Private equity is an apprenticeship. As a young practitioner at a start-up, I spend a decent amount of time picking the brains of the many grey-haired executives that have made their mark in the industry. I try to ask variations of the same questions to each investor so I can tally their responses. Below is a summary of responses to two questions I asked the most in 2016.
Question 1: What are the key drivers of success for a fund?
- Valuation: Valuation is often the biggest driver of return. Valuation must allow for the investors to achieve their mandated return while representing (i) a realistic growth profile for the business and (ii) the operating team’s capability and ambition. Not all businesses must achieve 100% C.A.G.R and billion dollar valuations! Venture investors looking for outsized returns should avoid investing in entrepreneurs seeking to optimize for other equally noble goals e.g., social impact or steady profitability. Additionally, investors must adjust their calculations for the impact of other systematic factors – economic cycle and exchange rates – on exit valuations.
- Intentions and proclivities: It’s tempting to pick business partners based on resumes, references and stated intentions. However, certain contextual factors that are harder to uncover might result in value-destroying conflict. Entrepreneurs feeling pressured to conclude a deal might agree to restrictive conditions, but retain the resolve to renege. Minority investors feeling confident about their legal prowess or their skill to influence might include “Convince the entrepreneur…” as part of an investment thesis. Even where there’s honest intent to cooperate, certain inclinations that are a result of character traits or past experience, could result in even more debilitating conflict.
- Idea/strategy vs. execution: (I’m lumping ideas and strategy to tie to the chart below): Mike Tyson once said that “everyone has a plan until they get punched in the face”. The strongest of business strategies barely survive impact with reality. Great investors spend time with operating teams to thoroughly unpack, test and update execution plans. Derek Sivers presented this idea succinctly in the illustration below. They also update their competitive edge e.g., through engaging advisers, recruiting stellar hires, participating in industry events etc.
Question 2: What is a PE firm’s most meaningful contribution to its portfolio companies?
- Facilitation: A private equity firm’s mandate is to build a platform around its core strengths and to render the platform accessible to its portfolio companies. Successful firms are able to subdue the common penchant to dominate relationships with portfolio companies, but still command professional trust and respect to be summoned early for material issues. Entrepreneurs place their first calls to firms whose competitive advantage is clear, relevant and accessible. For example, family offices with more flexible mandates for capital deployment can cement their advantage by maintaining ample reserves and developing clear processes to efficiently fund follow-on rounds. Eventually, this reputation could translate into preferred access to proprietary deals.
My article is a simplified summary of the opinions I’ve collected. I’d love to gain additional perspective from your experiences and research.