Saturday, November 01, 2014

On Private Equity Investing ....


Preface: This post has taken the longest time for me to write, because it summarizes my entire 10-year investing career. I'm trying to recap things we have done right, and also things we have done wrong. 

As investment professionals, we are obligated to uphold the highest ethical and professional standards in making our investment decisions.  As opposed to public equity analysts or mutual fund managers, private company investors don't have the benefit of public companies and their SEC-sanctioned disclosures and regulations.   So the burden lies on us to identify strong investments, companies with good potential.  I've grown to appreciate several Do's and Don'ts to keep in mind during the investment process:

1. Don't fall in love with a deal
If you force yourself into doing a deal because of external pressures, then you're not doing it right; I'm talking things like sector allocation ("I need to do a coal deal because everybody else does"), timing ("the market is so hot and I haven't done a deal yet") or even something trivial ("the CMO can hook me up with VIP football tickets").  Listen to your own team, is there any dissenting opinions about the deal and why.  Keep in mind at the end of the day, none of these pressures matter and investors only care about realized returns. And don't forget...

2. Don't skimp on due diligence
For large investors, due diligence means hiring an alphabet soup of BCG, PWC, OMM, or other consultants to write 100-page reports evaluating everything from industry trends, legal status, and financial accounts of the target company.  For smaller firms, due diligence means the team of analysts and associates run around talking to suppliers and customers.  Either way, don't skimp on DD.  Sure, if you end up striking it big it wouldn't matter, but if you end up losing money then your investors will grill you on how much or how little you spent on diligence.  Spend the brainpower, whether it's BCG's or your analysts'.

3. Dive deep into the strengths and weaknesses of management
Unless you're putting in an entire new group of people to run the company, you need to gauge how strong (or weak) your frontmen are.  If they are lacking in some aspects, you need to identify talent that can gel with and augment the rest of the team.  Just like football, investing is a team sport; and you happen to be GM, head coach, and head of PR concurrently.  After the team is set, you need to....

4. Carefully set proper incentives 
If profitability or sustainability is your target, don't set top-line growth as your benchmark.  PEs differ from VCs in this aspect.  VCs only need to usher the team to the next funding round.  PEs need to get to either sustainability or a liquidity event.  Whatever it is, the goal determines the incentives that need to be set.  Formulate the incentives for top management, then work down and determine the middle and lower rank's incentives.  Regular employees may not appreciate stock options; whereas entrepreneurs may prefer a larger portion in them.

5. Spend time with your co-investors/partners 
How do your partners see the investment.  What do they think about the current management.  Of course there is a risk of herd mentality here, but it never hurts to venture outside of your cave and know what the rest of the world sees. Do this in the beginning  and throughout the investment life, even if you are the lead investor.  *Especially if* you are the lead investor, because leaders are most prone to pride and tunnel vision.

6. Just like in real life, prepare for the unexpected
If you are expecting financing at some stage, prepare for if it doesn't happen or gets delayed. These things happen, sometimes no fault of your own.  Perhaps you don't get your license in time.  Perhaps the bank has to go a different strategy.  Whatever the worst case scenario is, you need to prep for it.

Long story short, the investment process does not stop when the SPA is signed and payment is wired.  In fact, it is just the beginning.  It is what you do afterwards that creates (or destroys) value.

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