Private Equity Investment Evaluation: Strategies For Success

Private equity firms are known for their impressive returns on investments, which are often attributed to their aggressive use of debt, focus on cash flow and margins, freedom from public company regulations, and hefty incentives for operating managers. However, the fundamental reason for their success is their buying to sell strategy. Private equity firms target acquisitions that have been undervalued or under-managed, aiming to increase the business's value before selling it for a maximum return. To evaluate potential investments, private equity firms conduct extensive due diligence, analysing a company's financials, market position, industry trends, debt financing, and management capabilities. They also utilise valuation methods such as discounted cash flow, comparable company analysis, and precedent transactions to determine a company's worth. This enables them to make informed investment decisions, manage their portfolios effectively, and generate high returns for their investors.

Due diligence: financial, commercial, and legal

Due diligence is an essential part of the private equity investment process. It involves "checking under the hood" to collect information and confirm management's financial and operational figures when evaluating a potential investment. Due diligence is how PE firms assess investment opportunities and determine which deals are worth pursuing.

Due diligence can be divided into two types: exploratory and confirmatory. In the exploratory phase, the deal team assesses the immediate fit against the fund's investment thesis and looks for confirmation that the firm and its investors can impact the commercial aspects and management of the company. The confirmatory phase involves spending more time and resources to ensure the information provided by the target company is accurate and up-to-date. This is where third parties, such as lawyers and consultants, are engaged in the due diligence process.

Financial, commercial, and legal due diligence are critical components of the overall due diligence process in private equity.

Financial Due Diligence

Financial due diligence focuses on confirming the financial performance of the target company. This involves a deeper look into the financial information provided, such as financial statements, income statements, balance sheets, and cash flow statements. It aims to determine the appropriate valuation for the target company. Financial due diligence may include analysing financial projections, customer acquisition costs, customer lifetime value, intellectual property, and quality of earnings (QoE).

Commercial Due Diligence

Commercial due diligence evaluates the industry and the target company's position in the marketplace. It involves understanding the industry dynamics, recent transactions, growth trends, competitive landscape, and the company's value proposition. By understanding the industry, the deal team can better grasp the company's commercial activity and how it operates.

Legal Due Diligence (LDD)

The main objective of legal due diligence is to gain a legal perspective on the target company and uncover any legal issues or risks associated with completing the transaction. This includes reviewing legal contracts and agreements, identifying key customers and partners, and assessing human resources information, such as the organisational structure and compliance with relevant laws and regulations.

Overall, due diligence in private equity is a comprehensive process that aims to uncover and mitigate potential risks to make informed investment decisions. It is a critical step in ensuring the success of the firm and maximising returns for investors.

Market position and trends

When evaluating potential investments, private equity (PE) firms consider a company's market position and industry trends. They analyse a company's market position by assessing its competitive advantage, sustainability, barriers to entry, switching costs, customer relationships, and market share. They also evaluate industry trends to identify companies that can benefit from them, resulting in above-market growth and stronger equity returns.

Competitive Advantage and Sustainability

PE firms seek companies with strong market positions and sustainable competitive advantages. This includes evaluating the company's value proposition, products or services, technology, brand, distribution capabilities, and geographic presence. They also assess the sustainability of the business model and its ability to adapt to changing market dynamics.

Barriers to Entry and Switching Costs

PE firms consider the barriers to entry into the industry and the costs associated with switching to a competitor's product or service. High barriers to entry and switching costs can indicate a company's ability to maintain and grow its market position.

Customer Relationships and Market Share

Understanding customer relationships is crucial for PE firms. They assess the "stickiness" of customers, including customer retention, satisfaction, and the potential for upselling. Additionally, they evaluate market share and the company's ability to gain or lose market share from competitors.

Industry Trends

PE firms analyse industry and market dynamics to identify high-growth industries or emerging markets. They consider market size, competition, regulatory environment, and market trends. By understanding these factors, PE firms can identify investment opportunities with strong growth potential.

Due Diligence

Conducting due diligence is a critical part of the investment process. PE firms perform a detailed analysis of the company's operations, financials, market position, competitive landscape, and growth prospects. This process helps identify risks, evaluate the company's value, and determine its fit with the PE firm's investment strategy.

By assessing market position and industry trends, PE firms can make informed investment decisions. This includes evaluating the company's competitive advantage, sustainability, barriers to entry, customer relationships, and market share. Additionally, understanding industry dynamics and identifying favourable trends helps PE firms identify companies with strong growth potential and attractive investment opportunities.

