A perspective devoted to Private Equity firms: to be successful they should adopt an innovative business model and control the richest parts of the value chain

1. perspective JULY 2013
private equity
firms need
to seek out
successful
business models,
not just st
andalone financial
projections
Alberto Calvo, Alberto Oteri

2. Private equity.
Firms need to seek out successful
business models, not just
stand-alone financial projections
Published by
Value Partners Management Consulting
via Vespri Siciliani 9
20146 Milan, Italy
July 2013
Written and edited by:
Alberto Calvo, Alberto Oteri
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For more information on the issues
raised in the report please contact:
alberto.calvo@valuepartners.com
alberto.oteri@valuepartners.com
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3. CONTENTS
PE firms need to seek successful business models,
not just stand-alone financial projections
5
Considering the general “robustness”
of the business model
7
case 1 / food & beverage:
Focusing on customer preferences
11
case 2 / industrial goods:
mastering technology to mitigate risks
14
case 3 / auto components:
intelligent outsourcing of selected activities
15
conclusions
18
authors
perspective private equity
19

4. Adopting an innovative business
model and controlling the richest
parts of the value chain are key
to successfully navigate and
ultimately succeed in turbulent
markets.
4–5

5. PE firms need to seek
successful business models,
not just stand-alone
financial projections
As the current economic downturn is
set to endure, Private Equity (PE) firms
should focus on the rare “gems” of the
market, which have been capable of
developing unconventional, yet successfully proven, operating models.
The three business cases we present
throughout this perspective are of
different sizes and belong to different
industries, but have built their core
strengths around three main pillars:
technological innovation, a consumer
focus and a savvy understanding of
when to ‘buy’ and when to ‘make’. These
three pillars have enabled these different businesses to successfully navigate,
and ultimately succeed, in their respective and occasionally turbulent markets.
perspective private equity
However, these have not been the sole
reasons for their success; their competitive advantage has also been driven by
an ability to position themselves well
within their respective value chains.

6. Exhibit 1
Billion USD, US Buyout deal value
1980-89
1990-99
2000-07
CAGR
2008-12
600
400
+40%
200
-6%
+59%
+18%
0
83 84 85
86
Source: Dealogic.
87
88 89 90
91
92
93 94 95 96
97
98 99 00
01
02 03 04 05 06 07 08 09 10
11
12

7. considering the general
“robustness”
of the business model
It has been four years since the peak
of the financial crisis in 2009 and stock
markets, especially those in Europe, are
only now beginning to return to their
pre-crisis levels. In comparison, the
Private Equity industry has proven to be
a cyclical industry capable of recovering quickly (sometimes at a compound
annual growth rate as high as 20-60%)
after stages of significant economic
downturn (e.g. in the early ‘90’s and
2000-2001). (See Exhibit 1)
However, the pace with which the PE industry will be able to grow over the next
cycle is still unclear. Indeed, despite the
encouraging signs from non-European
stock markets (e.g. USA, China and
Japan), such a turn-around is yet to fully
emerge.
While Private Equity grew significantly
in North America from 2011-2012 (23%),
it remained steady in the Asia-Pacific
region (-3%) and decreased both in Europe (-19%) and in the Rest of the World
(-33%) over the same period, maintaining a consistent level of investment
(excluding 2009) since 2008.
(See Exhibit 2)
perspective private equity
Within this challenging and uncertain
economic context, Europe seems to be
suffering the most; in 2012, the level of
investment of PE firms in buyouts and
growth-development-capital (approx.
€32 billion) was equivalent to the value
in 2004 yet was almost half the value
of 2007 (approx. €62 billion).Furthermore, despite a 50% reduction in the
level of transactions from 2007-2012,
the number of firms involved in PE deals
increased from 1,650 to 1,900, demonstrating both the overall scarcity of
resources available as well as the overall
potential of the industry.
(See Exhibit 3)
In a market characterized by a growing number of deals and a scarcity
of debt financing, the PE industry is
focusing more on growth transactions
and start-ups rather than turnaround
and secondary buyouts. This is driven
by the growing complexity and risk of
traditional operations of the latter, such
as the damaging effects that refinancing may have. In fact, LBO specialists
understand that in the coming years
yield could be increasingly driven by
profitability improvements and organic
growth rather than through financial
engineering.

