How to create a clear private equity investment thesis
For every dozen private equity deals, only one or two generate significant returns to their investors, according to Investopedia. The biggest reason why deals either fail to deliver or fall through altogether : Firms often neglect to deal with red flags early on in an agreement. To help determine whether a deal will be profitable, private equity firms must first establish a clear, concise investment thesis.
A private equity investment thesis is an evidence-based case built in favor of a particular investment opportunity. It opens with a two- to three-sentence argument showing how the potential deal supports a general partner’s fund investment strategy, then provides details that support that conclusion.
An investment thesis is required for all buy-side dealmakers. Beyond fulfilling a requirement, the detailed proposition serves to:
- Crystallize the group’s tactical plan, putting strategy into action
- Inform intermediaries, investors, and fellow partners what’s at stake if the firm does — or doesn’t — invest
- Answer the variety of questions that arise throughout a typical transaction
Follow these next steps to create a winning private capital markets investment thesis and identify the best opportunities for your firm.
Detail macroeconomic factors
To create a successful investment thesis, firms must first answer global and niche-agnostic economic questions. This will help set the stage for the acquisition target to shine against a macro backdrop .
Start by listing any relevant current headlines , political and social developments, and even consumer trends that are affecting investments across the board. These news stories will remind investors what they and your potential portfolio companies (portcos) are facing today.
For example, you might list the U.S. Securities and Exchange Commission’s most recent proposals, e-commerce adoption, or European political volatility as factors that are affecting investments. Detail the way these factors are helping or hindering the private capital markets in general.
You should also list headlines that affect the acquisition target’s industry, sector, and subsector, and explain whether these developments favor growth for your private company. For example, if a general partner’s acquisition target was in the durable goods manufacturing space, the principal would include the U.S. freight transportation services index (TSI) as a macroeconomic factor in his investment thesis, and would describe how its recovery predicts smoother supply chains to ease investor worries. Similarly, you can explain in your investment thesis how your portco will be positioned competitively among its sector rivals.
Risks aren’t traditionally included in investment theses, but you can include them if they strengthen your macroeconomic analysis . You may want to include factors such as whether global or national conditions oppose the potential portco’s growth or the investment’s performance. You can also describe how your acquisition target would sidestep or weather those pitfalls.
Bain & Co. experts recently declared that macroeconomic instability is dealmaking’s number-one enemy . Position your investment thesis to shine by having a good handle on macroeconomic factors.
Detail microeconomic factors
The macroeconomic information you gather can help you drill down into more granular information about an investment opportunity . Narrow your proposed direction by including microeconomic details about company-level questions to your investment thesis. Try to answer questions such as:
- Why do you believe the target’s founder or owner will lead the company to growth? Describe ways the current CEO demonstrates innovative, creative problem-solving and strong leadership.
- What do the company’s financial statements reveal about the business’s record-keeping? Are the reports straightforward and easy to read? Before due diligence, investigate the business’s financials to uncover thesis-supporting insights.
- What do the company’s financial statements reveal about the viability of the business? Are there clues as to how leadership has handled finances at key inflection points? How much variance does each metric — such as return on equity, profit, return on assets, and earnings per share — exhibit?
- How has the company navigated cash flow surprises in the past? Surprises can include headwinds and windfalls, and an event like a spike in the company’s quick ratio must be handled with as much finesse as a cash shortage. What proof is there that the business keeps growing sustainably amid short-term volatility ?
- How has the company used seed money? James W. Frick, former Vice President of Public Relations at the University of Notre Dame, famously said, “Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are.” When you look at previous injections , don’t just analyze the company’s capital efficiency. Draw conclusions about what the team prioritizes, such as growth over client retention.
- What opportunities are there for better cost management? Are there areas where the business is spinning its wheels and expending resources without gaining effective traction? Could certain actions — such as managing talent differently, renegotiating vendor agreement terms, or terminating a failed market expansion — efficiently address these areas ?
- What’s the company’s reputation like? Consider hiring a market research firm to perform an exploratory branding assessment. Take it to the next level by gathering observations from clients, employees, and vendors. If any quotes prove highly relevant, include them in your investment thesis.