Management and operations

When evaluating potential investments, private equity firms place a lot of emphasis on a company's management and operations. This involves assessing the company's management team, value proposition, market position, historical performance, and industry trends to gauge its ability to meet forecasted projections.

A crucial aspect of this evaluation is the due diligence process, which can be classified into three main areas: commercial, financial, and legal. Commercial due diligence involves understanding the company's value proposition, market position, competitive advantage, and industry trends. It helps assess the sustainability of the company's business model and its position relative to its competitors.

Financial due diligence, on the other hand, focuses on confirming the accuracy of financial information and understanding the unique dynamics of the company's financial reporting. This includes analysing historical earnings, adjusted EBITDA, debt and debt-like items, normal working level of capital, tax structure, information technology, and human resources.

Legal due diligence, which is mostly confirmatory, ensures that the target company is not subject to any future liabilities, including regulatory issues, lawsuits, and unusual contract provisions. It involves reviewing corporate filings, material contracts, property and equipment, human resources, health and welfare plans, and intellectual property.

Overall, the evaluation of management and operations is a critical aspect of the investment decision-making process for private equity firms. It helps them understand the company's ability to execute its operating strategy, identify areas for value creation, and make informed investment choices.

Growth strategy and potential

When evaluating potential investments, private equity (PE) firms consider a company's growth strategy and potential. This involves assessing the company's market position, growth avenues, financial performance, management team, and value creation opportunities.

Market Position and Industry Trends

PE firms seek companies with a strong market position and sustainable competitive advantages. This includes evaluating barriers to entry, switching costs, customer relationships, and industry trends. They look for companies that can benefit from favourable industry trends, such as increasing automation, changing customer habits, adoption of disruptive technologies, digitalization, and changing demographics.

Growth Avenues

A balanced and diverse growth strategy is essential. PE firms assess the potential for growth through new products, expansion into new locations or geographies, customer acquisition and retention, and exploration of adjacent industries. A company with multiple avenues for growth is more attractive as it reduces the reliance on a single driver.

Financial Performance

PE firms analyse a company's historical and projected financial performance to evaluate its growth potential. This includes reviewing key performance indicators (KPIs), historical growth, projected market growth, and the company's ability to meet its forecasted projections. Financial due diligence is also conducted to confirm the accuracy of financial information and understand unique dynamics, such as quality of earnings, debt and debt-like items, normal working capital level, tax structure, and capital requirements.

Management Team

The strength of a company's management team is crucial as they are responsible for executing the operating strategy. PE firms assess whether the management team has the necessary expertise and capabilities to drive growth and achieve the projected financial targets.

Value Creation Opportunities

PE firms identify areas where they can create additional value within the company. This includes improving operational efficiency, optimising pricing, restructuring the organisational structure, diversifying the customer base, and selling underperforming assets.

By thoroughly evaluating these aspects, PE firms can make informed decisions about potential investments, considering both the company's current performance and its future growth strategy and potential.

Risk and volatility

Private equity investments are generally considered to be riskier than other asset classes due to the nature of the underlying investments. They often have high investment minimums, which can magnify both gains and losses.

One of the main risks associated with private equity is liquidity risk. Private equity investors are expected to invest their funds with the firm for several years on average, with an average holding period of between four and seven years. This is because earnings growth for small companies can take time, and private equity investments are typically illiquid and cannot be easily converted to cash.

Private equity investors also face greater market risk due to the nature of the companies they invest in. These companies are often unproven and have a high failure rate, with only a small number making a significant return. There is also a high degree of uncertainty regarding their management team, new product launches, and the potential for their technology to become obsolete.

Additionally, private equity investments may involve the company taking on significant debt, which can be costly to service through interest payments over time.

Despite these risks, private equity is often associated with lower volatility compared to public equities. This is because private equity managers tend to be more conservative with their valuations, taking a slower and more measured approach during market downturns and bull markets. This results in lower levels of volatility.

Furthermore, private equity is less exposed to the excess volatility that dominates public markets. While earnings expectations drive fluctuations in public equity valuations, other factors such as momentum or fear also affect stock prices, resulting in excess volatility.

Overall, while private equity investing carries a higher risk profile than other asset classes, it also has the potential for notably higher returns. For investors with sufficient funds and a high-risk tolerance, private equity can be a lucrative addition to a well-diversified portfolio.

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