PE professional, what's your process while judging an investment?

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What factors or frameworks do you use while building up a thesis? Are there some that get more weight (I.e industry vs management)

Comments (47)

 
Most Helpful
Jul 2, 2020 - 2:33pm

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:

  1. Transaction dynamic
  2. Market
  3. Business model and competitive position
  4. Management team
  5. Financial performance
  6. Investment thesis and value creation measures
  7. Valuation and structure
  8. Exit and return
  9. Risk and reward

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

 
Jul 3, 2020 - 3:46am

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.

 
Jul 3, 2020 - 7:31pm

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!

 
Jul 4, 2020 - 12:50pm

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?

 
Jul 4, 2020 - 10:21pm

usually there are some tell-tale signs. On this side of the fence, once you churned enough screening investment memos in your junior years you'll quickly find out that there's a playbook for this, even from reading a simple CIM. ideas can't be completely random, even at the outside-in stage

for instance, open the CIM and:
- compare market growth and your company's growth: company underperforming vs market? problem is losing share so float to the interviewer that you might need to improve your product competitiveness
- margins have been flat or declining even with good revenue growth in last 3-5 years? cost structure problem. suggest ideas to reduce cost depending on where this cost build up is coming from (eg G&A).
- working capital days going up? suggest working capital improvements

there's a whole playbook I have in my mind on what to look out for and when to say what. all of the info I mentioned above is usually available in the CIM. if you approach it systematically like a consulting case interview (structured and interact with interviewer to probe for key info), you will crush it.

all the best!

-

 
Jul 3, 2020 - 7:50pm

What an awesome answer. Stuff like this is what makes this site worthwhile. I'll see if I can add anything of value:

Tamara_S:

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".


...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.

Tamara_S:

A, B and C should be:

= few things, not hundreds


Oh my God, yes. The thesis should be simple. Not necessarily easy, but simple.
Tamara_S:

= within your control, and not completely external dynamic (e.g. NOT oil prices will rise and we will make money)

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.

Tamara_S:

= 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

Yes, yes, and yes.

Tamara_S:

The process is as follows:
  1. Transaction dynamic
  2. Market
  3. Business model and competitive position
  4. Management team
  5. Financial performance
  6. Investment thesis and value creation measures
  7. Valuation and structure
  8. Exit and return
  9. Risk and reward

These are basically the sections of every investment committee memo I've ever written.
Tamara_S:

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.

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.

Array
 
Jul 23, 2020 - 3:06pm

Really really quality post - thank you. You categorically state that industry is far more important than management, but I'd imagine that recruiting and onboarding a new executive (especially at a middle market company) would cost meaningful time and money, not to mention distract you from other value-creating initiatives. Do you think smaller PE firms that focus on founder-owned businesses would take a different view on the question of management versus industry?

 
Jul 4, 2020 - 3:31am

Process:

  1. get desktop materials, evaluate those
  2. speak to management
  3. writeup 'flag' for fund partners to review. Get questions, ask co. mgmt

  4. execute first-pass due diligence (includes channel checks,

  5. build financial model
  6. write up prelminary investment proposal (PIP)

  7. present PIP + model to fund partners, get questions

  8. conduct in-depth due diligence

  9. Expand / tighten financial model land stress-test

  10. write final investment proposal (FIP)

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

 
  • Intern in IB - Restr
Jul 4, 2020 - 12:41pm

Very helpful, thank you. Can you elaborate on what you mean by the following:
- "Approach" (transaction structure?)
- "Facilities" (Credit or physical facilities?)
- "Origin" (where you sourced the deal?)
- "Product roadmap" (how is this different from "Products"?)
- "Science & Tech" (how is this diff from "Tech & IP"?)

Also, how do you categorize the risks in your "Risks & Mitigation" section, and what strategies do you use to mitigate risks?

 
Jul 4, 2020 - 8:13pm

This I pulled from a recent VC investment, but would also easily apply to a growth capital deal. I've done only one BOs in my career so it's mostly GC.

  • "Approach" - company's approach to creating their product. It's a science-driven investment
  • "Facilities" - labratory facilities that they use to create their product
  • "Origin" - yes, where and who sourced the deal
  • "Product roadmap" - roadmap is the timeline which they will follow and the milestones towards product creation. Right now they have proof of concept, but not a marketable product.
  • "Science & Tech" (how is this diff from "Tech & IP"?) - split the tech/science into two sections, as it covered the broader state fo the science across the industry, as opposed to the company's own unique tech and registered IP
 
Jul 4, 2020 - 4:30am

Amazing answers above. Whilst the "content page" summary really doesn't differ that much between firm to firms, I would add that true differentiation in buyout shops comes from the value creation element of the whole investment process.

Everyone recognizes what is objectively a good business when they see one. Its also not rocket science to call an industry "good" anymore. Whilst hedgies (HF managers) make their money off finding differentiated insights and misunderstood businesses, this is much less the case in Private Equity where literally all the information / transparency is out there (so less room for variant views).

The value creation is a huge part of this because it gives you conviction in the returns. Recognizing "good businesses / industries" is a commoditized skill. Everyone has (more or less) equal access to financing. Apart from paying the highest valuation, being able to i) have conviction and ii) actually execute on your value creation is what makes buyout firms fundamentally differ in generating superior returns

 
  • Intern in IB - Restr
Jul 4, 2020 - 12:44pm

Incoming IBD analyst here. If "recognizing good businesses" is easy, why do PE associate interviews test just that? Also, how can you stand out in those interviews by proposing some operational improvements or financial engineering strategies? Or would you advice just focusing on evaluating the business?

 
Jul 4, 2020 - 10:11pm

it's 'easy' meaning it's not unique to any PE firm themselves and they all have the ability to do it. it's basic to them.

it's included in the PE associate test because... well the interviewees know nothing about PE (given they've not worked in PE?) so they presumably should start testing you there first? just like how the modelling tests are honestly not hard once you have the reps in and it's not a real differentiator amongst candidates at all.

i would spend my time knowing how to evaluate the business and only when you're confident, then move on to the value creation piece.

each time I've heard a candidate floor an interview, it's precisely because they can do both and do it to a certain level of depth.

 
Jul 4, 2020 - 8:40pm

I am still learning this trade to be honest, as most of my career has seen me exiled to fundraising gulag. I work on deals for a VC I advise on the side, just to rebuild my PE deal muscles. Clearly access to sought-after deals is key. Being a bright brand name that deals flock to helps. Pricing on highly-sought-after deals is always a challenge to suss out. I'm good at doing research and organizing that information. But sussing out whether to invest is a more challenging question.

 
Jul 5, 2020 - 5:19pm

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:

  1. "How does this company make money?"
  2. "Why does this company make money?"
  3. "Will this company continue to make money in the future?"
  4. "What do you have believe for this investment to make money?"

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.

 
Jul 6, 2020 - 12:43am

Awesome comment. Really like this framework - it's simple yet powerful.

I use the "what do you have to believe" framing for projections a lot. Instead of predicting a future, let's assume a particular future. What would have had to happen for that future to come true? Lots of things? Just a few? Are they reasonable? Are they knowable? Can you control them?

Array
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