- In what ways are competitors excelling or lagging? The ideal investment is in a market where rivals are failing to innovate. Does your target acquisition have what it takes to exploit market conditions faster and better than competitors?
- What could go wrong? The best investment theses don’t deny risks but instead address them at an early stage. As you list potential pitfalls, identify ways the private equity firm’s management team can dodge or defuse these hazards .
Consider the professionals at Morgan Stanley , who use three questions to formulate the microeconomic portions of their investment theses.
- Agility and defensibility — Is the company a disruptor or is it insulated from disruptive change?
- Financial viability of the business — Does the company demonstrate financial strength with high returns on invested capital, high margins, strong cash conversion, low capital intensity, and low leverage?
- ESG (environmental, social, and governmental) and the responsibility to do no harm — Are there environmental or social externalities not borne by the company, or are there governance and accounting risks that may alter the investment thesis?
Once you’ve compiled a substantial body of information to use in your investment thesis, sort the details by order of importance. Each deal’s details should be arranged differently since each investment is unique.
Establish and describe the trade setup
The final component of a good investment thesis answers the question, “So what?” It offers bold implications of the micro- and macroanalysis you just performed, and reveals what your next steps should be .
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. Propound 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.
Keep in mind that the industry standard expects your firm to find the product of estimated earnings and your expected multiple. For example:
- Estimated earnings × EV/EBITDA = target price
- Estimated earnings × FCF/market capital = target price
- Estimated earnings × Price-to-earnings (P/E) ratio = target price
In your investment thesis, explain why your firm uses a particular multiple and how it came to estimate 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 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 outlines some of the strategic moves and operational improvements you believe will generate short-term wins and future sustainable growth. It should include no more than three or four actions; for example, you could include initiatives like increasing dividends or paying down debt to put free cash flow to work.
To wrap up the investment thesis, discuss how the deal would work into and support the fund’s overall investment strategy. Detail ways your firm brings a competitive advantage to the deal. Have your partners demonstrated acumen with similar deals? List the reasons why you’re the company’s best bet for making above-market returns.
Summarize your investment thesis
Now that you’ve built a complete — but also quite complex — investment thesis, it’s time to develop a clear, effective presentation . General partners distill their investment theses into bite-size, portable overviews that are more memorable and digestible for their audiences. Concisely summarizing your thesis will:
- Help busy readers better understand your thesis. For skimmers and scanners who want to skip around your thesis, a synopsis gives them a starting and ending point.
- Steer future investments, further defining your role in your niche. If, for example, a particular investment thesis persuades limited partners and intermediaries to commit to an event-based investment, you may become a firm known for that type of strategy.
- Provide you with a successful deal that you can use as an example during events like employee training, marketing, and roadshows. Imagine one of your vice presidents attends a trade event and meets an esteemed limited partner who expresses interest in your firm’s most recent deal. A quick investment thesis summary is the perfect way to explain the deal and further the partner’s interest.
- Set up a memorial to look back on. As the investment’s time horizon approaches, your team should reflect on how the deal began and what twists and turns you and your portco navigated along the way. This exercise will help prepare your team for future scenarios and investment opportunities.
Examples of investment thesis summaries
Authors David Harding and Sam Rovit highlighted a summary of Clear Channel’s merger-specific investment thesis. The media company had decided to expand into outdoor advertising sales and needed to build its case and present it to stakeholders. Note the three concrete benefits the company describes in detail:
“Clear Channel’s expansion into outdoor advertising leverages the company’s core competencies in two ways: First, the local market sales force that is already in place to sell radio ads can now sell outdoor ads to many of the same buyers, and Clear Channel is uniquely positioned to sell both local and national advertisements . Second, much like the radio industry 20 years ago, the outdoor advertising industry is fragmented and undercapitalized. Clear Channel has the capital needed to ‘roll up’ a significant fraction of this industry, as well as the cash flow and management systems needed to reduce operating expenses across a consolidated business.”
