Episode 54: Aldy Keene of Loyalty Research Center on the Importance of Customer Loyalty for Portcos 

Episode Transcript  

 Shiv: Alright Aldy, welcome to the show, how's it going?

Aldy: It's going great. Shiv, as we talked about, it's been a long time in the making. I'm really looking forward to this podcast. Thanks a lot for having me on.

Shiv: Yeah, excited to have you on and actually really interested to have the audience learn from your insights. So why don't we start with your background and what your firm Loyalty Research does and we'll take it from there.

Aldy: Sure. Shiv, this firm has been in existence for 27 years. We're based here in Indianapolis. We've evolved a little bit, but I came to it. My start was as an economist. I taught economics at the University of Chicago and at Purdue University and did a lot of work with customers and looking at firm strategies and how firms succeeded. Created a small firm, sold the firm. Went with it, learned the business, learned consulting and a little bit about managing, and went from there into starting my own firm. 27 years later, we're here talking.

Shiv: That's awesome. And talk a little bit more about exactly what you do in terms of the services you provide to investors and especially in the area of measuring customer loyalty and customer diligence.

Aldy: Shiv, about 65% of our business is private equity. And in that private equity business, we work on both pre-transaction customer diligence programs and then post-transaction working with the portfolio company. With the pre-transaction, the customer diligence, it's really laying the foundation for understanding what's the relationship between the client, the projected investment, and its customer-base. When I say customer, I mean that very broadly. It can be actually the end user, or it can be the distribution channel. So for example, we do very little B2C, but we work in that space through distribution. A lot of times, customers don't have a strong relationship with the provider of the products they're purchasing. But they do have it with the distribution channel. Ergo, if I'm a manufacturer of a product selling to consumers, it behooves me to really have a great relationship with that channel, positioning that product for sale. So when I say, what's the relationship with the customer, I mean that in a broad sense, the channel, all the way down to the end user.

Shiv: And how do you determine loyalty, right? There's tons of mechanisms that look at CSAT ratings or NPS scores and things like that. But every business has some set of customers that are loyal to it and that have maybe retained over time. And so how do you figure out how sticky your product is or the quality of customer relationships?

Aldy: That's a great question and one that has a couple of different interpretations. Let me tell you the approach we take. We look at this, and we have a proprietary approach to this for looking at the relationship the customer has with the company. What's that relationship? Is it strong? Is it moderate? Is it weak? We'd call it loyal, neutral, vulnerable. Now, we do interviews or surveys or combinations of the two. And we're looking for measuring that relationship to accomplish the following, Shiv. We look at what are the behaviors we're looking for as a company, as a client, Share of their spend, retention, margin, referrals, likelihood to cross purchase. If I measure this relationship properly, I should get really strong behaviors in all of those categories. For the strong and for the weak, probably really weak measures in each one of them. You know, I don't think you're special. As a result, I give you a very low share. You're in my secondary or third choice when I go to this product category. You're going to buy my relationship so the margins are really thin. I'm likely not to stick around very long. I surely don't recommend you to anyone else. And when I try something else you provide, dah. So it has to be able to differentiate those behaviors or behavioral intentions. If you've got a great measure of the relationship, it does that. And so you've got a set of incredibly strong customers, neutral right in the middle and in very weak customers. And that gives you a ton that you can work with. As you look at that. And in fact, Shiv, what do you think the average finding for the percentage of loyal customers would be thinking about that?

Shiv: The percentage of customers that are actually loyal you mean?

Aldy: Loyal in that measure that you have a really strong relationship that give you a high probability the behaviors you're looking for. What percentage?

Shiv: it's gotta be less than 40%.

Aldy: You're spot on. It's 30%. Most of the clients we work with think 50 to 70%. 30%. And we know what percentage of the company value, the enterprise value that 30% represents.

Shiv: Yeah. And actually, it's funny you say that because one of the things that we preach, because what we do on our side, we're doing marketing due diligence. So we're looking at the potential to scale marketing efforts. And if you look at how companies go to market, they deploy equivalent budget to people that are a great fit for what they have to sell just as much as they would for people that are not a great fit. And so that's why I said it would be less than 40 percent is you would think that 100% of their budget would be focused on their best fit customers, but that's just not true. And the main reason for that is they don't know who their best fit customers are because they haven't done that work.

