The $30 million private equity fund raised primarily from offshore investors who wanted to be a part of Sri Lanka’s growth story plans investments in the range of $3 million to $7 million in small to medium-sized businesses across a range of sectors and levels of maturity. The firm hasn’t made its first investment yet, but a number of potential deals are at an advanced stage.
Ironwood Capital’s Hiran Embuldeniya told Echelon of his three key learnings from running the fund in the first year.
First Learning: There is a surprisingly large amount of information possessed by private companies or that can be obtained from the public domain
The realization that a large amount of information already exists in private companies and the public domain, and knowing how to use that information is the first big learning for the year.
In a private context, companies are sitting on lots of data about their manufacturing processes, customers and the markets they serve. They can use this data to understand profitability at an SKU level, what customer-level profitability is and how to target good customers either using market information or historic buying information. However, they aren’t using this information to make better business decisions.
Very little of the information available in the public domain can be found on the internet. We have sourced information by visiting customs offices, ministries, departments and even government bookshops. These records are great to identify rapidly growing sectors, and thereafter, identify individual companies that will be interesting conversations for us to have.
In the companies with which we have had detailed conversations, we have seen the ability to improve the performance of the business just by using the information already available with the company. However, most companies in the size that we are looking at – in the $10 million range – don’t use this information.
[pullquote]Getting them to give us that level of info takes at least six to nine months. So it’s taken longer than we would have anticipated, but it makes sense[/pullquote]
They are just trying to get through the day, fulfilling orders, getting new orders and running their day-today processes. It’s only when companies have a $100 million business and a team of people to get the routine work done that they can focus on using this information in the right way; but in the smaller cap phase, information can be better leveraged.
Second Learning: It takes longer than anticipated to find the right firms and build trust
The second learning is that, even though the process of selecting companies to invest in took longer than anticipated, it made business sense.
We’ve looked at over 70 or 80 companies during the course of this year, which is a large number of conversations, and we have found only one company to invest in and maybe two to three others that we would like to invest in. However, this is a normal hit rate. It’s not from one in 10 conversations, but maybe through one in 30 to 40 conversations that you find an exciting idea that the entire investment committee agrees with. Usually, one of us will think it’s interesting, but all four saying it unanimously is the kind of hit rate you would expect.
The challenge is getting these companies to move past day-to-day operations and think of the long term. We approach companies that are doing really well (not needing new capital), but we give them the opportunity to do what they would do in a 10-20 year timeframe within five years. People say okay at first, but then question if they really want to do it that fast, what they have to give up to do that or what we really bring to the table. Proving all this takes multiple conversations, and for us to do our full due diligence, we need to get to the point where they let us into not just their financials and legal reports, but provide very detailed information about their manufacturing processes or customer data, or even let us talk to their customers. Getting them to give us that level of info takes at least six to nine months.
So it’s taken longer than we would have anticipated, but it does make sense.
Third Learning: Working out how to create value
Once you get past these first two steps, you have a fact base that fundamentally grounds you on how to create value. What is more important is that we have a partner that trusts us and has opened up to the extent that they allow us to appoint the chief executive of the business (the litmus test says the measure of whether you can really add value to the business depends on your ability to change its chief executive). Valuation then doesn’t become a negotiation because now you are all focused on the end point, which is getting the 10-20 year plan done in five years, and we are working together to put all the resources behind it, so you almost get a discount on entry, rather than a premium on entry because you are working hard to see this outcome achieved. The common goal becomes to sell this business off to someone else in five years time.
If valuations are attractive, and with the overall market (and public markets like the CSE) being reasonably flat, we also have the ability to negotiate based on the value we are able to bring to the table. People are saying ‘we would have otherwise sold this at 2x book value, but we were able to take a discount to this because we see the value’, or ‘we would have otherwise sold this at 15xPE, but we’ll sell it at 10x or less because we would like you to be our partner on this journey’.