This summary explains that the acquiring executives planned to generate returns by:
- Using existing talent and preventing costs usually associated with successful deals
- Applying skills and processes from one sector to improve the newly added operation
- Combining assets or “ rolling up ” to share costs and benefits through a newly formed industry rather than fragmented sectors
Best of all, the summary uses a single paragraph to get the job done.
Here are a few examples from dealmakers in other private capital markets:
- Private equity — Read the overviews of investment theses from Arcspring , Sun Capital Partners , WestView Capital Partners , and Safanad , a team that clearly communicates its commitment to private equity with real estate incorporated.
- Real estate private equity (REPE) — CrowdStreet articulately summarizes how and why the firm invests, and it states its intentions by asset class and sector. The synopsis covers hospitality, industrials, health care, multifamily, office space, retail, self-storage, senior care, student housing, and life sciences.
- Impact investing — The FSIG and Creatella investment thesis summaries are clear and give a high-level flyover of the model deal’s macro- and microeconomics.
- Venture capital — Wavemaker Partners , Chloe Capital , and La Poste Ventures substitute corporate language with simpler and more digestible terms.
What to do with your new investment thesis
An investment thesis is more than a report: It’s the developing narrative of a successful deal. You’ll likely need to update your thesis and presentation more than once, and in a variety of ways, throughout the lifecycle of the investment.
Publish the investment thesis in your team’s internal deal management system, and assign permissions to those who refer to the plan often. Set up notifications so that you receive alerts whenever someone comments or edits the investment thesis. If your current deal management system doesn’t support this level of effective collaboration, contact DealCloud to request a demo today.
Remember: Successful deals start with successful investment theses. Don’t let investors wade into a transaction before taking the steps above to identify red flags and create an evidence-based plan that everyone can buy into.
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The Private Equity Case Study: The Ultimate Guide
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The private equity case study is an especially intimidating part of the private equity recruitment process .
You’ll get a “case study” in virtually any private equity interview process , whether you’re interviewing at the mega-funds (Blackstone, KKR, Apollo, etc.), middle-market funds , or smaller, startup funds.
The difference is that each one gives you a different type of case study, which means you need to prepare differently:
What Should You Expect in a Private Equity Case Study?
There are three different types of “case studies”:
- Type #1: A “ paper LBO ,” calculated with pen-and-paper or in your head, in which you build a simple leveraged buyout model and use round numbers to guesstimate the IRR.
- Type #2: A 1-3-hour timed LBO modeling test , either on-site or via Zoom and email. This is a pure speed test , so proficiency in the key Excel shortcuts and practice with many modeling tests are essential.
- Type #3: A “take-home” LBO model and presentation, in which you might have a few days up to a week to pick a company, research it, build a model, and make a recommendation for or against an acquisition of the company.
We will focus on the “take-home” private equity case study here because the other types already have their own articles/tutorials or will have them soon.
If you’re interviewing within the fast-paced, on-cycle recruiting process with large funds in the U.S. , you should expect timed LBO modeling tests (type #2).
If the firm interviews dozens of candidates in a single weekend, there’s no time to give everyone open-ended case studies and assess them.
You might also get time-pressured LBO modeling tests in early rounds in other financial centers, such as London .
The open-ended case studies – type #3 – are more common at smaller funds, in off-cycle recruiting, and outside the U.S.
Although you have more time to complete them, they’re significantly more difficult because they require critical thinking skills and outside research.
One common misconception is that you “need” to build a complex model for these case studies.
But that is not true at all because they’re judging you mostly on your investment thesis , your presentation, and your ability to answer questions afterward.
No one cares if your LBO model has 200 rows, 500 rows, or 5,000 rows – they care about how well you make the case for or against the company.
This open-ended private equity case study is often the final step between the interview and the job offer, so it is critically important.
