory program cool to trade chosen and then what rise together we one of the hardest thing that we do and particularly in this day and age where the markets have become incredibly efficient meaning there are by side brokers their investment banks there are people that have networks and friends and family it is incredibly hard to find proprietary deals so what's the issue of finding non-proprietary with being approached by an investment bank the other shops right the same view probably the price with it exactly so in investment bank these guys you know are probably better in networking than we are and they have a whole slew of companies that they've developed years of relationships with in the venture that the companies eventually up for sale privately held company that's a just for example and they showed to a whole slew of private equity firms they run an auction process and you end up paying a very hefty price to be able to close that transaction so sourcing deals and don't forget this is incredibly hard and it's becoming increasingly hard because the markets have become incredibly efficient the private equity business has become an industry and there are hundreds and thousands of investment banks in Europe in the United States and increasingly so new in Latin American increasingly so in Asia that are all running after these investment opportunities and very hard to find interesting opportunities that are proprietary ok so what else do we do so we spend a lot of time trying to find interesting investment opportunities what else that all we do I mean terms outsourcing of other things now forget sourcing because that say let's move on to the next report in fundraising do that one okay fundraising I'll get back to that so but that's a very important point I'll come back to that in a minute what else do we do oh follow Investments okay so how do we do that usually and you prefer for reports from data images for the goats okay and you assess a motion services so we're typically when we do an investment we typically take a board seat in investments or several members of our firm we'll take a board seat and we oversee the investment and the execution of the investment and we oversee essentially management reports then to the board and we we oversee the image so that takes a lot of time and a difficult process okay what else we talk about sourcing we talk about fundraising I'll get back to that in a minute I'm in relationship with lenders are you able to borrow - all right so we got fundraising and debt financing okay we're in the business of doing leveraged buyouts right and to finance these transactions we need to have debt the whole process of raising equity and debt financing for any transaction is a very very difficult and very complex process raising a billion dollar fund it just doesn't happen from one day to the next it's a very difficult and arduous process it's very very competitive there are a lot of people trying to do what you do the LPS and the Opie community whether it's pension banks whether it's family offices or endowments then these people know what they're doing and they're very good at picking good managers who have a good organization who have a good set up so the whole process of fundraising is a tremendously arduous process it takes a tremendous amount of time it costs a lot of money as well and you can end up empty-handed too so the whole process of fundraising and also raising debt financing for transactions particularly in these markets and I'll get back to that at the end of this lecture is a difficult process okay what else do we do so that's it so we raise funds we source deals or what else source okay so we execute on the deals that we source right and which is what due diligence and negotiations and do you have any experience in negotiating private equity transactions yes okay so tell me a little bit is that an easy process is a hard process it's very challenging because often times you need to reconsider it between the expectations of the management of the owners or whoever's selling the business and has a form there general requirement to risk four or five so negotiating transactions is another it's a pretty complex type of business you have to have it a little bit in your fingers the sellers have to like you you have to come up with a good bid it's not only about price I've actually won auction processes not by paying the highest price but having the best structured deal having the best relationship with the management team having the best developing the best relationship with the sellers and coming up with a transaction that is ready doing right by the business and doing right by the company and really ensured that the sellers felt happy to whom they were selling the business to now private equity business and particularly in Europe by the way we do transactions in Europe as well has developed a very bad name the whole concept during the last five or six years the whole concept of doing these leveraged buyouts where you would buy a business at a high purchase price multiple and kind of justified that hyper stir spice multiple by using tremendous amount of leverage and two years into the into the whole investment you're breaking through your covenants and in the worst case going bankrupt so these types of structures and transactions people becoming much more savvy about that and negotiating and structuring transactions in a in a way that in an effective way that you can actually make the acquisition of the businesses is my increasing your more difficult and and competitive alright so I'll just quickly go through that so we talked about sourcing we'll get back to about due diligence due diligence is incredibly important due diligence is not only financial due diligence it's much more broader than we'll get a get to that in a minute but we spend a lot of time on due diligence now just a minute about valuation and how do you know what you pay for a business Silvia what should you pay for for if a company walks or an investment banker walks through the door it gives you all sorts of information about the business so how do you determine what the valuation should be for the business you know what's your return applying for you fund this you have to maximum level or what you can pay right that number with other okay and so how do you determine that ultimately well price you should be paying for the business I mean you can do all that work but so what so you have all this all this information what I do I mean what are you going to pay for it in the end for the business what really truly determines what you're what you end up paying for the business okay get some guidance with the bank's where you stand bidding and then based on that you decide it's worth you to me spend more time to find synergies apply another waste and to pay more for business okay okay Diego you wanted to connect accomplish the same thing this your walkway bank should try to raise I provided other sources as I said you know by having a relationship or the management bringing way that can advance new business based Lois's okay the the whole concept evaluation has gone completely haywire and certainly during the last four or five years the people have been overpaying for these assets for years and somehow justifying the price by using a lot of leverage that whole game has changed now the the debt financing that these companies used to be able to get for justifying these types of deals are no longer available so it's becoming increasingly more difficult to justify a high valuation a high purchase price for a particular business financial modeling so just just very quickly so how how who's run leverage buy up models here in the past in a private equity context so you guys here a time to tell