How you should create business plans to attract private equity funds

Far from the glamor of unicorns, there are thousands of leaders building businesses the old-fashioned way, carefully and profitably. In India, a large portion of these are service companies. Likewise, most serious private equity (PE) firms are ignoring the hype and looking for companies that can grow quickly, but sustainably and profitably. This column explains how service companies can create plans to attract PE investment.

While there are many areas that PEs evaluate, four are crucial: 1. Target Addressable Market (TAM) and competitive position, 2. Revenue model, 3. Demonstrably superior leadership, and 4. Clarity in investment areas to drive growth.

PEs focus first on TAM and competitive position. The reason is probabilistic: mediocre management can deliver superior results in a fast-growing market with manageable competition. Even the best managers struggle to deliver results in a tough market. PEs bet on growing markets with manageable competition.

The TAM should be specific and reflect a deep understanding of the market structure. For example, for a standalone Analytics player, just saying the Analytics market is $150 billion is incorrect. More than half of this market is made up of hyper-scalers like AWS (Amazon Web Services) and is not addressable. Similarly, if the company specializes in commercial data and analytics in pharmacy, the addressable market is proportionally smaller. And while that market largely includes licensing fees paid to third-party data partners, the actual TAM is a fraction of $150 billion.

To access this TAM, it is important to identify white spaces that can be protected. If the market position is not differentiated and protected by the moat, growth will be neither sustainable nor profitable. Getting the market structure, resulting TAM and competitive position right is the first step.

Next, the revenue model becomes important. PE leaders prefer predictable income for the next two to three years. They closely analyze recorded revenue, pipeline, conversion rates and key customer relationships. PE leaders and their CDD (commercial due diligence) consultants spend about half of their time on the revenue model. We have ways to independently validate the quality of key customer relationships and arrive at a risk-adjusted revenue projection.

Because of this scrutiny, it is advisable to create income plans that are grounded. Empty plans, such as those showing stagnation over the past three years followed by magical growth after PE investment, are easily identified and affect credibility.

Next, having demonstrably superior senior leadership is an enviable moat. We have seen investors willing to pay a 15-20% premium to gain access to this leadership.

Top leaders have three characteristics: One, a visceral understanding of market structure and competition, which leads to the rapid identification of growth levers and associated actions. Second, a record of productive allocation of capital limited to the areas that produce the highest returns. Three, the ability to simplify and communicate strategy to the larger organization and deliver results through middle-level management. Although these parameters are qualitative, I can assure you that these top leaders are rare but not difficult to identify. And often, they are the company’s top salespeople.

Caveat: We often see companies that have outperformed in recent years by leveraging one or two top leaders. While this may sound like a positive, it’s a red flag. Senior leadership is notoriously difficult to scale. Instead, what matters is the depth of leadership and its ability to make the most of available resources.

Finally, clarity on how EP money will be deployed is important. PEs want maximum returns, and it is encouraging that investment areas are already identified. An analytics firm that recently raised PE funding knew that hiring strong account managers for its key clients would drive rapid growth. Net Promoter Scores (NPS) with these customers were high, but they weren’t being cultivated properly. Conversely, it’s a red flag if a significant proportion goes to paying existing shareholders. Processes and quality also matter, but are considered easier solutions. Of course, attracting and retaining talent can be a deal breaker in hot markets and this needs to be addressed.

It is important to think like PEs while building business plans.

Abhisek Mukherjee is the co-founder and director of Auctus Advisors

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