Aldy: Exactly right. And we find, again, getting back that 30%, the best fit, not only are they the fit, but we've executed against that fit. A lot of times, your neutral customers, good fit, but we may not have executed against it. Even some of the vulnerables, great fit, really poor execution. Is it an execution or a fit issue that's damaged the relationship? But that 30% that's a fit against which we've executed represents for us on average about 65% of the enterprise value. Two-thirds come from that very small percentage.

Shiv: Right, yeah, because those loyal customers, the best fit customers are worth more in terms of LTV. They spend more, they retain for longer, they have higher conversion rates, they're just better across the board.

Aldy: Well put. That's exactly it, Shiv.

Shiv: Yeah, and it's funny, it's funny because when what we see is the companies that they don't really understand who their best fit customers are because they don't have this internal discipline of looking through these numbers. So as companies are thinking about this, or even investors, what are some things or practices they can put into place to understand this better? And I have my thoughts on this, but we'd love to hear kind of how you think about it.

Aldy: A lot of the relationships that we're looking at are B2B, as I'd mentioned, either B2B because the B is an end user or the B is the channel. And one of the things we've found that's really impactful is looking at the strategy of your customer. Now, if you have a position, if you've thought about your enterprise and you say, don't want to appeal to every, it's not a one size fits all. But I'm focusing my business design on a segment that has this need. I'm going to be best at it. A lot of times in B2B, it's driven by the strategy of your customer. Not all the time, but a lot of times it is. If I'm producing a niche product and it's the best product for that niche, then it behooves me to find the customers that want to sell to their customers using that product. 

Let me give you an example. We worked with a company that manufactured a chemical that was a replacement for wood pulp in the production of paper. And they had different formulations, all patented, for providing or producing different types of paper properties. Office paper, more opaque. Newsprint, cardboard stronger, they had several different formulations. And if you wanted as a cardboard producer to compete on the basis, our boxes are stronger. We're not going to have this issue. This was your company. Same thing with office paper. We did the initial study and we found 27% of the customers were vulnerable. After I quieted down the table of the management team, were yelling and disagreeing and telling me I didn't know what I was talking about. We got into the detail of it. And they did have 27% that were vulnerable. And the team went, what the heck? Who's managing these accounts? Let's get rid of these guys. They don't take care of our customer. Our customer should love us. And instead, it was, Shiv, these customers wanted something else. They competed on the basis of price and or order cycle time. Let me describe my client to you. You come to me as a customer, you schedule production, you schedule when it's going to be produced and delivered because we put it in the production cycles to when that batch is run. We have different formulations. It's also a little more expensive because of that. Vulnerable customers are used to dealing with people that have a stockpile of this product. They make one type. And they get it immediately. And of course, it's cheaper. How do those customers sneak in? How did that 27 get in here? Well, you're frequently thinking about, whoever gives us money, we're selling to. But that wasn't always the case. Sometimes a new management team comes in and changes the strategy. There's all kinds of reasons why I could change from being a buyer that values the quality of the product to one that really wants to go on price and order cycle time. The solution was lots of hugs. You know, we'll just give these customers lots of hugs. That's not the solution because as we had measured in some of these cases, you're losing money on these customers. You don't want to lose money on them. And that's a frequent finding in this research. Certainly what we found here and the lots of hugs strategies for companies is not going to work.

Shiv: Yeah, you said you said a bunch of things there that are compelling. It's something that we preach a lot is, you know, as you grow a business or you start a business and you start scaling it, it's really difficult to say no to revenue. And especially it's guaranteed money that's coming in the door. You feel like you're being productive. But I think one of the things that companies miss as they're going about building the business in that way is that the essence of healthy businesses is healthy gross margin. And you can only have healthy gross margin if you have your best fit customers in the door. And it makes you way more efficient on the backend when you're thinking about servicing and fulfilling or delivery and your margin on that. But when you start to kind of spread yourselves too thin or you have too many products and services that appeal to different segments, you kind of have a mishmash of revenue that some of which is productive. And some of it is just not even necessary for you to have a healthy business.