me a little bit about okay what's what's ready the concept of the leveraged buyout model the key concept is busy for a free cash flow yeah what kind of what can we deal with what do you have any kind and we finally return to the equity holders right the basic constable okay so it's a very simple concept right you basically look at the cash flows of the business you kind of try and identify how much debt and what kind of capital structure this business can sustain over the years and and it spits out what what what does it spit out at the end so the cash and cash return and the IRI and the and the IRR so a lot of people will understand how to do this and develop leveraged buyout models what's really the important part of that to figure out what are the key growth drivers what are the key drivers of the business activity okay and model the business if there's seasonality then you figure out what is the right time period if there are other structural driver than you identify what was on look at the various bank well okay so the whole concept of leveraged buyouts is not so difficult to understand and and actually running leveraged buyout models is not that difficult the whole point is is what you're really putting into that and if you really understand the underlying asset the underlying business how the financial operation of the myth of the business and what the future cash flows of the business are going to be and if you get that wrong you can very very quickly the whole investment can go south and before you know you can go bankrupt we talked about debt and equity financing we talked about negotiation deal structure a little bit about exit planning it is I have come across many many investment opportunities where we were kind of talking about an investment opportunity said well should we do this yes or no and and we were very much on the fence about this particular investment when you make an investment have a very very clear idea of actually what the exit is going to be because if you're on the fence of it about this particular investment opportunity in good times and you want to sell it in five years from now and the business has done so so and you're going to have a hard time I'm sending the business down the line so don't buy businesses that are unsellable and just because you are desperate to get a particular transaction done or and don't underestimate the the difficulties either you might run into of investing in certain companies and certain businesses where it's very difficult to exit out of the transaction because the business is virtually unsellable and and there are certain companies that are very very difficult to sell go ahead so in your opinion because if we're looking also about the largest of the large number of competitors that you have in an auction yeah your price is gonna be high yeah trade means that if you have a business that is equal to so you have to between different lies in that business maybe you're going to get a better price but you may not have some more problems in the exit prime yeah so my question is how you can make a decent is not very solo-e to its who are you know converted into a business in time period for that's exactly where your due diligence comes into is is evaluating this business and thinking and being creative in your thinking and thinking okay what is the likelihood of taking this business and setting it up for a much more interesting business a much more interesting operating model and healthier cash flows a better management team and what is the likelihood of succeeding and let's say a matter of four or five years and and to whom might we be able to sell that business and you'd be surprised how many businesses are bought with people not thinking about how they're going to exit and there are I have come across hundreds of companies that are owned by private equity firms that they've had for ten years and these companies come up every two or three years then they hire another investment bank and they try and sell the business again nobody wants to touch it don't underestimate it you could be stuck with a business that's doing you know five hundred million dollars in revenues and it's just a business that an investment in an industry taken industry I mean we were talking about it earlier about the printing industry printing industry is going through tremendous demise there are hundreds of private equity firms and made big investments in the printing sector because they you know they had the wrong strategic approach now so now these companies are owned by these private equity firms nobody will touch them and so their continue to hold them you know they still cashflow they pay down the debt that they can't sell them good is it more than just Egyptian or there are also certain aspect or characteristics of a business that when you see you should run away it can it can be it can be as a structural give you an example we're actually looking at a business right now in the aerospace and defense sector it's a business that and these businesses can be actually very very good and we've got some very very good advisors in in this sector but they're in the business of buying and selling parts to airplanes okay not commercial airplanes but actually military planes and this company has bought this huge inventory of of parts of military aircraft from a wide variety of European and US manufacturers the problem is that there are two problems with this business the ownership structure make it very very complicated there are a number of investors and a family office that's involved in this company and that and the families running the business and secondly the inventory hasn't been properly catalogued so they really don't know what they have it's actually fairly big business it's a big business that has a huge amount of inventory that is actually cash flowing quite nicely and but they haven't catalogued their inventory and we're talking about millions and millions and millions of parts and so they're trying to find somebody who has the guts basically to step into this business to make a valuation of the business to spend a huge amount of money in immature izing all of these spare parts of these planes and making a bid for the company it's not so easy no you have to have somebody who's willing to do that anyway there are many examples like that of these quirky companies that cannot be large but they're very difficult to sell or to buy okay okay so we talked about so what we do on a daily basis from a from a private equity perspective and and actually all of these facets of any type of deal making make this business tremendously fun and interesting this guy called me and he said look you know I had this this idea there are all these luxury optical retailing stores here in the United States and they're incredibly profitable it's a very fragmented market and I know all the owners of these stores because I've sold stuff to them over the years and and you know I think that you guys should take a look at this with me and back me about and potentially making an acquisition of a number of these companies in the luxury optical retailing business so and he's told us a little bit about the about the sector and about the business and sounds like a pretty interesting idea where we were stores all across the United States potentially even in Europe they had pretty high margins it was a fairly fragmented market so we said okay what let's let's take a look at it so where does this process ready start so what do we do next so we have this idea we have this guy who walks through the door with this idea and he says well I have relationships with a number of these owners of these types of companies and you know you guys should back me in doing this so what would you