The Private Equity Case Study, in Parts
This is another technical tutorial, so I’ve embedded the corresponding YouTube video below:
Table of Contents:
- 4:32: Part 1: Typical Case Study Prompt
- 6:07: Part 2: Suggested Time Split for a 1-Week Case Study
- 8:01: Part 3: Screening and Selecting a Company
- 14:16: Part 4: Gathering Data and Doing Industry Research
- 22:51: Part 5: Building a Simple But Effective Model
- 26:32: Part 6: Drafting an Investment Recommendation
Files & Resources:
- Case Study Prompt (PDF)
- Private Equity Case Study Slides (PDF)
- Cars.com – Highlighted 10-K (PDF)
- Cars.com – Investor Presentation (PDF)
- Cars.com – Excel Model (XL)
- Cars.com – Investment Recommendation Presentation (PDF)
We’re going to use Cars.com in this example, which is one of the many case studies in our Advanced Financial Modeling course:
Advanced Financial Modeling
Learn more complex "on the job" investment banking models and complete private equity, hedge fund, and credit case studies to win buy-side job offers.
The full course includes a detailed, step-by-step walkthrough rather than this summary, an additional advanced LBO model, and other complex case studies for investment banking, hedge funds, and credit.
Part 1: Typical Private Equity Case Study Prompt
In some cases, they’ll give you a company to analyze, but in others, you’ll have to screen for companies yourself and pick one.
It’s easier if they give you the company and the supporting documents like the Information Memorandum , but you’ll also have less time to complete the case study.
The prompt here is very open-ended: “We like these types of deals and companies, so pick one and present it to us.”
The instructions are helpful in one way: they tell us explicitly not to build a full 3-statement model and to focus on the market and strategy rather than an “extremely complex model.”
They also hint very strongly that the model must include sensitivities and/or scenarios:
Part 2: Suggested Time Split for a 1-Week Private Equity Case Study
You have 7 days to complete this case study, which may seem like a lot of time.
But the problem is that you probably don’t have 8-12 hours per day to work on this.
You’re likely working or studying full-time, which means you might have 2-3 hours per day at most.
So, I would suggest the following schedule:
- Day #1: Read the document, understand the PE firm’s strategy, and pick a company to analyze.
- Days #2 – 3: Gather data on the company’s industry, its financial statements, its revenue/expense drivers, etc.
- Days #4 – 6: Build a simple LBO model (<= 300 rows), ideally using an existing template to save time.
- Day #7: Outline and draft your presentation, let the numbers drive your decisions, and support them with the qualitative factors.
If the presentation is shorter (e.g., 5 slides rather than 15) or longer, you could tweak this schedule as needed.
But regardless of the presentation length, you should spend MORE time on the research, data gathering, and presentation than on the LBO model itself.
Part 3: Screening and Selecting a Company
The criteria are simple and straightforward here: “The firm aims to find undervalued companies with stagnant or declining core businesses that can be acquired at reasonable valuation multiples and then turn them around via restructuring, divestitures, and add-on acquisitions.”
The industry could be consumer, media/telecom, or software, with an ideal Purchase Enterprise Value of $500 million to $1 billion (sometimes up to $2 billion).
Reading between the lines, I would add a few criteria:
- Consistent FCF Generation and 10-20%+ FCF Yields: Strategies such as turnarounds and add-on acquisitions all require cash flow. If the company doesn’t generate much Free Cash Flow , it will have to issue Debt to fund these strategies, which is risky because it makes the deal very dependent on the exit multiple.
- Relatively Lower EBITDA Multiples: If the company has a “stagnant or declining” core business, you don’t want to pay 20x EBITDA for it. An ideal range might be 5-10x, but 10-15x could be OK if there are good growth opportunities. The IRR math also gets tougher at high EBITDA multiples because the maximum Debt in most deals is 5-6x.
- Clean Financial Statements and Enough Detail for Revenue and Expense Projections: You don’t want companies with 2-page-long Cash Flow Statements or Balance Sheets with 100 line items; you can’t spare the time required to simplify and consolidate these statements. And you need some detail on the revenue and expenses because forecasting revenue as a simple percentage growth rate is a bad idea in this context.
We used this process to screen for companies here:
- Step 1: Do a high-level screen of companies in these 3 sectors based on industry, Equity Value or Enterprise Value, and geography.
