Structuring Private Equity Investment Thesis: A Comprehensive Guide

An investment thesis is a crucial document for any investor, outlining why they should pursue a particular investment strategy. In the context of private equity, an investment thesis is even more important, as it guides direct deal sourcing efforts and enables firms to stand out in a competitive market. This paragraph aims to introduce the topic of how to structure an investment thesis in private equity by providing an overview of the key components and benefits of a well-crafted investment thesis.

An investment thesis is a formal written document that serves as a strategic decision-making tool for investors and businesses. It provides a concise and comprehensive argument for a specific investment opportunity, backed by rigorous research and analysis. In private equity, an investment thesis helps firms identify and secure ideal investments that align with their objectives. By structuring an investment thesis effectively, private equity firms can enhance their outbound strategies, optimise their deal sourcing efforts, and ultimately improve their chances of success in a challenging market.

The process of creating an investment thesis involves answering key questions and considering various factors. These include determining the fund size, investment focus, portfolio construction, macroeconomic and microeconomic factors, and understanding the trade setup. A well-structured investment thesis should be specific, realistic, and sustainable, taking into account the firm's network, untapped market opportunities, and investors' interests.

By following a structured approach and conducting thorough due diligence, private equity firms can develop a compelling investment thesis that guides their investment decisions and improves their chances of success.

Top-down vs bottom-up theses

Overview

The two main types of investment theses are top-down and bottom-up. A top-down investment thesis helps your team understand and seek out ideal investment targets when sourcing. Once your firm has identified an ideal company that fits its top-down thesis, it's time to create a bottom-up version.

Top-down theses

Top-down investing involves looking at big-picture economic factors to make investment decisions. It focuses on the macro factors of the economy, such as GDP, employment, taxation, and interest rates, before examining micro factors such as specific sectors or companies.

Top-down investing is easier for investors who are less experienced and for those who don't have the time to analyze a company's financials. It may also produce a more long-term strategic portfolio and favour passive indexing strategies.

Bottom-up theses

Bottom-up investing looks at company-specific fundamentals like financials, supply and demand, and the kinds of goods and services offered by a company. It can help investors pick quality stocks that outperform the market even during periods of decline.

Bottom-up investing can lead to more tactical, actively-managed strategies. Bottom-up portfolios often have a much larger share of individual stocks.

There is no right or wrong method of investment analysis. Choosing the right approach depends on your individual goals, risk, and comfort level. Both approaches are valid and should be considered when designing a balanced investment portfolio.

Macroeconomic factors

When structuring an investment thesis in private equity, it is important to detail the macroeconomic factors that can influence the success of the investment. This will help set the broader context and identify potential risks and opportunities. Here are some key considerations for the "Macroeconomic Factors" section of your investment thesis:

Current Headlines and Trends:

Begin by listing relevant current headlines, political and social developments, and consumer trends that could impact investments. For example, regulatory changes, e-commerce adoption, or political volatility. Explain how these factors are affecting investment opportunities and the private capital markets in general.

Industry, Sector, and Subsector Dynamics:

Identify headlines and developments that specifically affect the acquisition target's industry, sector, and subsector. Explain whether these developments favour growth for your private company. For instance, if the target company is in the durable goods manufacturing industry, you might include the US freight transportation services index (TSI) as a macroeconomic factor and describe how its recovery predicts smoother supply chains, easing investor concerns.

Global and National Conditions:

Consider whether global or national economic conditions could hinder the potential portfolio company's growth or the investment's performance. Explain how the acquisition target could navigate or mitigate these challenges.

Competitive Landscape:

Assess the competitive landscape within the target industry. Are there any imminent substitute products or competitive threats? How do the target company's competitors perform and position themselves in the market?

Interest Rates and Their Impact:

Discuss how rising interest rates could affect banks and real estate investments, which in turn may have a ripple effect on other sectors.

Market Consolidation:

Look out for industries or sectors that are undergoing consolidation. This can impact pricing, margins, and market power. For example, an increase in consolidation may lead to reduced operating expenses for some companies.

Cyclicality and Seasonality:

Understand the cyclicality and seasonality of the target company's industry. For instance, certain industries like housing may be subject to economic downturns and systematic overbuilding, leading to a negative impact on investments.

Regulatory and Government Influence:

Evaluate any regulatory changes or government interventions that could impact the investment. For example, changes in tax policies, trade regulations, or industry-specific standards.

Remember, the goal of this section is to provide a comprehensive overview of the macroeconomic environment that will influence your investment. Be sure to support your arguments with relevant data and examples.

Microeconomic factors

Leadership and Growth

Describe why you believe the target company's founder or owner will lead the company to growth. Highlight instances of innovative problem-solving and strong leadership that have contributed to the company's success. This includes assessing the founder's ability to navigate cash flow surprises, such as sudden windfalls or shortages, and their impact on short-term volatility and long-term sustainability.