do next Gus where we were you in my shoes for business and what one's money right so you can be DSS with these plans are work your time in your money okay so it starts with you know doing a little bit of due diligence on this industry right so what this guy said there were all these stores all across the United States in this this this little group that he was talking to is like 25 stores so it starts with kind of a due diligence process so what what is it what we're trying to do with with due diligence what does already mean Aaron who tried to verify I mean for this specific case you probably be trying to verify the economic to the store and you know what what he thinks is achievable whether that can actually be achieved okay but it's it's it's think of due diligence and kind of like a more broader concept and what is it rather we're trading trying to do through due diligence go ahead I mean that's it comes to that by the way I mean obviously we have we have to do kind of the financial analysis of and the the the understand that say the economics of these stores but what else in a broader drug do I think you're just trying to confirm your investment pieces exactly what's your right so due diligence is really kind of trying to understand the benefits and and and the liabilities of proposed investment and and and try to understand kind of the past the current situation of the business and where it's going to go in the future right and in addition to that you're basically on this trying to understand and really get a very very thorough understanding of this business and how it operates in its environment and and use that information to come to an accurate value evaluation of the business and and and develop predictable financial models so and this is this is really one of the hardest things that we do in in the private equity business there are so many businesses that we see on the daily basis now we must have looked at probably about 500 transactions in 2009 okay so we looked at 500 500 transactions and so we're constantly seeing these these these opportunities across a very wide range of different industry in the industries and sectors in the consumer and the industrials and manufacturing aerospace and defense sectors and there's certain similarities between companies in each of these different industries however every single company is different and it's it's very difficult to develop a nose for what is a good company and what is a bad company what is a sound financial operating model and what's a a bad one it's not that easy and you can't look at financial statements of a company and just say well ok this looks pretty good you know pretty good Eve it down margins pretty good cash flows yeah it's much more complex than that and it's and and it requires also a certain intuition with respect to the business but also being able to put together all of these different due diligence aspects that you're looking at not by yourself but with my team of people and boiling it down to your understanding of the business and evaluation ok so what it really involves is and from top to bottom looking first at the macroeconomic environment so we've got this optical retailing business and it really starts with doing a macroeconomic analysis and how these businesses and industries kind of develop with in in fluctuating macroeconomic environment okay so so from the macroeconomic environment what work what's the next step where do we then go into Carlos industry what next weather due diligence elements are there apart from kind of macroeconomic environment seeing how the industry performs in a particular macroeconomic environment so once you've assess the industry you probably wanted to get to specific aspects of the firm both the firm's operating performance and in the management team okay all right should we look at the the financial operating model the operating model of the business you look at comparable and precedent transactions and and then we you obviously do financial do divisions right and in addition you look at management it's very very hard to do a proper evaluation of management I've done I've made so many mistakes with that where you can have great management teams that are great PR people when it really comes down to really running the business then a mutton it may not be as good as they as they claim to be so it's very hard to do a proper determination of how good the management team is a particular company go ahead yeah one question so the situation described it seems like it was a case different from you know what the company you can acquire you jump on it and do whatever you need to do now it seems like there's a theme that you have your friends it thinks it's interesting and you're going to explore so how do you go about this particular phase of establishing your strategy how to go about certain you know triskin rather than looking into a specific company and trying to dig deeper well I mean well we we did this guy walked into and it often happens like this and this guy but even if an investment banker comes to you with a CI M that thick you still have to take a step back and you have to say okay how does this business that we're looking at how does it perform in a particular industry right so where is the company positioned according to its competitors and how does it perform how does this industry in general perform in the US market or in the u.s. European and Latin American market okay so you have to always have to kind of take a step back and say look at the industry and this is a viable industry you want to invest in and what is the competitive set in this particular industry pretty you know you've got you guys have done this 100 times before but people sometimes forget to do that so they look at they become myopically focused on the financials of the business without kind of taking a step back and said well should we really even be looking at this industry in the first place so with this obstacle situation we kind of looked at the industry we looked at at and and I'll come to come to you know some of the work that we did in in a minute and we decided actually well this could be a really interesting situation okay so financial due diligence you look at management legal big mistakes are made in private equity type of investments without doing proper legal due diligence so I don't do that we get a whole slew of lawyers our lawyers are at Kirkland Ellis and they evaluate the transaction structure but they also evaluate the assets that we're buying and you can make some big mistakes with respect to buying these type of assets where you find out that they're huge liabilities and I'll give you an example most most recent example that we dealt with is we looked at doing consolidation play and kind of gas station type of businesses so these are gas stations across the United States they have you know 200-300 gas stations three or four different companies and with maybe a total of about thousand gas stations notoriously difficult business when it comes to liabilities and environmental liabilities because these gas stations turns out or leaking gas into the ground right so these gas stations have been around for 25 years or so they have these kind of tanks they need gas into the into the ground and before you know you've bought a thousand of these things and you're dealing with huge huge legal and and environmental liabilities that you didn't foresee and this is a more kind of obvious example but they're less obvious examples that if you haven't done your legal due diligence and your environmental type of due diligence properly literally you can get notice from one day to the next and your investment is virtually gone because you didn't foresee something properly so spending the