- Step 2: Quickly review the list of ~200 companies to narrow the sector.
- Step 3: After picking a specific sector, narrow the choices to the top few companies and pick one of them.
In software , many of the companies traded at very high multiples (30x+ EBITDA), and others had negative EBITDA, so we dropped this sector.
In consumer/retail , the companies had more reasonable multiples (5-10x), but most also had low margins and weak FCF generation.
And in media/telecom , quite a few companies had lower multiples, but the FCF math was challenging because many companies had high CapEx requirements (at least on the telecom side).
We eliminated companies with very high multiples, negative EBITDA, and exorbitant CapEx, which left this set:
Within this set, we then eliminated companies with negative FCF, minimal information on revenue/expenses, somewhat-higher multiples, and those whose businesses were declining too much (e.g., 20-30% annual declines).
We settled on Cars.com because it had a 9.4x EBITDA multiple at the time of this screen, a declining business with modest projected growth, 25-30% margins, and reasonable FCF generation with FCF yields between 10% and 15%.
If you don’t have Capital IQ for this exercise, you’ll have to rely on FinViz and use P / E multiples as a proxy for EBITDA multiples.
You can click through to each company to view the P / FCF multiples, which you can flip around to get the FCF yields.
In this case, don’t even bother looking for revenue and expense information until you have your top 2-3 candidates.
Part 4: Gathering Data and Doing Industry Research
Once you have the company, you can spend the next few days skimming through its most recent annual report and investor presentation, focusing on its financial statements and revenue/expense drivers.
With Cars.com, it’s clear that the company’s “Dealer Customers” and Average Revenue per Dealer will be key drivers:
The company also has significant website traffic and earns advertising revenue from that, but it’s small next to the amount it earns from charging car dealers to use its services:
It’s clear from this quick review that we’ll need some outside research to estimate these drivers, as the company’s filings and investor presentation have little.
Fortunately, it’s easy to Google the number of new and used car dealers in the U.S. and estimate the market size and share like that:
The company’s market share has been declining , and we expect that trend to continue, but it’s not clear how rapid the decline will be.
Consumers are increasingly buying directly from other consumers, and dealers have less reason to use the company’s marketplace services than in past years.
We create an area for these key drivers, with scenarios for the most uncertain one:
You might be wondering why there’s no assumed uptick in market share since this is supposed to be a “turnaround” case study.
The short answer is that we think the company is unlikely to “turn around” its core business in this time frame, so it will have to move into new areas via bolt-on acquisitions .
For example, maybe it could acquire smaller firms that sell software and services to dealers, or it could acquire physical or online car dealerships directly.
Another option is to acquire companies that can better monetize Cars.com’s large and growing web traffic – such as companies that sell auto finance leads.
As part of this process, we also need to research smaller companies to acquire, but there isn’t much to say about this part.
It comes down to running searches on Capital IQ for smaller companies in related industries and entering keywords like “auto” in the business description field.
In terms of the other financial statement drivers , many expenses here are simple percentages of revenue, but we could also link them to the employee count.
We also link the website traffic to the sales & marketing spending to capture the spending required for growth in that area.
Finally, we need to input the financial statements for the company, which is not that hard since they’re already fairly clean:
It might be worth consolidating a few items here, but the Income Statement and partial Cash Flow Statement are mostly fine, which means the Excel versions are close to the ones in the annual report.
Part 5: Building a Simple But Effective Model
The case study instructions state that a full 3-statement model is not necessary – but even if they had not, such a model would rarely be worthwhile.
Remember that LBO models, just like DCF models , are based on cash flow and EBITDA multiples ; the full statements add almost nothing since you can track the Cash and Debt balances separately.
In terms of model complexity, a single-sheet LBO with 200-300 rows in Excel is fine for this exercise.
You’re not going to get “extra credit” for a super-complex LBO model that takes days to understand.
The key schedules here are:
- Transaction Assumptions – Including the purchase price, exit assumptions, scenarios, and tranches of debt. Skip the working capital adjustment unless they specifically ask for it. For more on these nuances, see our coverage of Enterprise Value vs. purchase price and cash-free debt-free deals .
