Value the individual: investing in people-led businesses

In private equity, it is rather the rule than the exception that an investor makes changes to a portfolio company's management team. A 2015 Harvard Business School report, What Do Private Equity Firms Say They Do, found that 58% of GPs recruit their own senior management teams for their portfolio companies.

However, while some GPs buy certain businesses despite their management make-up, in some cases the key people represent the asset's main value. This is a sector of its own, often referred to as people businesses. The term encompasses companies such as consultancies, public relations, recruitment and advertisement agencies. They are typically located within the creative industries and rely heavily on their people's - especially their management's - ideas and network. Thus, these individuals are usually the main value drivers.

For private equity firms entering a people business, it is therefore not an option to replace the management. Instead, GPs must make every effort to ensure stability within the leadership team, as well as cultivating strong relationships. William de Laszlo, partner at Agathos, has experience with these types of deals: "Since the value drivers are individuals, you look at the deal as a long-term understanding, but try to lock in the individuals as much as possible. Making sure, pre-deal, that there is an understanding where we are going with the business plan and that everyone is comfortable with it is very important."

His firm acquired a minority stake in London-based EAT Communications in Q3 2015. EAT is the umbrella under which Inhabit, a communications agency for clients in the property and technology sectors, operates. Agathos has known the management for a long time and made sure it was a team it can work with. "Shareholders have to mutually support each other. It is a hard thing to get the balance right, because ultimately, in a people business, they run the business and they are the asset," says de Laszlo.

Forging the contract
Despite efforts to build good relationships, a GP's main concern is to secure its investment on the legal side. Mark Spinner, partner at Osborne Clarke, says investments in people businesses have to be handled with special care from the start: "The people in that type of business are typically creative and therefore often quite emotional. They need a little bit more careful handling in terms of some of the provisions in a typical private equity context. Those might appear brutal to them because they are quite black and white and primarily in favour of the financial sponsor."

Spinner finds that since the business owner's response to the negotiations is often emotional instead of technical or legal, their expectations have to be handled carefully through a collaborative approach between advisers acting for the financial sponsor and those representing management.

Spinner also sees an issue in shareholder freedom to operate the business as they see fit: "The investor will often want to have some overall control about what the business can and can't do without consent. Sometimes, creatives find that very difficult because they still feel it is their business."

When it comes to ironing out the details of an investment agreement, a main focus for GPs is to protect the business from competition. Former owners might start a new enterprise or a member of management could leave and subsequently compete with the business.

One way to protect against those scenarios is to have main players in the business invest themselves. A common clause used with former owners is a deferred consideration, which is an element of the purchase price that is to be paid at some time in the future. This payment can be tied to other agreements regarding future events, thereby preventing the sell-side setting up a competing business and poaching clients.

"Another key way to protect the business is with restrictive covenants," says Spinner. "You don't want somebody, particularly a vendor, to take the money that you have just given them for their shares in one company to immediately try and attract all of the people and customers of the business you have just bought to their new platform." To prevent this from happening, legal restrictions on senior staff are agreed on when they are leaving the company, preventing them from engaging in specific activities that could have a harmful impact on their former business. Restrictive covenants are effective for a set period and are particularly important for people businesses because they are typically inexpensive to set up.

Determining people-value
Quantifying a people business can be tricky, since its assets are more abstract. Harvard Business Review states that "to identify where and how value is being created - or squandered - people-intensive businesses need performance metrics that are as financially rigorous as economic profit, but that highlight the productivity of people rather than of capital."

Ingo Krocke, CEO of Auctus Capital, says: "It is possible to quantify the business by looking at the cash flow and the market. If the company grows in line with the market and the margins are good, it is possible to estimate the company's future value." However, de Laszlo finds that when "quantifying in terms of overall returns, you let the market decide the value of the business".

Following an acquisition, GPs must keep in mind that managing people is one of the key tasks in a people business and is central to its success. Harvard Business Review underlines that "employees represent both the major cost and the major driver of value creation". Hence why people management is a core operational process, not just a support function. The priority for value creation is therefore a focus on hiring the right people and establishing or maintaining an environment in which they can be as productive as possible. The report finds that traditional performance metrics and management practices can often not be applied in this sector.

A GP investing in a people business must forge strong relationships and hire competent lawyers who can make sure the company is protected from competition from former employees or owners. With the right clauses in place, these investments are not as risky as they may seem. Throughout the investment, people management should remain a core focus and hiring the right creatives - or buying successful competitors - is the major factor for accelerating value.

 

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• AUCTUS Management GmbH & Co KG
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