money on due diligence but also managing the due diligence process effectively is incredibly important and what we do is we ready manage this process I mean we're not you know doing the legal the legal due diligence ourselves we hire people to do that we have a whole team of 30-40 people working for us on a particular transaction that do all of these different aspects we have KPMG working on the financial due diligence or certain aspects of financial due diligence the the management's assessments there and here again this makes private equity investment investing in the United States a little bit easier there's a whole industry in people who do management evaluations you know what it's it's always being worth spending the money on these types of situations and in a minute I'll give you an example how we made mistakes sure go ahead interview when's the right time to hire outside firm or legal and financial duties after you sign your any women for you to be the only bidder when you bring them well actually a very good question because and one of the things what keeps us alive and what keeps our business alive is the management fees that we get from our Opie's right and hiring Kirkland and Alice and the accounting firms is an expensive proposition and when you do one hundred one hundred million dollar transaction before you know it you're spending ten million dollars in due diligence fees so the you have to be careful as to when to decide that you pull the trigger on hiring all of these people on a retainer basis on the particular transaction that said you can't wait too long because you have to show the sellers that you're also committed enough to actually spending the money so and this goes back to kind of the negotiation process in some cases we've actually hired our due diligence team earlier on in the process because we were very eager for the particular investment to show the sellers and the investment bankers and the lending institutions that we were very committed to this particular transaction so if you further along than your competitors and the other people that are bidding for the transaction that can actually help you getting getting the deal done earlier and sooner ahead of the time that some of your competitors are so timing is a critical issue in this game because particularly the investment bankers but in many cases also the sellers want to get the deal done as soon as possible so one of the things that you see for example is I don't know if you familiar with the process of doing private equity transactions but it typically starts with signing an NDA then you get a investment memorandum from the investment bank and then you submit an indication of interest which is basically an indication of kind of the valuation range that you guys are that that you're interested in bidding for the company and then you're selected with a smaller group of people you're left on the basis of the valuation that you put forth in your indication of interest you're left with a smaller group of bidders and then you have to make your final bid in the form of a letter of intent now the difference between a letter of intent and an indication of interest does anybody know what that is what's the core difference between a letter of intent of the indication of interest fortunate letter of intent is banking let's let's data late NY is executed I just make sure that I write what LOI has two sections and I guys the ones that we've drafted the one section is a binding okay should I portion at the end of the other way correct write an indication of interest to say okay we'll probably you know we'll pay you this this for the business more or less a letter of intent is actually contractual agreement so there's a portion of it that is indeed binding and the the other important aspect of a letter of intent typically is that you have exclusivity meaning that nobody once they've set both both parties have signed it nobody else you basically are protected to spend all your money on due diligence to be able to work towards closing without being outbid in the process okay so I care go ahead so for more there you know like the Bain & McKenzie we'll be sell like no business with diligences down to two key folks to use that a lot or do you do it absolutely and I mean these businesses businesses around not because you know some some publicly listed corporation needs help to you know to figure out what their strategy is going forward not only that but these these all of these consulting firms have huge private equity operations where they help people like us do due diligence work and in fact what they do Bain does growth and strategic analysis type of opportunity is okay we have this company it's grown ten percent 10 percent kegger over the last five years okay pretty good growth numbers it's a five hundred million dollars in business how can we take this business from five hundred million dollars in revenues two billion dollars in revenues over a period of five years okay and what are the problems so we hired Bane to do a whole analysis and figure out and do a very very precise and careful analysis on on you know what the likelihood is and to mitigate some of the risks there and and and to ensure that we have a good plan in place go ahead back to this the growth I don't know if this is the ten growth in strategic analysis but consolidation is a common type of pieces you'll have in private equity the when doing a constellation players such as this that depends on multiple positions do you how do you go about understanding if it's actually feasible of those owners will sell if actually have a chance to it's a really good question and consolidation plays are is there's a lot of jargon in this business and a lot of kind of a yeah consolidate we're going to do a consolidation play in this industry consolidation plays are incredibly incredibly difficult to do and a lot of them fail and and I'll get to that in a minute a lot of consultants work by the hour how do you think about whether that marginal dollar or marginal hour time should be spent or is this enough me too well that's the art of what we do and know already is it's a very good question I mean well why should we use spending you know $500,000 on Bain to put you know a thick report together of something that we could probably do ourselves well we couldn't do we definitely couldn't do it as good as Bain does it what I've what I found out is is typically if you're managing a process like this where there's so many moving elements and there's so much to think about it is typically better to have more due diligence information than less and and and because what you're getting is ready you're getting on one particular aspect of the transaction an outside opinion and you can disagree with them and by the way we often disagree with our consultants in these deals we often disagree with our with KPMG on a report that they put together we are we we disagree with Bain we disagree with our consultants are operating advisers on these particular transactions but but it does in the end mitigate some of the risks and it doesn't leave it what it what it what's very important is that it it leaves you with a situation that you're not caught by surprise and things will never work out in the way that you actually expect them to - there's always something in a particular transaction after the trends after you've done the transaction that it doesn't just didn't work out the way that you expected it to or you come up come some sort of surprise happens in the transaction that you didn't expect by doing the due diligence and covering all of these aspects and working with people who already know what they're talking about and working with people who are very thorough and give you an