- Sources & Uses – Short and simple but required to calculate the Investor Equity.
- Revenue, Expense, and Cash Flow Drivers – These don’t need to be super-complex; the goal is to go beyond projecting revenue as a simple percentage growth rate.
- Income Statement and Partial Cash Flow Statement – The goal is to calculate Free Cash Flow because that drives Debt repayment and Cash generation in an LBO.
- Add-On Acquisitions – These are part of the “turnaround strategy” in this deal, so they’re quite important.
- Debt Schedule – This one is quite simple here because the deal is not dependent on financial engineering.
- Returns Calculations – The IPO vs. M&A exit options add a bit of complexity.
- Sensitivity Tables – It’s difficult to draft the investment recommendation without these.
Skip anything that makes your life harder, such as circular references in Excel (to avoid these, use the beginning Cash and Debt balances to calculate interest).
We pay special attention to the add-on acquisitions here, with support for their revenue and EBITDA contributions:
The Debt Schedule features a Revolver, Term Loans, and Subordinated Notes:
The Returns Calculations are also simple; we do assume a bit of Multiple Expansion because of the company’s higher growth rate by the end:
Could we simplify this model even further?
I don’t think the M&A vs. IPO exit options mentioned above are necessary, and we could also drop the “Growth” vs. “Value” options for the add-on acquisitions:
Especially if we recommend against the deal, it’s not that important to analyze which type of add-on acquisition works best.
It would be more difficult to drop the scenarios and Excel sensitivity tables , but we could restructure them a bit and fold the scenario into a sensitivity table.
All investing is probabilistic, and there’s a huge range of potential outcomes – so it’s difficult to make a serious investment recommendation without examining several outcomes.
Even if we think this deal is spectacular, we must consider cases in which it goes poorly and how we might reduce those risks.
Part 6: Drafting an Investment Recommendation
For a 15-slide recommendation, I would recommend this structure:
- Slides 1 – 2: Recommendation for or against the deal, your criteria, and why you selected this company.
- Slides 3 – 7: Qualitative factors that support or refute the deal (market, competition, growth opportunities, etc.). You can also explain your proposed turnaround strategy, such as the add-on acquisitions, here.
- Slides 8 – 13: The numbers, including a summary of the LBO model, multiples vs. comps (not a detailed valuation), etc. Focus on the assumptions and the output from the sensitivity tables.
- Slide 14: Risk factors for a positive recommendation, and the counter-factual (“what would change your mind?”) for a negative one. You can also explain the potential impact of each risk on the returns and how you could mitigate these risks.
- Slide 15: Restate your conclusions from Slide 1 and present your best arguments here. You could also change the slide formatting or visuals to make it seem new.
“OK,” you say, “but how do you actually make an investment decision?”
The easiest method is to set criteria for the IRR or multiple of invested capital in each case and say, “Yes” if the deal achieves those numbers and “No” if it does not.
For example, maybe the targets are a 30% IRR in the Upside case, a 20% IRR in the Base case, and a 1.0x multiple in the Downside case (i.e., avoid losing money).
We do achieve those numbers in this deal, but the decision could go either way because the deal is highly dependent on the add-on acquisitions.
Without these acquisitions, the deal does not work; the IRR falls by 10%+ across all the scenarios and turns negative in the Downside case.
We need at least 5 good acquisition candidates matching very specific financial profiles ($100 million Purchase Enterprise Value and a 15x EBITDA purchase multiple with 10% revenue growth or 5x EBITDA with 3% growth).
The presentation includes some examples of potential matches:
While these examples are better than nothing, the case is not that strong because:
- Most of these companies are too big or too small to fit into the strategy proposed here of ~$100 million in annual acquisitions.
- The acquisition strategy is unclear ; acquiring and integrating dealerships (even online ones) would be very, very different from acquiring software/data/media companies.
- And since the auto software market is very niche, there’s probably not a long list of potential acquisition candidates beyond the few we found.
We end up saying, “Yes” in this recommendation, but you could easily reach the opposite conclusion because you believe the supporting data is weak.