Financial Statements and Record-Keeping

Scrutinize the company's financial statements to evaluate the business's record-keeping practices and financial viability. Assess the ease of understanding and transparency of the financial reports. Look for clues on how leadership has handled finances during critical periods and inflection points. Analyze key metrics such as return on equity, profit, return on assets, earnings per share, and their variance.

Seed Money Utilization

Examine how the company has utilized seed money to gain insights into their priorities and capital allocation efficiency. Assess if the company effectively manages talent, vendor agreements, and market expansion strategies. Identify areas where the business may be expending resources without achieving effective traction and propose alternative actions to improve cost management.

Competitive Landscape

Evaluate the target company's reputation and competitive position in the market. Hire a market research firm to conduct an exploratory branding assessment and gather insights from clients, employees, and vendors. Analyze the strengths and weaknesses of competitors and determine if the target acquisition can exploit market conditions more effectively.

Risk Assessment

Address potential risks and pitfalls early on in your investment thesis. Identify these risks and explain how the private equity firm's management team plans to mitigate or navigate them successfully. Consider factors related to the company's agility, defensibility, financial viability, and environmental, social, and governance (ESG) compliance.

Trade setup

The trade setup is the final component of a good investment thesis and answers the question "So what?". It offers bold implications of the micro and macro analysis and reveals the next steps.

To describe the proposed trade, explain how the micro and macro factors will work together to increase carry for partners and returns for limited partners. Propose an entry point or "setup price" and describe how you arrived at your proposed acquisition's target price. Industries and different private equity firms within those spaces vary in how they calculate reasonable prices.

The industry standard expects your firm to find the product of estimated earnings and your expected multiple. For example:

• Estimated earnings x EV/EBITDA = target price
• Estimated earnings x FCF/market capital = target price
• Estimated earnings x P/E ratio = target price

In your investment thesis, explain why your firm uses a particular multiple and how it arrived at the estimated future earnings. Be sure to include these details as a footnote or sidenote for more curious readers.

Once you've proposed a purchase price, describe why the buy side should value the business at that entry point. You may need to briefly repeat what you've stated in your micro and macroeconomic research findings but within the context of your financial investment.

You should also outline what will happen if you choose not to invest in a particular business. Will the current owners keep their stake or will a rival scoop them up? Will a competitor fumble the operational improvements or liquidate too early or too late? Or will the competitor execute brilliantly, generate alpha, and solidify or even expand its limited partner pool?

Finally, you must weave in a capital plan to detail how your investors' committed capital will improve company profits for either returns or reinvestments. The capital plan should include no more than three or four actions, for example, increasing dividends or paying down debt to put free cash flow to work.

Summarising the thesis

• Concise and Digestible Format: The summary should be concise, typically ranging from one to two paragraphs or even a single sentence. This format makes it easier for busy readers to understand and helps them quickly grasp the key points of the thesis.
• Clear and Effective Communication: The summary should be written in a clear and straightforward manner, free from jargon or complex language. It should effectively communicate the investment strategy, including the type of investment, expected returns, potential risks, and any unique advantages your firm offers.
• Highlighting Concrete Benefits: Instead of vague strategic justifications, focus on describing concrete benefits that the investment will bring. For example, explain how the investment will leverage existing resources, improve operational efficiency, or capitalise on new market opportunities.
• Addressing Stakeholder Concerns: Ensure that the summary addresses the concerns of all stakeholders, including investors, employees, debtors, and vendors. Clearly articulate why the deal will make the company stronger and how it aligns with their interests.
• Tangible and Quantifiable Results: Wherever possible, include tangible and quantifiable data to support your claims. This could include financial projections, market analysis, or metrics demonstrating the potential impact of the investment.
• Differentiation and Competitive Advantage: Explain what sets your firm apart from others and why you are the best partner for this investment. Highlight any unique expertise, network, or experience that gives you a competitive advantage in executing the investment thesis.
• Flexibility and Adaptability: Recognise that the investment thesis may need to be updated and adapted over time. Market conditions, competitor actions, and other factors can influence the viability of the investment. Be prepared to adjust your thesis accordingly and communicate these changes effectively to stakeholders.
• Visual Aids and Supporting Materials: Consider using visual aids, charts, or graphs to support your summary. Additionally, provide a more detailed version of the thesis, such as a pitch deck or a comprehensive document, for those who want to delve deeper into the specifics.
• Addressing Red Flags and Risks: While the focus is on the positive aspects, don't shy away from addressing potential risks and red flags. Demonstrate your ability to identify and mitigate risks effectively, increasing investor confidence in your firm's ability to navigate challenges.
• Storytelling and Narrative: Craft the summary as a compelling narrative that tells the story of the investment opportunity. Help your audience connect the dots and understand how the investment aligns with the firm's broader strategy and goals.

By following these guidelines, you can effectively summarise your private equity investment thesis, making it more accessible, memorable, and persuasive to your intended audience.

Frequently asked questions