outside opinion you mitigate some of the risks and and you'll imitate some of the surprises go ahead yeah risks can you comment on how that's changed from their perspective postal crisis so they looking yeah it's a it's a very good question and it has changed actually and I would be amazed sometimes in kind of 2006 2005 how easy the banks were and just as a little sideline the the use of leverage in these types of transactions is a dangerous game right you're playing with fire because the more leverage you use the the thinner the margins are between being able to service the debt and your and your cash flows and if you get it wrong and if you're caught and if you haven't done your due diligence properly you'll find yourself in a situation that you don't have sufficient cash flows it's as simple as that you don't have sufficient cash flows to service the debt right and you blow through your covenants and it all gets very very ugly very very quickly right because the banks will have you by the nuts and the it's really an unpleasant experience I mean I've been through it and it becomes a very very nasty game because the banks are basically I mean you know you have good banks and you have bad banks but you know typically if you've really over levered the transaction you really get into into into serious problems in kind of 2005 and 2006 I I was amazed sometimes how easy the banks were and how laconic they were with respect to financing transactions it was amazing I mean you they were throwing money at you and I actually and believe it or not we did a number of transactions whereby we went back to the banks and said well thanks for your offer in leveraging this set of four times leverage multiple but we'll only take three and they couldn't believe it said well I you should take four you know we're offering you four while you wouldn't you take it and by the way ninety-five percent of the private equity firms would take four so this the the and the banks were were laconic with respect to and bad in their due diligence process they basically kind of followed the lead of the private equity firms and kind of toad to the line of what the private equity firms are telling them that has changed now and you know the banks are becoming smarter about who they lend to who they work with from a private equity perspective and how thorough their due diligence is and the banks what happens is the banks work with the combination of the work that you provide them so it's sometimes good I mean if you want to get a bank on your side it's good to have you know a thorough Bain report and a thorough KPMG report and a thorough management report done by a Human Resources firm and and you know a thorough environmental report because it gets the bank's over there over the over the hump to lend you a large amount of cup capital for the transaction so it has changed and the more thorough that your due diligence work is the easier the process is okay well I mean you have the banks of have have three sources of information right they have the information that they get from the investment banks which is usually worthless I hate to say it I don't know who's an investment banker here there you are so we're we're typically Erika and it but you know we take the CI M and we love kind of like getting on the phone with the investment bankers and kind of saying well that doesn't make sense or you know I'm really kind of grilling the investment bankers and of course of course so and and and by the way there are definitely I'm making a gross generalization but there are definitely investment banks that do really really great jobs and it's not actually the big investment banks necessarily that do great jobs and putting CI ends together there are some smaller investment banks like middle market investment banks that are incredibly thorough incredibly reliable in the information that they give us so the event the banks work with free sources of information they work with materials from the investment bank and the due diligence material that the investment bank puts together for the debt providers as well as the private equity as well as the buyers and they work with materials from the private equity firms and in some cases the bank is thorough they do their own due diligence work but it's very limited and it doesn't cease to amaze me how limited and the work typically is from from the bank the unica they get on the phone and they take all the material in they do their own analysis but they don't spend money themselves and doing their own due diligence work typically they don't go ahead each fund has its own way of good business and stirring the item your checklist that's like black or white just to know to look for instance if you like management you can go like the oil change management are somewhere else is there an item that it's very sensitive or why there are forces to go arrest well in your wheel well what we one thing is that we stay away from kind of the financial engineering trickery okay so doing overpaying for businesses and using high levels of leverage and kind of thinking you know what we can wing it we stay away from that type of stuff and that's kind of a traders mentality to doing private equity it's like buying an asset just for the sake of buying it and and assuming that you're on kind of the growth curve and thinking that you can flip it in two years a lot of transactions were done that way okay so you buy business for ten times and you use a seven and eight times leverage multiple in the transaction and you think and you know in two years we can sell it again because we're in a high-growth market and you know a exuberant M&A market and as long as we stay on the growth curve we can make money that way we've stayed away from those types fortunately stayed away from those types of transactions what we do is we ready focus on the operating side of these businesses we have about 60 to 70 X CEOs of major fortune 500 companies X CEO of coca-cola ex CEO of EBSCO X CEO of Campbell Soup ex CEO one of the largest spare aerospace and defense spare parts type of business we bring these people in in an advisory capacity to transactions that we do in particular sectors so we're very very kind of strategic focused operating focus and we want to buy businesses to create bigger better more profitable businesses so we're not in the financial engineering game we're about supporting actually and you're talking about management supporting management teams to take a five hundred million dollar business to a billion dollars in sales and how do we get there and then support that growth plan with an equity infusion now it was far najin is concerned you have to do your due diligence management because particularly in the middle market sector if you get it wrong with respect to management it is a huge headache to change management in the pros and I've actually just bought gone through one in one of our portfolio companies and thank God it worked out fine but we made a mistake we did not do thorough due diligence we actually did not hire the people that we should have hired to do an evaluation of the entire management team and we thought you know what that's I think these guys can can do it and and turns out they couldn't and we had to change management we have to change the CEO and it was a huge problem and you know it's incredibly destabilizing to a business if you're doing if you do that to a a five billion dollar business or 10 billion dollar business it's different because there's a huge organizational structure typically in that business that is very very difficult to destabilize so the CEO you know maybe it's you know people talk about it but it's not going to be incredibly destabilizing to the business you're dealing with a 