In short: For a 1-week open-ended case study, this approach is fine, but this specific deal would probably not stand up to a more detailed on-the-job analysis.
The Private Equity Case Study: Final Thoughts
Similar to time-pressured LBO modeling tests, you can get better at the open-ended private equity case study by “putting in the reps.”
But each rep is more time-consuming, and if you have a demanding full-time job, it may be unrealistic to complete multiple practice case studies before the real thing.
Also, even with significant practice, you can’t necessarily reduce the time required to research an industry and specific companies within it.
So, it’s best to pick companies and industries you already know and have several Excel and PowerPoint templates ready to go.
If you’re targeting smaller funds that use off-cycle recruiting, the first part should be easy because you should be applying to funds that match your industry/deal/client background.
And if not, you can always make a lateral move to a bulge bracket bank and interview at the larger funds if you prefer the private equity case study in “speed test” form.
If you liked this article, you might be interested in:
- The Growth Equity Case Study: Real-Life Example and Tutorial
- The Full Guide to Healthcare Private Equity, from Careers to Contradictions
- Healthcare Investment Banking: The Best Group to Check Into When Human Civilization is Collapsing?
About the Author
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street . In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.
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How to Write an Investment Thesis in Private Equity
Get looped in.
2022 was tough for M&A. Private equity deal volume was 46% lower than the previous year. Venture capital deals were down 42% globally in the first 11 months. And as deal volume slows, dry powder continues to grow, with more than $1 trillion USD in the US alone.
This surplus of cash coupled with a lack of deal flow means firms must change how they do business to succeed in 2023. While the first step is to supplement intermediary deals with a direct sourcing model, economic uncertainty is causing firms to refine their outbound strategies.
Dealmakers must find ways to be highly efficient with their time and search only for the most strategic investments. They must make a strong case for each and every transaction with a clear rationale of why this company should choose their firm amidst stiff competition.
The best way to do that is by carefully crafting an investment thesis and using it to guide your direct deal sourcing efforts. Keep reading to learn more.
What Is an Investment Thesis in Private Equity?
An investment thesis is, quite literally, a thesis statement. It's succinct, yet comprehensive enough to serve as your firm's guiding principle to both source and secure ideal investments.
Imagine you're back in school and writing a term paper. Remember how a thesis was treated as a single defining statement that guided the development of your entire paper? The same is true of an investment thesis for your private equity firm. Unlike your term paper, however, firms often have more than one thesis because they often focus on multiple types of deals at once.
Dealmakers' theses can also be broken down into two specific types: top-down and bottom-up. A top-down investment thesis is something that helps your team understand and seek out ideal investment targets when sourcing.
Top-Down Investment Thesis for Venture Capital Example:
"This $10MM seed fund focuses on US-based cannabis startups that are furthering the industry through technology and infrastructure research and development that can leverage our partners' vast experience in the logistics and supply chain sectors."
Once your firm has identified an ideal company that fits its top-down thesis, it's time to create a bottom-up version. Far more direct and specific in nature, a bottom-up investment thesis includes everything from particular information about the target company including financial statements and forecasting, future business plans, funding strategy reasoning, industry trends, etc. as well as why your firm is the best choice.
Bottom-Up Investment Thesis for Private Equity Example:
"Smith Partners is seeking to invest a $20MM Series A round in Asclepius, Inc. to aid in their rapid growth and contributions to the advancement of the healthcare industry. Their dedication to modernization combined with SP's vast network of cutting-edge automation manufacturers and forward-thinking healthcare providers make this partnership particularly exciting."
A bottom-up thesis would then continue into specifics about the company, detailing financial and employee records, proprietary knowledge or advantages such as patents, and more about what your firm brings to the transaction. A final bottom-up thesis can take many different forms: e.g., a comprehensive document, presentation, or video.
The key to both a top-down and bottom-up investment thesis is specificity. Every thesis your firm creates should be valid only for your firm . The combination of geographic location, sector or industry, company stage or type, fund size, reasons behind the investment or focus, and your firm's specific differentiators should make each of your theses unique.