8. Exhibit 2
Billion USD, Buyout deal value
0%
+5%
-5%
-3%
-9%
-19%
+10%
186
182
+2%
-5%
188
186
+23%
73
2008
2009
RoW
Asia-Pacific
2010
Europe
2011
2012
North America
CAGR (08-12)
CAGR (11-12)
Exhibit 3
Europe, 2012
Investments
Billion Euro (Buyout and Growth investments only)
62
Companies financed
# of companies
1.400
1299
1161
1.200
45
994
1.000
40
36
32
775
800
881
878
2011
2012
783
593
600
18
1047
932
615
400
348
200
2007
2008
2009
Source: Dealogic, EVCA.
2010
2011
2012
0
2007
2008
Growth
2009
Buyout
2010

9. Previously, the availability of low rateliquidity from 2004-2007 enabled many
funds to engage in significant LBO activities. However, this level of risk would
no longer be sustainable today, given
the economic stagnation within Europe
and the difficulties emerging as a result
of high capital market rates.
Typically, growth operations and startups occur in industries with fewer comparable benchmarks and less available
market information (though specific
company analysis remains crucial),
whereas turnaround and buyout opportunities are typically associated with
more ‘open’ market sectors. For this
reason, when assessing the attractiveness of a potential deal, PE firms should
primarily consider the general ‘robustness’ of the business model in question
and the firm’s positioning within the
value chain, rather than stand-alone
economic projections that might not
reflect the true potential of a firm.
Based on our experience as industrial
advisors for the major PE funds, when
evaluating the potential of a number
of target firms, it has emerged that if
properly explored, some industries have
succeeded in developing innovative
business models, which have strengthened the whole business case even in
those markets characterised by a high
level of competition and an uncertain
outlook.
perspective private equity
In this perspective, we will discuss three
different cases in which, by leaveraging
their business models as a source of
competitive advantage, companies have
been able to excel in their respective,
albeit different, markets.
More specifically, these firms have built
their competitive advantage through:
• Centrality of the end customer –
capturing preferences and trends by
having direct control over the last
part of the value chain and leaving
the burden of investing in assets for
production to firms operating at the
top of the value chain
• Technological exclusivity – offering products and solutions that are
technologically unique and hard to
substitute
• Outsourcing opportunities – evaluation of potential advantages through
a prudent analysis of the “make-orbuy” business decision

10. Exhibit 4
Wine, Consumption, 2011
# of
countries
Stable* /
in contraction
(122 MLH)
market
share
9
cagr
2006-2011
top countries
(MLH)
-1,5%
24,9
24,7
21,1
14,0
10,2
• Argentina
• Japan
• Portugal
• S. Africa
5,3%
• China**
• USA
• Russia
• Australia
• Canada
• Brazil
38,7
27,3
11,6
5,3
4,8
4,4
• Netherlands 4,2
• Belgium 3,1
• Switzerland 3,0
• Sweden
1,9
• Norway
0,8
n.a.
50%
• Italy
• France
• Germany
• UK
• Spain
9,7
8,6
4,9
3,6
• Chile
• Mexico
• India
• Thailand
• Turkey
• ...
RELEVANT
(227 MLH)
growing
markets
(105 MLH)
WORLD
244 MLH
MARGINAL
(17 MLH)
11
43%
~175
7%
* Countries with a yearly growth <1%.
** Data influenced for more than 50%
from fortified wine and wine not from
grapes.
Exhibit 5
Wine, Volumes, Mlh, 2011, Top 10 exporting countries
24,3
22,3
14,1
~ 25% of world export
7,0
6,6
4,2
4,1
3,6
3,1
3,0
Italy
CAGR
2007-11
% EXPORT
ON PRODUCTION
Spain
France
Australia
Chile
USA
+5,2%
+10,3%
-1,9%
-2,8%
+2,1%
-0,1%
+3,9%
+3,4%
-3,6%
-3,5%
57%
67%
28%
63%
63%
22%
43%
37%
20%
39%
Source: Euromonitor International, Global wine compendium, Value Partners analysis.
Germany S. Africa Argentina Portugal