500 million dollar business it can be and you know there's some magic between the whole management team and the whole operations of the business if you change the CEO then somebody else leaves the CFO leaves because they were friends and you know before you know you know you know before you know it you have a big headache on your hands go ahead so just I'm just curious as to your visa bill how valuate management it seems to me to be one of most toughest spots to really get your head arranged I'm just curious though what guidelines you follow or what you suggest in order to make sure you don't mean well I mean the easiest thing is just to look at their their track record right so what type of businesses have they managing in the in the past and what happens is what you typically find is that the management team of a five hundred million dollar business that you look in their past and they've been there for fifteen years and they've grown the business from a hundred million dollars to five hundred million dollars but can they manage a two billion dollar business and the answer is probably no unless you give them a lot of guidance and sometimes we do that sometimes we make the bet on the CEO or the CFO for that matter but when we give them a lot of after having run the reports and and after having these due diligence people come in interview them and making an assessment of their core abilities sometimes we need to compliment their skill set with adding on their other people or in some cases even giving them training as we go through the process so so the and you know the firms that do these types of reports and these are the typical headhunting firms that have also a private equity business to their to their services to their consultancy services they do these types of evaluations and they come up with a whole report and they say well we think that this CFO has these types of skill sets but if if if you want to get take this business if you're asking us if if he can manage a two billion dollar dollar business the answer is is no but there are some solutions that we can provide rather than actually changing out the CFO okay any other questions all right so that's the quick quick overview of kind of the the due diligence work that we're constantly faced with on a day-to-day basis and how incredibly importance it is we started doing some research and so wow this this optical retailing business in the in the United States is huge it's like a twenty billion dollar market it's a very cyclical business and the incredibly competitive business that dominated by LensCrafters and pearl and then also later on by Walmart that have you know if you walk into a Walmart you have these you can buy a pair of pair of glasses you can actually have your eyes checked and walk out of theirs you know spending $60 or so and you have a pair of glasses and eye care centers America is another huge consolidator of kind of mid market optical retaining stores in in the United States and lot these stores are typically very large with an eye doctor on the premises and a fairly low average ticket price and actually this this has gone substantially lower also with the advent of mobile Walmart and sales per square foot of about 400 dollars per square foot and and these businesses were typically kind of high-volume type of businesses with low margins though story better margins okay so not really an attractive business you know it's very competitive why the hell would we want to get into this so but then we did some more research and when we looked at the luxury optical beat retailing sector so it was this sub segment of the of the optical retailing business here in the United States also in in Europe for that matter where and it was a very small sub sector was about four hundred million dollars in sales only three percent of the total market a very fragmented ownership there were these mom-and-pop type of stores very small type of boutiques very high sales per square foot and the very height average ticket price and incredibly high gross margins okay so these were mom-and-pop operations that were selling Cartier and kind of proprietary these very small proprietary brands and people were walking in there and spending $1200 for a pair of sunglasses okay so or spending $2,000 for you know gold-rimmed diamond-encrusted special zeiss lenses type of glasses and very high story Betar margins and also where you notice is that these businesses were non cyclical and that the people that frequented these stores were true luxury buyers that would buy we're willing to spend high dollars on these fashion accessories what would have really become and and regardless of the macroeconomic conditions these stores typically did well so said okay kind of interesting opportunity so we started getting intrigued about this opportunity by looking at the industry and the competitive set and we said well you know what this could given the fact that this such a fragmented ownership this kind of reeks of you know potentially an interesting consolidation play opportunity okay so what are the cow who asked a question about consolidation play earlier okay Carlos so what are the characteristics of a good consolidation play opportunity what does it mean a consolidation play why the hell would you go to a cost consolidation play general you have to believe that well first up putting together these individual assets that's here you'll have more advantages bring them together either from the cost side or revenue side okay so they're exactly to add to consolidate two industries but what was sure would just be specific I so what what kind of so you're consolidating these businesses whether regardless of the industry what kind of benefits you have by consolidating them so you can have in terms of suppliers so you can have just one centralized negotiation with the or supplier okay so what does that do reduces your cost of it so right you can have more marketing cost pisanio can have a unified brand again so you can get same number of customers it's on one graph what else so you can marketing to gross margins marketing what else benchmarking within the store just like knowing what is what doesn't work okay you mentioned to me also Brody so you can trust our best practices as increase overall revenue growth right so best practices gross margin marketing what else when you reduce competition right you can get your back office in certain GNA cost you can really just add a lot of leverage and just there's an intangible aspect of it which is just by having more for these stores located everywhere you create a brand awareness that the pension means you'd be able to charge higher prices okay all right the thing you have to realize with consolidation plays that bigger is not necessarily better with consolidation plays it makes businesses more complex you really need to know what you're doing the the whole the opportunities that we were just talking about are not necessarily always there and in fact in many cases are not but in this particular case and and particularly the retailing business and the luxury retailing business and luxury opposite optical retaken vision we kind of discovered by doing the due diligence that we were doing that you know what this actually meets all of the aspects of what good consolidation plays already about its a large fragmented market there no dominant players very important that there are so many consolidation plays that have been done here in the United States and in Europe during the last 20 years where they do consolidation plays while there are a couple of dominant players in the market why the hell would you do that so on up just because we can be creative bigger we have a bigger share of the pie well but if you're doing that