Aldy: I couldn't agree with you more, Shiv. That's spot on with our findings. I'd say we find the same thing. Sometimes it's near the beginning when you're starting up and you just say, don't want to turn away the revenue. Other times it's, I've got to keep growing. I've got to keep growing. We dealt with a major truck leasing operation. And they fell into it because they wanted to grow. And they loosened up their sales requirements to include some smaller truckers that had lower budgets, less financial stability. And whereas they grew initially, eventually the truck started having issues. These companies hired, they spent less money on drivers who maintained the vehicle less. They broke down randomly and more frequently. It started clocking up their maintenance centers. So not only higher cost, but it started squeezing out their best customers, their best fit customers, as you describe. It started squeezing them out and making them unhappy. And all of a sudden, sales turned down because of my initial decision to start serving poor fit customers. So I'd say spot on, Shiv. We've got that experience as well.

Shiv: Yeah, I think the other thing that you said that really resonated is as you have aggressive revenue or growth targets, what companies end up doing is there's, well, there's the customers that are coming inbound that you're like, okay, I don't want to say no to revenue. But then you also start to chase different opportunities. So one of the most common ones that we see are mid-market SaaS companies that want to go up market and compete in the enterprise. And so they'll start to say, we do kind of well here. We see these other competitors out there and we're better than them in terms of product and we can compete in that space. And so they start chasing that revenue. And over time, it's possible that you have a product line or set of product lines that is down market, middle market, up market. Like you're kind of doing all of the, all of these at the same time, but you really are truly best in class in one of those areas in terms of what you're offering. But you're almost forced to do these things because of the revenue targets or the pressure put on the business. So how much of that in your experience are you seeing that it's more top down, either from the executive team or the investors that are involved and how much of that is kind of like self-inflicted?

Aldy: I'd say that not as much anymore top down. We've seen some of that. And I'll give you an example. But some of it just, I don't have a great measure of my customer to be able to, and I think you started out this way, to know when it's a great fit and when it's not. And that's an issue. My example is, we had a PE that was looking at buying two sports equipment distribution firms distributing to retailers. And one in the Midwest, they focused on logistics and price. And one down in the southeast that focused on service. And the service was this great group. And this is their terminology. We're to be careful. They had these, according to them, southern bells on the phones that were just tremendous in handling customers. And they were able to sell, they were able to pass through higher margins. They wanted to combine both of these and combine them and apply the Southern Bell strategy to the Midwest. We said, we're happy to look at this, but I don't think it's going to work. What do mean? And of course, we did it. The Midwestern group was not at all interested in it. They had choices, they could go to other distributors that offered them great pricing and distribution. So they bought it. They bought the two. Didn't work. And Shiv, my takeaway, I repeat a lot, the road to ruin is paved with trying to change the needs of your customers. This is the need or the strategy. Hey, we can change those retailers to make them want this new service we're going to give them and they'll be willing to pay for it. Didn't work. That's a very difficult proposition. You pretty much have to take that as it is, especially if they've been competing this way for years and years and years. It's a tough proposition to show them they can be more effective by going a different route. Has your experience been the same?

Shiv: Yeah, those are almost like famous last words in a lot of these cases, right? It's like, of the most common things that I see is like, you know, we had one client recently that was absolutely crushing it in the middle market and even down market, but the executive team had convinced themselves that they can win up-market. so for the last year, they had been reallocating their budget to go up market and deserting the strategy that got them to this point. And this is a quite a successful business and they were struggling on the upmarket side. And then eventually they had to stop the upmarket motion and go back to what made them successful. And stories like that, I see all the time, whether it's expanding to new segments, different geographies, price points, new product lines, new offerings. Like, you have to make sure that the thing that you're picking is very close to the thing that makes you special or what differentiates you in the marketplace. And you have to really know who you are and what your competitive advantage is.

