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Four Questions to Help You Find a Diamond in the Rough

With nearly $1 trillion in dry powder, the private equity market is becoming steadily more competitive. EBITDA multiples are rising, PE firms are holding their portfolio companies longer, and pension funds are starting to make direct investments. So how do you compete?

As we showed in our article about investor clustering, sometimes the way to compete is to change the requirements you have as an investor in order to take advantage of pockets with less competition. Other times you need to try a completely different strategy.

We turned to Member John McNamara, founder of LongueVue Capital, to discuss the ways they find companies that are good values but often overlooked. LongueVue specializes in “opportunistic, situation-driven, value” by regularly looking at companies that don’t have perfect financials but are otherwise valuable companies. McNamara talked us through the four questions he uses to find diamonds in the rough.

1) Does this business deserve to exist?

According to McNamara, the first question he uses to filter deals in the pre-distressed stage is to consider whether or not the company should exist in the first place. Does the business serve a market that is underserved, is it bringing value from employees that have significant experience, or is there some other differentiator that the business has in the market?

In a recent LongueVue investment, an oil field tools company, McNamara saw that the business was providing a solid service in an industry with growth prospects and simply needed a push in the right direction. He explained, saying “we have found that businesses with exposure to the natural gas world have quickly become value plays. We have seen greater numbers of opportunities in the services side that focuses on natural gas. There has been a big disparity in the value between oil-driven businesses and gas-driven businesses because the pricing differences in the commodities. It is just a question of picking out which of those businesses have sensible business models.”

2) Does it have a robust business model?

Once McNamara has determined that the company – or a company like it – should exist, he then goes searching for the right business model. Robust is a relative term, but in most cases LongueVue looks for solid cash flows that are being undermined by other problems.

McNamara explained some of the more common situations he sees, noting that “If you see a business that is producing decent gross profit, but has a bloated G&A [general and administrative], that’s an easy one. Or, if you see a business that demonstrates a consistency in revenue, but has other extracurricular expenses, those are fairly easy changes to address by cutting costs and rationalizing the business.”

In the case of the oil field tools company, McNamara saw that it demonstrated strong cash flows, but had other internal issues – namely financial issues that weren’t core to the rest of the business model. Even though the financials didn’t look very good on the surface, LongueVue saw there was good potential with the right partner.

3) Why has it gone off course?

Assuming the company should exist and has demonstrated a strong business model – why is it in its current situation? Understanding what pushed the company off-course is critical to determining whether or not your firm is the one who can actually make a difference.

McNamara said that there are many reasons for problems, “It could be a covenant bust, a liquidity crisis that was caused by an exogenous event like a lawsuit, or a rival competitor product that has been put out on the market.” In the case of the oil field tools company, it was a consequence of the “the company [breaking] a technical violation in their covenant package.” The break “occurred in 2009 when there was a material slowdown in the gas industry…and on the heels of the financial crisis.” After breaking the covenant, “the bank gave the company a six-month ultimatum.”

4) Is there anything your firm can do to bring the business back on course?

Once the problems have been clearly established, the ultimate question is to determine whether or not that major problems can fixed in a way that dramatically changes the company. In the case of the oil field tools company, McNamara and his team determined that their experience in other industries could be leveraged to fix many of the internal operational issues.

“The business needed a new operating system, a new accounting system, and a new CFO. The CEO was very talented, and he just needed help in handling the administrative side of the business.” This asymmetric skill allocation is not that irregular in early businesses. “Generally, we have found that entrepreneurs are very knowledgable about their particular business, but they’re very shallow in their knowledge about business practices that help drive value and efficiency.”

“We infused capital and deleveraged the business. We even kept the incumbent bank and just provided the comfort the bank needed.” He continued, “By layering in those improvements – and a few other ethereal changes, like improving the marketing position of the company – we have made the company the leader in its particular industry in the North East. Today, the business is worth 3x our initial investment and we are very proud of how the business has grown.”

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