Benchmarking is a trait that’s commonly found in the most successful emerging growth companies. I note it as a “trait” and not simply a “practice” because the benchmarking approach is inherent in these companies’ DNA. These agile companies are continually scanning within, and across, industries as they test their operating assumptions, perceived limitations and potential opportunities. The underlying benchmarking process is a critical element of their focus of working “on the business” as much as working “in the business”. You’ll find that these companies are typically incorporating benchmarking results into their planning processes, and within their execution metrics. As a result, they easily outperform less nimble larger corporate competitors, and other inwardly focused challengers.
One of the best benchmarks for gauging how well a business is operating is to look at companies run by Private Equity Groups (PEG’s). PEG’s are certainly known for their ability to earn higher-than-average returns given their understanding and application of financial leverage. What’s equally important, and not as well known, is that PEG’s have derived much greater benefit from improved operating performance than they ever have from financial leverage. A McKinsey study referenced in a November 2007 Harvard Business Review article (“If Private Equity Sized up Your Business”) reported that improved operating performance, not financial leverage or overall market gains, was the primary determinant of Private Equity Group’s higher-than-average returns. More recently, even blue chip companies such as GE and Dell have demonstrated that financial machinations aren’t sufficient to support sustained growth and results. Operating performance improvement is required.
So what do Private Equity-owned companies do differently than the rest? It might surprise you to find out what their secrets are, and aren’t. The good news is that what they do is not rocket science. The approaches and the tools they use are published, well-known and readily available to every company. They difference is that PEG’s have developed an elevated competency, and moved further up the experience curve, by rigorously benchmarking their own companies. How they apply their expertise helping companies achieve maximum value can be broken down into seven interrelated areas:
1) Understanding how companies create and capture value. Ask an executive at a privately held firm how they create and capture value, or to describe their business model and more often than not you’ll get a blank stare. PE firms quickly understand how to gauge the pervasiveness of a targeted market problem; who benefits from the solution; how to measure the value; and how much of the created value is captured in the go-to-market approach. In other words, how well a company’s business model works.
2) Investing in leadership and management. Contrary to popular opinion, PEG’s have no interest in running any of their portfolio companies. The harder truth is that few emerging private companies invest in leadership development. Most emerging companies lack even a rudimentary succession plan. To cross that bridge, numerous PE firms invest real dollars in continuing development of their operating executives, or at the very least bring their operating executives together on a regular basis to share gained wisdom and insights. It would also be difficult to find a board member of a privately or publically-owned company that puts as much time and effort into understanding a company as does a partner at a Private Equity firm.
3) Creating alignment that drives execution of the operating plan. The best firms understand very well the role that vision, business model, culture, metrics and aligned compensation have on the execution of the operating plan. PE partners continually seek validation that there are adequate resources supporting the operating plan; that human capital is succeeding and developing; that the operating plan is being executed; and that the business model is creating and capturing sufficient value. In many ways, PE firms are more adept at organizational and human capital development than many Talent Development organizations within Fortune 500 companies.
4) Building appropriate capital structure. Understanding when and how to add debt or sell an appropriate equity stake is a body of expertise unto itself. Many emerging stage companies unwittingly compromise their flexibility or viability, hamstring future growth or limit exit options by creating unnecessarily complex capital structures. The Software Equity Group (www.softwareequity.com), a San Diego-based software-only M & A advisory firm regularly notes that a software company’s equity structure is one of the top three most important determinants of the company’s valuation. Getting the capital structure right is critical to keeping the business growing and preserving shareholder value.
5) Understanding the issues of scalability. The challenges of rapid growth have broken more emerging stage companies than almost any other factor (For more on this topic see Doug Tatum’s “No Man’s Land – What to do when your Company is TOO BIG to be small; and TOO SMALL to be big”) . The nature of PE firms is that they generally focus on selective industries. They have experience working with several companies at different life cycle stages within an industry sector. As a result, they have and can share first-hand experience navigating the challenges that high growth can bring.
6) Thinking critically and making the tough decisions. Gaining arms-length or third-party objectivity can be one of the hardest things a founder or entrepreneur can ask of themselves. Such is the nature of pride of business ownership or business plan authorship. The best PE firms tend to ask the most incisive questions and demonstrate a unique balance of patience, expectation and decisiveness. They’re proponents of testing new approaches and will give an idea or concept ample runway, but will push for objective benchmarks that demonstrate success or failure in a stage-gate approach. More so than a typical board member would.
7) Making focused strategic investments. Cash is a scarce resource in emerging growth companies and comes with significant opportunity cost that’s rarely discussed. Private Equity firms focus on growth and recognize that usually requires cash. Once a PEG’s initial investment is made their focus quickly shifts to maximizing shareholder value through profitable growth. As noted earlier, they understand and willingly make strategic investments that drive market share or enhance and improve operating performance. What’s important and valuable is understanding where PEG run companies are investing their resources.
If you’re not benchmarking, you may be missing critical insights into the evolution of your market. At the same time, economic downturns like we’ve seen over the last two years can give emerging growth companies a breather to validate operating assumptions and the business model. Down cycles provide companies time to make the adjustments necessary to cost effectively gain scale as the economy rebounds. On the other hand, if you are benchmarking but not yet against companies run by PEG’s then let me know. I would be more than happy to help you identify and connect with companies to benchmark with.