Aldy: Shiv, what have you found in terms of, first, let me give you my start. We've found, and a lot of research from others supports it, is that most of my enterprise growth comes from organic growth. Looking at exactly what you're talking about, where I'm serving right now, both in terms of existing customer and new customer, where do you find, or your clients find, most of their value creation is it with existing customers or bringing in new accounts.

Shiv: It's most of the value creation, especially in a PE environment that we've seen as on the expansion side, new customers, people really struggle on scaling pipelines, scaling revenue in a predictable way. I think, and a lot of it comes back to some of the things that we've discussed. Actually in my book, the one that recently came out, the first chapter is all about TAM and segmentation. A lot of PE firms do like a TAM SAM SOM analysis, but the secondary step to that is really knowing where you'll win and where your win rates are highest or where you have a right to win really. And I think the internal teams don't action that. So even if you understand that, it has to actually translate into tactics. And it's a lot easier to do the farming model or account management model than it is to land net new customers that you know are going to be a great fit for your business. So we've seen that as an issue. And I guess my, my follow up to you on that would be, you know, how much of the, that type of work are you doing for your customers? And, and what have you uncovered as you start to look into the customer diligence side? What are some of the other areas that you're evaluating to figure out the best fit segments?

Aldy: The key thing that we look at to establish best fit segment is, as I said, one of the things is strategy. But we then look at what experiences the customers had, what are the drivers of the relationship that we determine fit with that customer. Sometimes you simply don't have all the measures you need, other than the fact that this is what I want. These are the key things that drive my decision. And then you have to try to project that out to the others using some other descriptors of the customer, but both of what they experience and some of the descriptors of firmographics.

Shiv: And how do you transition from understanding these segments to then making them a reality? Like what are some of some of the best practices that you've seen that have made this come to life?

Aldy: As we look at that and thinking about segmentation, it's one, projecting our results out to everybody else in the customer base. What do I mean? Well, we collect primary information to help form them. As I said, interviews, surveys, combine it with third party descriptors, third party data, company data, to really form these segments. But then you don't want to just use that segment to take action with the segment that you've sampled. You want to be able to project it out. And that can be trying in terms of getting a really great fit to think about a needs segment or some behaviors. We've found that using experiences, combinations of experiences can really help do that. You know, firms would say, don't have the information to be able to do that. It's amazing how much information exists out there. That's incredibly valuable. 

Again, let me give you an example, Shiv. Way back, we worked with a software slash software service provider, a SaaS. And they were killing it in the marketplace. Competition enters. They start having some challenges. They started having customer defections. We're doing ongoing surveys combined with company information. What can you tell us about this? Well, the driver of the relationship, the key experience that was creating this weakness in the relationship was customer service. It wasn't the product, it was customer service. So now we focus our search in modeling this from the ocean into the pot, just on customer service. And they had, fortunately, the number of calls, the timing, calls into customer service. We modeled it and we came up with if they called three times within 35 days into customer service, calling or emailing or chatting, they had like an 87% probability of defecting. Holy cow. That really helped in a variety of ways, Shiv. One way was we can apply that to everybody that's still with us. Right? They're still here. Let's look at who right now is incredibly vulnerable and put a probability on that and stack rank it by value of customer, their spin, their economic value, and tier in what our response is to try to salvage these relationships, which they did. The second thing is let's train up our customer service reps. And the third is, let's look at what the issues are and try to resolve that and keep it from occurring. So that tiered response. 

Example there is we're looking at incredibly vulnerable customers that are a fit for us. How can we find them out in the customer base? How can we tier our response and have a very selective proactive strategy for retaining them? So you've got this segment, strong relationship, incredibly strong. We opened with this incredibly strong relationship. They behave differently. You look at the average share of spend, 64%, 64% of their spend dollars. They have an extremely high margin. They have great retention, cross-sell referrals. You look at that, and those are averages. My point being, many of those are under the average, right? It's an average. Maybe the bottom quartile, identifying those loyal, strong relationship customers out in the database and their current behaviors. There's a ton of gold out there that you can extract by changing margin, by going after the low share. We love you. We think you're special. You're a great provider. Why aren't we getting more than 42% of your spend? What's the hurdle? Those are immediate dollars that can be extracted from the customer. We did that with one client last year. And they came back and said, we were able to boost revenue by 8 to 9% just by taking action right there. That's a great example.