11. Case 1 / food & beverage:
focusing on customer
preferences
The wine industry is characterised by a
stable level of demand concentrated in
a few selected markets. (See Exhibit 4)
Recently, a growing number of new
wine-producing countries (e.g. South
Africa, Chile, Australia) have successfully entered various global markets,
managing to offer differing taste-profiles, yet high quality, at a competitive
price. (See Exhibit 5)
Traditionally, Italy has produced a wide
variety of wines and remains the major
global wine-producing exporter (approx. 25% of total global export), with
hundreds of small and medium-sized
firms ranking at the highest level for
quality on the international stage.
Through our work, we have observed
three major business models being
adopted by the major Italian producers
(See Exhibit 6):
1. Classic model – firms that are fully
integrated throughout the value
chain, from viniculture through to the
commercialisation and sale of wine
(asset-heavy)
2. Commercial focus – firms mainly
focused on ageing the wine and commercialisation (relying extensively on
outsourcing – asset-light)
3. ‘Chain director’ – firms that focus exclusively on wine commercialisation
and control the entire value chain
through specific partnership agreements (asset-light)
Empirical evidence demonstrates that
it is vital to have direct (i.e. proprietary)
control over the entire production chain
for the premium and super-premium
segments, whereas for the medium/
medium-high-value segments the
primary success factor is the ability to
understand and address end-consumer
trends and tastes. (See Exhibit 7)
perspective private equity

12. Exhibit 6
ASSET-HEAVY
BUSINESS
MODELS
OF WINE
INDUSTRY
CLASSIC
MODEL
“FROM
GRAPEVINE
TO WINE”
VITICULTURE
WINE
PRODUCTION
AGING
BOTTLING
SALES &
MARKETING
PARTIAL OUTSOURCING IN SOME CASES
COMMERCIAL
FOCUS
ASSET-LIGHT
MAINLY OUTSOURCED
“DIRECTOR”
OF THE
SUPPLYCHAIN
Source: Il Mondo, Cerved, Value Partners analysis.
No investments
Activity performed internally

13. Flavour specialty, wine innovation and
attractiveness of the bottle are also key
success factors within the medium/
medium-high-value market segments.
For the majority of non-Premium
winemakers it appears then to be more
appropriate to adopt an agile business
model with no territorial and asset constraints (e.g. vineyards, casks, etc.),
a greater ability in understanding and
addressing consumer preferences, the
use of advanced marketing and a proactive management of the main distribution channels.
HIGH MARGIN
Exhibit 7
TYPE OF ACTIVITY
Sales &
Marketing
Aging
LOW MARGIN
Wine
production
Viticulture
Bottling
LOW
HIGH
INVESTED CAPITAL
Source: Value Partners.
perspective private equity
Recently, a very smart player has in fact
created value in the sector through the
use of a more nimble business model
where the company has been able to
maintain direct involvement within the
final stages of the value chain. This has
permitted the targeted distribution
of hundreds of labels geared towards
international markets which makes up
to 70-90% of domestic production,
without committing large capital in land
and equipement, thus reducing risk.
PE funds that are willing to invest
in such opportunities should evaluate,
with the assistance of industry experts,
not only the product portfolio
of targeted firms, but also the solidity
and smartness of their business
models.

14. Case 2 / Industrial goods:
mastering technology
to mitigate risks
The filtering of food ingredients and
derivatives is a niche market, yet
dynamically evolving, characterised by
continuous research of technological
performance and cost optimisation.
However, significant barriers to entry
exist as a result of the required skills
and expertise related to the employed
technology in use. These barriers are
further strengthened as the required
knowledge varies depending upon
the specific fluid and the associated
production process, ranging from fruit
juices to wines.
Technology is thus key to protect
profitability and competitive position.
In this sector expertise is considered a
strategic asset which enables firms to
develop a fruitful business relationship
with the major bottling companies or
food processing specialists.
As the industrial advisor of a PE fund,
Value Partners has appraised the innovative operating model of a leading
firm in this particular industry which has
built a globally recognised expertise in
a variety of different market segments
(including beer, wine, fruit juice, etc.).
Albeit very small in size, the firm uses a
proprietary technology to build a solid
and well protected position in a very
complex value chain. This has prevented
so far an uncomfortable position as
second or third tier supplier, and has
ensured a direct relationship with the
final decision makers at clients.
14 – 15
However, this competitive advantage is
not easy to maintain. It requires continuous investment in innovation, also
through partnerships with universities,
research institutes and industry unions.
PE funds willing to invest in these
technology-centric industries should
consider the ability of a target firm to
nurture these core capabilities as well
as to ensure that they have necessary resources to deploy in on-going
research and development.