with a dominant player in the market you're dead in the water so consolidation plays are actually in the in the true sense of the word they could should be done when there's no dominant player in the market when you have a fragmented market and by consolidating that you become the diggers did the dominant player and the biggest player in the market in this business it turns out if you really looked at the luxury optical retailing business as a sub sector from optical retailing business because these two businesses the mid market type of business hadn't actually nothing to do with each other so different products it was a whole complete different game so you could look at the luxury optical retailing business is actually a business there is a business as its own and by doing the consolidation of a bunch of these operators you could actually become the dominant player in the market okay so very important not to do consolidation plays where there are dominant players because this is a known point so consolidation will create an immediate market leader a large the other thing is is to find acquisition platforms that are relatively large meaning doing consolidation plays with hundreds of little players can be an absolute nightmare because the process of actually consolidating companies is very complex very very difficult and the sum of the parts you end up with a with a with with a bad business and that that has is virtually like creating a new business an inefficient market very very important very very hard to find typically these businesses that operate in these businesses know everything about each other okay so it's very hard then to do a consolidation play because they all start talking and when they start talking what happens what's what's what's the problem having a very efficient market and trying to do it consolidation playing on the efficient market what time exactly they started they start talking to each other they literally pick up the phone and say hey do you approach way these guys yes or was I so yes are colluding and it happens trust me it happened to us it happened to us in this situation so now that didn't happen in such a bad way that we couldn't do the deal but okay gross margin opportunities you have to be clear cost of goods sold opportunities there are many consolidation plays that are done and people talk about consolidation about cost of goods sold opportunities because we're bigger player and we can go to the suppliers and get bigger discounts well if there's a dominant player in the business you go to your suppliers as well so what I don't care if you you've got you know I don't care if you're double the size or triple the size and you know you're still not my most important customer and the discounts that you're asking for you're not going to get them and end a story okay because it's actually one of the most important aspects of the consolidation play that you have immediate gross margin improvement okay economies of scale and operating expense opportunities clearly by consolidating businesses you need to have a clear and well-thought-out plan and you need to have done your due diligence and get people involved that really know what they're talking about when it's when you're discussing operating expense improvements and benefiting from the economies of scale such as an SGA opportunities when consolidating all these businesses on the one roof because if you do it badly it actually ends up costing more rather than less okay just kind of curiosity into look the luxury market how do you press the supplier that where their brand is also extremely important and where you already have kind of a 65% gross margin because in this case by we were betting on the fact that we would become the most dominant player and I'll get into some of the aspects as to why we were the most dominant player after the consolidation take Cartier for example right they have they want to be in the highest end stores in the United States well they're only a handful of them you know that ten kind of major cities here in the United States they may have you know one or two kind of really high-end stores and Cartier wants to be in those stores if you on all those stories trust me they'll talk to you okay go ahead know your one question one of the most important issues in the lecture business venture management when you have much bigger scales much easier so how do you factor this in your allowance if it draws more that is not possible to improve well gross margin is employee is past assuming assuming assuming you'll get just a little bit I'm not sure to extend the fact that you have to be scale kind of helps your investment in this and I'm asking it extent okay I'm going to get back to your question because it's actually the most one of the most important aspects of this deal that we discovered while we were doing due diligence what we're doing the financial dude is yep that's it okay now I'm talking too long and too much all right so the what we I'm going to skip this you already understood that this was a consolidation opportunity you guys have done this a hundred times Porter's five forces analysis analysis don't forget it's really important it really is it may seem mundane but we do this stuff every single day so Barris to entry supplier power by up I relationships with suppliers and you'll see down the line that it's a very important aspect in any case when we financial due diligence so we look at the balance sheet income statement and the cash flow statement of the business obviously and in one thing not to forget is who is doing really the financial statements there are thousands of privately held companies in the United States large companies that are on audited okay so who's ready doing the financial reporting if a major major red flag if they don't have audited numbers beware and get some really really good accountants to do the financial did revisions for the firm because you'll find a lot of mess and a lot of problems in those books and you'd be surprised how many companies are out there that don't have a large companies that don't have audited financials okay in any case when we're doing the financial due diligence of this business and per we're looking at the balance sheet and we discovered some interesting things and you were talking a little bit about the inventory the biggest asset in this business this is is obviously the inventory right this we're not talking about a steel steel manufacturing plant that has huge amounts of assets and needs a large amount of assets to generate its cash flows and its profits this business the only asset and our only real asset that the business has Israeli apart from some intangible assets Israeli the the inventory now it turns out unlike the middle market sector or the the mid-tier kind of optical retailing business is the way that these guys were financing their inventory was incredible I couldn't believe it when we're doing the financial do due diligence we discovered that these guys had 250 to 300 days payable outstanding on their balance sheet what does that mean what exactly so they're basically getting their inventory for free until they sell it it turns out that the luxury optical retailing business has this kind of age-old business practice that you buy the inventory but you don't pay and you don't pay unless you've sold it so these guys all had we started looking at one for the next acquisition target and turns out all of these guys in the same situation we couldn't believe it they all had like 200 250 and we would ask them say well why haven't you paid your bills so no no they never bother us okay great so we these so what essentially was happening is that they were buying the inventory and they weren't paying for it not