Shiv: Yeah, it brings me to something that's there's an interesting point that especially in my, when I started learning more about product management and this concept that the building is full of product experts, but there aren't enough market experts inside companies. And in this case, like attaching yourself to your most loyal customers and understanding them and how to increase their spend is a better strategy than trying to think about how else you can generate revenue by creating new products and services for different sectors.

Aldy: Yep, yep, yep, absolutely. And as we were talking about earlier, you can have great fit customers that are neutral or even vulnerable because you have not executed against your model. Hey, I want this type of service. I want this type of relationship. But you failed me. It happens, right? Identifying those and fixing them, that should be job number one for the team to try to migrate these weaker relationships to strong, they should love us because of our model.

Shiv: Yeah. And it should kind of cascade down through everything that you do. Like even like the content that you're producing, the messaging that's out there. Like I'll give you an example just from our side. Like, this podcast is called the private equity value creation podcast. It's so niche, but it is specifically for private equity because that is our audience. We could have made it the investor value creation podcast to include VCs. And there are VCs who listen to the show, but our ICP is the PE investor that's buying larger businesses, at least 10 million and upwards of 100 million in a lot of cases. It's a trade off and trade offs can be scary for companies, but it really puts a stake in the sand that says this is what we're for, which also means this is what we're not for, but that's okay because then the people that are for you are going to gravitate towards you more.

Aldy: Mm hmm. Right.

Shiv: And I guess I wanted to ask you one question is like, talk about just the downstream impacts of not getting this right. Just cause I'm, I'm thinking about it. You mentioned support and tickets and stuff like that. Like definitely on the acquisition side, your customer acquisition cost is going to be higher for people that are less of a fit for what you're selling. But there's also other downstream effects of distraction, like your product roadmap is going to get pulled in other directions as you're trying to serve folks that are not the best fit for what you're selling and that you're not going to have enough resources going to product roadmap items that are a good fit for those people. And then same thing on the support side, you have calls and tickets and inquiries and help articles and all of the stuff that you're now creating for people that are likely vulnerable and not in your best fit segments.

Aldy: What a great observation, Shiv. In economics, you call that an opportunity cost. You're distracted by trying to expedite orders, fix problems. If you've got a bad fit customer, they've got all kinds of issues. They want to be made happy, but your model just doesn't do that easily. And you take incredible amount of time from executives, managers, lower level personnel to try to alleviate these problems. Nobody likes a problem. No one likes to have a customer problem. The more time you spend on that, it's not only putting more cost into servicing, probably already that low margin customer, but it's distracting you from developing the strong customer relationships and doing the things to really extract that gold from them. We find that all the time. I couldn't agree with you more.

Shiv: Yeah, I also think one of the understated benefits or risks there is that as you are more distracted, you're leaving yourself open to an actual challenger in either one of those categories that's hyper focused to take that section of the market. Like one great example is like Canva. They went after this market of almost being able to design without having design expertise and they leaned all the way into that. And if you were kind of in between Photoshop and Canva, you probably got killed. then, but Photoshop still has a market of more expert designers and folks that use a tool like that, right? So you can kind of see this competition threat that exists if you don't figure this out fast, especially inside competitive verticals.

Aldy: Let me give you a different example. It's a little different from what we've been talking about. We've got a small business that serves associations, professional associations. A lot of it's professional health care, optometrist, ophthalmologist, surgeons of various. These associations serve them with all kinds of benefits, education, networking, all kinds of things. We have an association, and this is not unusual, that created the category for their space, serving a specific type of practice. And they grew. They were the dominant association serving it. And they just grew and grew and grew in what they did. How can we provide more service, more service, more service? It's just as you described. And guess what? Now that it's grown so much and they've created the demand, smaller associations are forming that just take off subsets of those specialties. And they're biting at one, and another's biting over here. And that happens all the time, not only in associations, but also in businesses. I grow and become, I create this sort of product category. And as I grow and thrive and profit, it attracts all these smaller fish coming in and taking a bite here and here and they grow. That's the beauty of our economy. That's the beauty of competition.

