You guys are smartest finance professionals on the planet.
What factors or frameworks do you use while building up a thesis? Are there some that get more weight (I.e industry vs management)
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Very interesting question.
I haven't seen this written out anywhere. Here is my framework:
Thesis: "We are investing in company X because we hope to achieve A, B, and C* and then sell the company in 5 years for more than we bought it for".
A, B and C should be:
= few things, not hundreds = within your control, and not completely external dynamic (e.g. NOT oil prices will rise and we will make money) = achievable within your investment horizon = requiring resources that you have accounted for in your model = with management, either incumbent or external, who will actually deliver the plan that you have in mind
The process is as follows:
Industry is far more important than management. If the industry is in permanent decline, the best management team in the world won't be able to help you. Also, if you get management wrong, you can change and some PE investors have to change management more than once. You just need to make sure that you are a majority investor if you are hoping to initiate management change.
Good luck,
Tamara
Under Market, I mean Industry.
What goes there?
Sector performance, market size, growth drivers, cyclicality, demand factors, supply factors, what determines price in the sector, what risks sector is facing
Under Business Model, I mean how does the company actually make money.
What goes there?
Revenue model of this specific business, positioning, current strategy, target audience, cost structure, value proposition, competitive advantage, value chain - all specific to this company.
I list key risks.
Then look at three scenarios: 1) base; 2) upside; and 3) downside. Assign rough probabilities to each. See if the reward (i.e. investment return) is worth taking on the risks. What is the distribution of my return across all three scenarios?
In other words, do I get paid for the risks I am about to take? Do I get paid enough?
I like to get fancy with scenarios. I don't know if it has ever actually influenced someone's decision on a deal I've done but I think it's fun.
I see two schools of thought on scenarios: (1) model the returns scenarios that result in a "good," "ok," and "return capital" outcomes, and then back into what you have to believe for those futures to come true; and (2) model the most likely outcome for the business given a few key assumptions, and the returns fall wherever they fall.
(2) is more intellectually satisfying, but (1) is quicker and arguably more useful. It might be really challenging to determine the market adoption of 9 new products under development by a target company, but if you can figure that the 25% IRR case only requires that one be successful, and 80% of previous launches have been successful...then I think I'd feel comfortable that the high end is within reach and spend more time understanding downside risk. Similarly, if a company is leveraged to its eyeballs and a 10% revenue miss means your investment gets flushed, then to me, it doesn't matter if the upside is the moon, it isn't making it through my IC.
Whichever scenarios you choose, I do think it's useful to try to assign probabilities to each, and then try to fit a probability distribution function to the universe of outcomes. It's totally illustrative at this point, unless you're actually using Monte Carlo simulations to model future possible outcomes over a broad set of input variables, in which case you have a lot more horsepower on your hands than I do. But the nature of the curve of a particular investment, especially when compared to other examples, is informative.
This is where transaction structuring can come into play - someone may argue that your deal is "high-risk, high-reward" because the variation in outcomes is really high. But if the variation is in a high returns band, and there's structural downside protection so that the worst you can do - the "end of the world" case - is 1.5x your capital, then ... is it really that risky?
Thanks a lot for your post - this framework is very helpful and applicable in the context of a case study interview.
Does the value creation thesis always have to be predicated upon specific actions you as the investor would take? In other words, if you are assessing a business, particularly in a timed scenario with limited information/inability to conduct real world diligence, could the vast majority of the value creation thesis simply be that "this business has a highly competitive position in this niche, high-barrier market and will ride the organic growth that the market as a whole is set to see over the investment period"?
I worry that in the context of an interview it would be difficult to isolate specific actions to create value (e.g. improve margins by consolidating factories X and Y, acquiring this competitor etc.) because I may not have enough information (e.g. competitor margins to see if this company should be performing better on a margin basis, potential M&A targets etc.)
Do you have any advice on forming a specific and impressive value creation thesis in an interview context? Thanks!
Thank you for your question.
I think you are wondering how to think about value creation from outside-in, especially when you don't have enough information about the business.
While value creation measures are different for each transaction, they are likely to come from the following areas below:
*Value creation = Operational and / or Financial *
Operational improvements could be either radical or not.
