With depolarisation looming and consolidation in the financial services industry almost inevitable, Framlington's Neil Birrell explains what factors are important for attracting investment into a company
As an investment house, we buy into companies, but what does our UK desk actually look for in a company?
First of all, before we even see a company, we look at the industry in which it operates. It has to be attractive before we will meet any firm.
So what do I mean by attractive? What I'm talking about is essentially growth characteristics ' the factors that will help the individual business produce good returns going forwards.
Our industry, financial services, is fortunate to be in a secular growth phase. Remember, the UK is actually in a good state compared to a number of European countries. So what does this mean?
What it means is that a 25-year-old starting work today needs to save 11% of their income for the next 47 years to generate a pension two-thirds of their salary. This has to be done in the private sector, as we can be sure the State will not bail us out of this particular problem.
Moving on to competitiveness, there is nothing wrong with competition as long as good returns can be made by the practitioners.
It is worth remembering that industries do change. Take the telecoms industry for example. If you go back to 1999-2000, the telecom industry was busy digging up the roads to put fibre-optic cabling underground. What this was supposed to achieve was exponential profitable growth but within two years it has turned into unprofitable over-capacity. The value of the businesses has been absolutely destroyed, which shows just how dramatic change can be.
Any industry that is too competitive will consolidate into strong players. It is important to have growth, and competition is fine, but you don't want competition from everyone. That is why having some sort of barrier to entry in your industry is good.
In general, the services industry has very low barriers to entry. Estate agents or travel agents, for example, are industries in which it is easy to get involved. Financial services has developed greater barriers to entry and, while people might not be overly pleased by the level of regulation coming in, it is a pretty big barrier to other people wanting to get involved in the industry.
So, once we are satisfied with the industry, what do we look for? The key issue is the company.
There are a number of factors a buyer will look for in a company an profits is pretty obvious. A good profit and loss both historically and going forward is of benefit. The balance sheet also needs to be of a decent size and of a good quality.
Assets will obviously be fairly important. These can be tangible, like a freehold, but a key area that is much more difficult to value is intangibles such as goodwill or client base.
We also look at liabilities, such as any overhanging litigation or mis-selling fears. Visibility is obviously important and that is where factors such as renewal commission become important.
One thing often held up as important is the management of a business, particularly in small companies. Obviously, management has much more of an influence in smaller companies than it does in larger businesses. The thing to consider is the quality. It's worth remembering that no one is indispensable but some people are considerably more important than others.
The true test of the quality of management comes back to the numbers but it must be able to display an understanding of its business and be seen to make tough decisions when necessary.
The structure of the management is also important. What we look at is its age, number of staff, experience and corporate governance.
You can distil it down to one or two factors buyers will actually look for. First of all, they look for a well-positioned business with good dynamics that has been well managed. This is why the buyer wants to buy into the business ' to participate into its future.
The second is a poor-quality business, where a buyer or investor sees an opportunity to turn it around with or without the current management.
The former of these two options is preferable, mainly because the returns that can be made will be considerably greater.
Now the difficult bit, namely valuation. There is no easy solution to valuation. The business is ultimately worth what anyone will pay for it. Timing is key ' every buyer has their own criteria and is driven by different issues.
So how best to maximise the value in a business? Well, in the long term, what you want is a good, profitable well-managed business that is growing. That is the easy bit.
In the short term, there are one or two tricks when approaching the stage of maximising value. It will be necessary to bulk up the profits in the short term. Avoid expensive capital items ' don't invest in that new IT system, keep your costs down. Get rid of underperforming clients to make the ratios look better. In essence, make the company look lean.
How do we realise value? Ultimately, the only route to realising value is selling. This could be through external investors, either corporations or individuals, but remember, investors always want something. They will be sitting on the board asking questions.
The other route, which is probably the quickest and easiest, is a trade sale. However, there are issues with that as well ' at the end of it, you might not have a job.
The third route, which requires the company to be of a decent size, is go to the stock market. Why would a company do that? They would have to put up with people like me and our UK desk quizzing them every six months when they publish their results.
The arguments for the stock market have always been to obtain capital, but you can get capital anywhere. The banks are giving it away at the moment.
Timing is important when looking to maximise and create value out of a business. Downturns are generally not the best time for profitability of businesses, or for when people are going to pay maximum value to buy into them. The economic sentiment indicator has usually been correct in terms of direction.
There is currently a disconnection between sentiment and actuality. So, if thinking of going down this route and trying to find buyers, there is one thing that is paramount: timing.
Timing is everything and there will probably be a better time than today.
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