Shiv: Yeah, which is that as the market grows, you end up having more players emerge that are more specialized for sure. Let me ask you more of a side question. As you're doing diligence, is there a percentage of when you look at the customer base where you're like, hey, there's too many people here that are vulnerable. This is actually not a good business to buy. Like what is that threshold for you?

Aldy: Boy, that threshold in looking at a... And we do a lot of work in the lower and lower middle market area. You know, when you've got a smaller organization that has 30% vulnerable, 30, 35% vulnerable, that's a red flag. It's a red flag, but it can be a green flag, Shiv. Now, you look at this and say, this smaller organization is doing A, B, C, and D. Those things can be fixed. These customers can be saved. These issues that are coming up that's creating the vulnerability and their execution issues, not design, execution issues. Those can be fixed. We can recover the customer and make this work. On the other hand, if it's, we just have a bad fit. This product or service doesn't work for us. That's a gigantic red flag. That's an issue where you've got to look back and say, they targeting the right customer? And is there enough in the market? You referred earlier to TAM and SAM. Is this something we can address? And is the market big enough for us to take care of? We see that in some cases. I'll tell you another red flag is we get the database and start going through it. And it's A, dramatically different in terms of size than we were led to believe. We got 1,000 customers. Well, there are 432. And we start going through and contacting them, and half the information's off. That person hasn't worked here in three years. Bounces back, wrong information. What are they doing to manage their relationships? That's even maybe a little bit more telling than measured weak relationships. They're just the non-exists.

Shiv: Yeah, the depth of the relationships, right? Yeah.

Aldy: You bet. You bet. But you're spot on. If it's 35 or 40% for a smaller organization, that's a red flag if it's a fit issue.

Shiv: What advice would you have for founders or entrepreneurs that are going to eventually sell their business and potentially exit? What can they do to better prepare for this kind of analysis so that a potential investor looks at their business more favorably?

Aldy: Yeah, you know what's going to happen. I mean, for a small business person who's looking at down the road selling their business, get out in front of it. I look at your database, your customer database, your CRM. And what kind of shape is it in? Is it accurate? Is it updated? That can be one of the most valuable assets you have in your business because only you have it. There's incredible information in there. Or is it simply a spreadsheet that's not updated, that's wrong in many cases? So one, CRMs. Two, do you look at your relationships on a regular basis? You're starting with some sort of internal program, just looking at what's the relationship. Let's have a QBR and record those. Let's have a note on those. We see a lot of businesses start that way and over time get a little more sophisticated on top of it. So that when people are looking at you in terms of an investment or an acquisition. Here's what we have, and here's what we've done. I'm having lunch on Friday with the president of a portfolio company. And he knows, he's a smart guy, he knows in a year and a half to two years, he's going to be sold. His unit's going to be sold. And he's doing all those things, Shiv, to look at, we look at the value of our relationship with customers. Here's what it is. Here's how we measure it. Here's our database. Here's what we do. Here's how we use it. He's going to extract the most that he can out of that business unit. He's not leaving a ton of potential on the table.

Shiv: That's awesome advice. Yeah, I think a lot of companies would be well suited to do this earlier on and not just because you want to eventually be acquired or get an investor, but it also leads to just a healthier business being built. So that's constantly what we preach here too. So Aldy, thank you for sharing that. I think that's a good place to kind end the episode, but before we do, what is somewhere that people can go to learn more about you and the work that you do?

Aldy: You bet. Well, we're going to put some information up on the folder associated with this. Our website, www .loyaltyresearch .com, that has our contact information. Would love to talk to anybody about this. Is that what you're looking for, Shiv?

Shiv: Yeah, yeah, that would be great. And we'll make sure we include all of that in the show notes and we will include the link to the website and any other articles that we need to include as well. And then with that said Aldy, thanks a lot for doing this and coming on and sharing your wisdom. I thought this was some great content and I think folks will learn a lot from it. So thanks again for doing this.

Aldy: Shiv, thank you so much. I've really enjoyed going back and forth with you. Great questions, great discussion.

Shiv: Awesome, man. Thanks a lot.