15. Case 3 / auto components:
intelligent outsourcing
of SELECTED activities
The global mechanical gear market is
worth approximately €20 billion with
around 60% of it controlled by non-OEM
integrated, stand-alone manufacturers
(though this may vary depending on the
technology used, final application and
volumes produced). (See Exhibit 8)
Typically, OEMs (Original Equipment
Manufacturers for cars, trucks, boats,
etc.) do not run all of their product’s
associated operations and activities
in-house, but rely on external suppliers
and assemblers for the provisioning
of components and peripherals.
(See Exhibit 9)
A common misunderstanding is that
the process of outsourcing is only used
for standard and low value components: it may occur also within other
more complex or demanding processes
as well.
This outsourcing of complex components is often managed through
external business partners, as they have
unique technologies and know-how.
Such partnerships not only involve the
communication of technical requests to
suppliers but also the sharing of expertise to improve and simplify solutions
designed by the OEM.
Exhibit 8
World, Gears, Revenues
Gear Business
Billion Euro, 2012
Expected growth of addressable gear market
Percentage points
20 bln
(100%)
60%
+5%
100
107
113
118
122
2014
2015
2016
40%
Total gears
Captive*
Addressable**
Source: Value Partners analysis.
perspective private equity
2012
2013
* OEM, Tier 1
** Tier 2, 3, ...
CAGR 2012-16

16. Exhibit 9
Example of supply-chain
AUTOMOTIVE
AGRICULTURE
CE
• Technical specification
OEM
• Final production
• Assembly of all components
TIER 1
TIER 2
• Detailed specification definition of each component
• Supply of finished / semi-finished components
• Production of assembled components
• Production of individual components
COMPONENTS MANUFACTURERS
TIER 3
• Production of individual components
TIER ...
• ... ...
Note: CE = Construction Equipment.
Source: Value Partners.

17. For suppliers, opportunities for value
creation often resides in the parts of the
value chain in which large OEMs have
a small direct presence and economic
interest, enabling more specialised firms
to operate and develop technologically
advanced solutions. As a matter of fact,
these opportunities have resulted in
new technologies being introduced by
indipendent suppliers in many specialised applications (e.g. gear oil pumps
for braking systems) with new materials
(e.g. plastic), replacing iron and steel in
many components (e.g. electric windows).
A number of leading firms have cleverly
positioned themselves within these
long supply chains. One such firm,
a global gear producer, was able to
accompany the major OEMs throughout
their internationalisation processes by
developing innovative technologies and
solutions which were customised to
their client’s needs. Such a partnership,
which involved the joint engineering
and development of some components,
enabled the firm to contribute to the
success of the OEM, and share with it
the value generated
perspective private equity
To mitigate against business volatility
(and the underlying cyclical nature of
the automotive, construction equipment and agriculture industries), the
firm also entered a range of new and
diversified markets such as power tools
and gardening equipment.
For PE firms, a careful analysis of
each segment in OEM’s value chain
is required to assess these types
of businesses.

18. Conclusions
In a challenging and fast-changing
economic environment, PE funds
should focus on targets that not only
have success brands and products, a
competitive cost position and a proven
commercial strength, but also on those
that are able to build real competitive
advantage through a winning business
model.
As a consequence, PE funds should also
consider investing in more specific industry analysis, to understand relevant
demand drivers and critical value chain
dynamics rather than focusing on the
financial engineering details within a
transaction.
18 – 19
This new focus for PE firms has two
major implications.
Firstly, the competencies and resources
destined for investment screening and
industrial analysis should be reinforced
and sharpened.
Secondly, it is important that PE firms
have the capabilities and expertise to
support growth at their targets through
relevant industry skills, contacts and
know-how.

19. AUTHORS
Alberto Calvo
Partner, Milan Office
alberto.calvo@valuepartners.com
alberto oteri
Associate, Milan Office
alberto.oteri@valuepartners.com
perspective private equity

20. About
Value Partners
Value Partners is a global management consulting firm that works
with multinational corporations
and high-potential entrepreneurial
businesses to identify and pursue
value enhancement initiatives across
innovation, international expansion,
and operational effectiveness.
Founded in Milan in 1993, Value Partners’ rapid growth testifies to the
value it has created for clients over
time. Today it draws on 25 partners
and 280 professionals from 23 nations, working out of offices in Milan,
London, Istanbul, São Paulo, Buenos
Aires, Beijing, Shanghai, Hong Kong
and Singapore.
In 2007 Value Partners acquired
Spectrum Strategy Consultants – a
leading UK company specialized in
publishing, broadcasting, entertainment, IPTV and mobile – thus further
strengthening its international presence. Today Value Partners is a leading advisor in the telecom, media
and technology sectors worldwide.
For more information on the issues
raised in this note please contact
the authors.
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