Posted on 09 May, 2020
Pankaj Raina, Managing Director, Zephyr Peacock writes for Inc42 Media on how to identify resilient businesses.
- Investors will sharpen focus on value creation as a result of Covid-19.
- A useful checklist comprises of both quantifiable and non-quantifiable parameters.
- No investment checklist is complete without considering qualitative metrics
With the wreckage of Covid-19 led recession smoldering and slow economic growth expected for the foreseeable future, it is not surprising to note that many companies are turning inward and hunkering down. Growth, profits, capital efficiency, and value creation seem to be stretch goals rather than baseline investor expectations.
Over the past decade, privately funded companies were praised for shareholder valuation growth (measured as price per share increase) over shareholder value creation (measured as revenue growth, profit growth, free cash growth, dividend, and capital gains).
One of the critical measures of shareholder value creation and business resilience is capital efficiency, which, if maintained over time, can lead to significant real wealth creation. However, the myopic view on raising share price in the short term has led to difficult times for most businesses – focus on growing revenues/market share at the cost of profits, high debt, no capitalization plan once customers are willing to spend again.
Several public and private companies are currently operating in a challenging environment. Some of these companies will continue to grow revenues and profits, gain market share, in contrast to their competitors’ intense focus on cost cuts to ensure survival. These are companies that may not have been the fastest to grow in terms of valuations but have found a way to build value over the long term. These businesses are successful because they have built what I call a ‘durable competitive advantage’.
“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage” – Warren Buffet
A combination of qualitative and quantitative factors allows most companies to build a competitive advantage in the industries in which these firms operate. A robust investment checklist can help generate high-quality resilient investment ideas.
The checklist makes use of qualitative (management strengths, culture) and quantitative (profitability and operating indicators) to identify sound business models. While the list of quantifiable parameters is never-ending, the below items summarize the most crucial indicators to identify sustainable business models:
"No wise pilot, no matter how great his talent and experience,
fails to use a checklist" – Charlie Munger
The investment checklist would be incomplete without considering the qualitative parameters that define a resilient business. A business is only as good as its leaders, its culture and it is important to ascertain certain qualitative parameters that could help separate a resilient business from others.
Quality Of Management
Reviewing management and founding teams before the investment is crucial. Companies are only as good as the management teams driving the business. Management teams and founders are vital to the creation and establishment of company values and culture. In most cases, an investor is testing capability and credibility, which in early-stage start-ups could be difficult, as information availability is limited. Past track record, if available, would be helpful.
As an investor, I recommend we find answers to the passion of driving the founders. Skin in the game, an important tool to measure what percentage of owner’s assets are invested in the company, is also an important determinant. I am interested in owners who are fully invested and don’t leave the business in economic downturns.
It is only during difficult times do we see wheat easily separate from the chaff. As the business matures, I favor management teams who efficiently allocate capital to high RoI initiatives.
An independent Board is one of the most important factors to identify a well-governed company. A well-structured Board can offer expertise to run a business efficiently and sustainably for the long run while keeping in place checks and balances for the short term. You may not get the most desirable Board; however, as investors, we can insist on revising the composition.
It is important to note that agile businesses could also be fragile businesses, but in the current times, business agility is synonymous with the ability to adapt; e.g., can your business move from offline to online? Do you lose customers in the process? What is the cost of moving entirely online? Is the supply chain flexible to help achieve this? Business agility also helps companies quickly adapt and respond to changing competitive environments. Was Nokia agile and able to respond to the threat from Android and IOS?
The fundamental test of resilient businesses has not evolved much over time. Qualitative parameters have gained prominence, given the emphasis on early-stage investing. However, after the current crisis and the lock-down, I expect investors to be more cautious and invest more time in studying quantitative parameters. Most investors would use quantitative metrics to correct portfolio companies to help them survive.
There will be funds keen on making new investments, and these funds will test new businesses for their ability to generate profits and cash flows.
The epoch of private investments driven by purely revenue growth at the cost of profits will come to an end. Investors will sharpen investment frameworks to identify unique businesses and use a far superior risk weighted investment approach in the immediate future.
This post first appeared on Inc42 Media and has been published with permission. Click here to read the article on ‘Inc42 Media.
Zephyr Management is a global emerging markets investment manager, specializing in the creation and management of highly focused private equity funds
Since its inception in 1994, Zephyr has sponsored and/or managed 26 investment funds in both public and private securities markets representing approximately $1.2 billion in combined commitments and assets under management
Emerging Markets Focus
The firm has initiated several private equity funds investing in several African countries, South Korea, Mexico, India, and Sri Lanka since its founding. Zephyr's funds serve medium size enterprises that are often ignored by larger private equity players. Zephyr funds provide growth capital to established companies with proven business models and sustainable competitive advantages.
Investment activities are currently focused on India, Sri Lanka and Africa.
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Zephyr Peacock India provides equity financing for fast growing, small to medium sized companies led by strong entrepreneurs and management teams.Read More
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Emerald Fund provides equity financing for fast growing, small to medium sized (SME) Sri Lankan companies led by strong entrepreneurs & management teams.Read More
Zephyr Acorn provides equity
Zephyr Acorn provides equity financing and business support to innovative early-stage companies in East Africa.Read More
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The firm's special expertise lies in bringing global best practices to medium-sized growing companies by assisting them in conceptualizing sustainable business strategy, management development, compensation, ESG, expansion outside of their home country, capital structure and positioning for stock exchange listing or trade sale.