only that if they didn't sell the inventory within 250 days they would literally get a box they would wrap up the Cartier frames put a big sticker Cartier SRL wherever it was and send it back and they'd get a credit go ahead that's obviously an attractive thing but I would be worried about that as a buyer because you know if they figure out that they own the inventory and it's just a matter of finding a customer then I would think that there would be a lot of potential for competition from web-based you know ecommerce sites that can sell that inventory for them in other words it would sort of disintermediated to retail no because this is such a high-end type of business that the inventory that was taken back by the by the suppliers was actually destroyed but to Alan's point actually there is another risk factor which is if the industry practice starts to change then you are working capital most likely firms like try to include Capital margin over time but if the suppliers start pushing down the AP days from 260 to 250 to 200 that we have that can have an immense impact on the cash flow business yes that would be a risk factor and you know what you hit the nail on the head because this is what happened so we went through all this financial due diligence and it's in the interest of time and I can't go through all of it but you kind of identified the key aspects of this this we were going to do this consolidation play where we're going to have substantial benefits from a gross margin perspective now just one little side note here it's very very difficult to predict what those gross margins are going to be because you just don't know right so in your financial models and your kind of predictions of where the business is going to go you don't really know so here again the due diligence and getting expert opinions are getting outside information and outside opinions in this whole process is very very important to narrow it down and that you really mitigate as much as possible some of the errors that you're bound to make in making these predictions in consolidating you know 10 or 20 of these businesses so but we were pretty comfortable that we were going to get these gross margins improvements and in fact we did we got we got our predictions pretty right from a financial perspective we had KPMG in there we did we we didn't find any red flags and if we did find them we kind of dealt with them we did a very very good transaction we negotiated very very cleverly it was a beautiful transaction so in any case I've kind of jumped through this this whole due diligence process but the the point I'm trying to get across is is that when you do your due diligence work and people have the tendency to think oh that's all about financial due diligence it's not it's due diligence really is a much broader concept it's understanding the business understanding the environment in which it operates and truly understanding the businesses operating model and the people that are managing your business and if you think of due diligence in that concept you get the right people involved because you can't do it all by yourself there's no way that you can do by yourself because ultimately what we do is we are the managers of this process we lead the process we are the the leaders of this team of you know 40 50 people that are working on a particular transaction that all know really well what they're talking about and I'm putting all of those pieces together and if you look at due diligence from that perspective and not think about only the financial due diligence then you're on the right track and and it will mitigate some of the risks and it will ensure that you don't make big mistakes that you're inevitably going to make in this business and you learn from your mistakes so we talked about the management and by the way just we had brought into this transaction an incredibly smart guy bernard andrews is a former CEO of i co synthesis america which was one of the largest players in the mid market type of sector and he was incredibly valuable to us in how we structured this transaction this was I was just talking a little bit about how we projected the business going forward how we were going to grow the business it was a combination of organic growth and new store openings and also acquisitions we did a very thorough analysis of the exit considerations for this business there were a lot of strategic buyers in the sector that were very interested in buying a consolidated platform and that remains true to this day and we still haven't exited this opportunity but we will some day soon here are some of the the comps that we ran at the time and okay in the interest of time I'm going to skip forward and just talk about two last things and when you do a leveraged buyout transaction what are kind of the key and I really want to leave leave leave this with you because this is really so important the whole structuring a leveraged buyout transaction is not that or let's say the concept of the leveraged buyout transaction not that not complicated you're leveraging cash flows you're buying a business leveraging their by leveraging leveraging the cash flows and but what what are the four key drivers of any leveraged buyout model what are the four key drivers of your irs some I tend to think of five but off okay when is sales growth okay second is profitability yeah there's free cash flow conversion yeah with this leverage and five I think is multiple orbitrim okay right now what one of them what is a single single most important one of that of those five growth if one generally operational growth because that gets multiplied okay but what does that lead into and of these of these four you mentioned five and what is the rather correlated and what is a single what's a single single biggest driver of you return of your IRS I mean if you're doing a leveraged buyout model and you're playing around with the numbers when you look at leverage that's generally I want the one game when you look at the growth into cash flow right there's a multiplier in fact to that and so that's really really good operation I would say it's multiple arbitrage okay where yeah listen if you have the discipline of buying companies on the cheap and really being disciplined in that sense it's your single biggest driver of your returns and what I'm trying to leave with you guys is just do yourself a favor and don't overpay for businesses because if you overpay for a business you're going to be stuck with it for years and even if it's a good sound cash flowing business you you try and sell it and you're still going to be disappointed with the returns of the business because you overpaid for it and multiple expansion and multiple arbitrage by creating bigger better more profitable businesses and by really doing some hard work and spending the money on improving the business and ready making a great company out of it that's where you ready to get your multiple expansion because people want to buy great businesses people will buy great companies people will buy companies that are well-run and if you find companies that are run so-so and you can really fix them and improve them and make them bigger and better you can make a lot of money in the whole process

Channel: Wharton School

Views: 271,837

Rating: 4.9148936 out of 5

Keywords: private, equity, class, finance, lecture, due diligence, private equity, fund, business, financial, Wharton, The Wharton School, merger, acquisition, M&A, consolidation, Penn, UPenn, University of Pennsylvania

Id: thyxopgzG4k

Length: 77min 35sec (4655 seconds)

Published: Thu Feb 10 2011

Reddit Comments

[u/qla_all_bay]

Basically everything Dan talks about coming straight from the mouth of a PE guy at Wharton School of Business.