Radical include: - selling divisions, shrinking business lines, closing off unprofitable facilities - expanding aggressively, organically or through M&A - new market entry (e.g. buy a license and enter mobile telephony if I am already a broadband provider) - brand extension (e.g. I operate Nobu restaurants and will now operate Nobu hotels)
Not radical include (i.e. more of the same but better): - making pricing more sophisticated, so average price per product goes up - pursuing aggressive growth of units sold (marketing, sales, digital, influencers) - cost cutting - productivity measures (automation, IT, lean manufacturing, better operational design) - more effective value chain, switching suppliers if needed - scaling up, and spreading fixed cost base across a larger business - better governance, better board, measuring net promoter scores, better forecasting, greater customer satisfaction and hence more repeat business, cross-selling
Financial measures include: - disposing of unnecessary and unproductive fixed assets from the balance sheet - securitisation or sale & leaseback - if appropriate for the business - renegotiation of contracts - insurance, etc - working capital improvements - better capital allocation decisions
If I were in an interview situation, I would say that without knowing much detail, let's see what the business can do in the following areas and run mentally through this framework.
Does this answer your question?
What an awesome answer. Stuff like this is what makes this site worthwhile. I'll see if I can add anything of value:
...or otherwise monetize the investment. Depending on the asset and the purchase price, could be a recapitalization to dividend out, or could be annual dividends from operations if cash flow is high enough. That's more of a lower middle market strategy, though - agreed that most returns in modern-day PE are going to be driven by an exit. Oh my God, yes. The thesis should be simple. Not necessarily easy, but simple. Depends on your firm's investment strategy, honestly. Seems like just about everyone today says "we aren't just financial engineers, we're operators" so most theses involve effecting some operational improvement within a business.A thesis that said "here's a business that does X, and the demand for X is going to skyrocket in the next three years and here's why, and this business's competitors won't be able to expand fast enough, and it's an industry with very high barriers and ... holy shit, as long as they keep up with demand, they'll print money" is a perfectly valid thesis. It's just that if it's this obvious, then it's going to be expensive. I'm not a hedge fund guy, but I get the sense that this is more along the lines of a thesis they could get behind.
Yes, yes, and yes.
These are basically the sections of every investment committee memo I've ever written. Boy, have I had some arguments about this one. So I think this is true - I'd much rather work with an idiot-proof business run by idiots than with a spectacular management team operating in either an overly competitive landscape or a declining industry. (I would say that no matter how attractive the industry or the team, you can't fix a broken business model.) But this comes down to the weights you apply to sources of risk. I've seen a great business survive its management team more times than I've seen a mediocre business driven forward by the force of will of its phenomenal management team, so I'm colored by those experiences. I'm also better at evaluating markets than management, so I am more confident de-risking an investment through competitive analysis than I am sitting down with a management team.Also, I think quietly great businesses with garbage management teams can be had at a relative discount when compared to the opposite. Remember, it's not the value of the business - it's the value of the business relative to the price.
Process:
writeup 'flag' for fund partners to review. Get questions, ask co. mgmt
execute first-pass due diligence (includes channel checks,
write up prelminary investment proposal (PIP)
present PIP + model to fund partners, get questions
conduct in-depth due diligence
Expand / tighten financial model land stress-test
Information summarized in most IC memos * Overview * Approach * Facilities * Origin * Products * Product Roadmap * Technology & IP * Consumer Audience * Go-To-Market Strategy * Market Size * Competitive Advantages * Competitive Landscape * Leadership Team * Milestones to-Date * Cap Table * Financials * Other Investors * Funding * Use of Funds * Timelines & Milestones * Investment Thesis * Risks and mitigation * Science and Technology * Comparables/Peers * Exit Strategy & Timing * Exit Comps * Returns Analysis * Projected Financials
Some phenomenal answers above (and definitely taking some notes for my own use going forward), but hopefully this is helpful as well. Taking a step back, broadly speaking what I think about is as follows:
The answers won't be the same for every potential investment - for some, industry plays a big role and a big part of the thesis is significant macroeconomic tailwinds driving growth in a specific industry. Some investments have highly experienced management teams that are critical in holding an edge over the competition, others you need to bring in new management. For others, it could be tech innovation, a great product, great processes, or building scale in a highly fragmented industry. And so forth.
Keeping that framework in mind is helpful for me when I think about investments, especially #4 and reminding me to think critically about assumptions / how to diligence the investment thesis.