Steps for Building an Investment Thesis Framework
Creating an investment thesis framework will help your firm draft theses more quickly and make sure all of the necessary information is included. Answering the following series of questions is a good place to start building a framework for both top-down and bottom-up theses:
- What is the goal of this thesis? This answer takes one of two forms: to find new target investment opportunities or to secure a potential deal. But before you can detail the rest of the thesis, you must know your end goal.
- What are the basic parameters of your ideal deal? Once you have your overall goal, sort out the basics first: overall available capital, company demographics (e.g., location, size, industry), etc.
- What are the influencing internal factors? What is your firm hoping to get from a deal that would fit this thesis? Do you need to bridge a valuation gap in your portfolio, for example?
- What are the influencing external factors? If you've ever gone through a thematic sourcing exercise, this will feel similar. While your thesis should not be nearly as large in scope as a thematic investing strategy, socioeconomic or industry trends can be a driving factor for why your firm is looking at this type of investment and should be called out in your thesis.
- Why your firm? While this is the simplest question, it's not only the most difficult to answer but also the most important. Your differentiator "what only your firm can offer to the industry or target company" and why you are particularly suited to this segment of the market (in a top-down thesis) or specific deal (in a bottom-up thesis) is the key to crafting a successful investment thesis in private equity.
- Why this deal? For a bottom-up thesis, you must detail why this deal should be transacted: - Why this company? Is it the founder that instills confidence? Do they have intellectual property that makes the deal worthwhile? How are their financials impacting this decision? - Why now? - What does the future look like and what are your plans post-transaction? - What is the eventual exit strategy? When would you plan for that to happen? - How does this deal impact your portfolio?
The framework you build from answering these questions can then be refined into a single statement or document that serves as your thesis. But be prepared to make iterations. You must continually refine your theses as you gather more data, learn more about your ideal investment, and the world continues to evolve and change.
Putting Your Investment Thesis to Work
Once your firm creates a thesis, it's time to put it to work. Remember that at its most basic level, a thesis aids your team in qualifying opportunities to see if they're worth pursuing.
Inputting the ideal criteria from your top-down thesis into a deal sourcing platform helps you map and understand the wider market, determine the most relevant conferences to attend, directly source the right opportunities, and much more. These tools can also help you learn more about specific target companies, their competitors, their investment readiness, and other key details to craft bottom-up thesis statements.
With over 130,000 sources and millions of data points, Sourcescrub's deal sourcing platform has helped firms improve their research productivity by 42.8% and deal sourcing pipeline by 36%. Let's chat to find out how we can help you create and execute your investment theses in 2023 and beyond!
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Writing a Credible Investment Thesis
by David Harding and Sam Rovit
Every deal your company proposes to dobig or small, strategic or tacticalshould start with a clear statement how that particular deal would create value for your company. We call this the investment thesis . The investment thesis is no more or less than a definitive statement, based on a clear understanding of how money is made in your business, that outlines how adding this particular business to your portfolio will make your company more valuable. Many of the best acquirers write out their investment theses in black and white. Joe Trustey, managing partner of private equity and venture capital firm Summit Partners, describes the tool in one short sentence: "It tells me why I would want to own this business." 10
Perhaps you're rolling your eyes and saying to yourself, "Well, of course our company uses an investment thesis!" But unless you're in the private equity businesswhich in our experience is more disciplined in crafting investment theses than are corporate buyersthe odds aren't with you. For example, our survey of 250 senior executives across all industries revealed that only 29 percent of acquiring executives started out with an investment thesis (defined in that survey as a "sound reason for buying a company") that stood the test of time. More than 40 percent had no investment thesis whatsoever (!). Of those who did, fully half discovered within three years of closing the deal that their thesis was wrong.
Studies conducted by other firms support the conclusion that most companies are terrifyingly unclear about why they spend their shareholders' capital on acquisitions. A 2002 Accenture study, for example, found that 83 percent of executives surveyed admitted they were unable to distinguish between the value levers of M&A deals. 11 In Booz Allen Hamilton's 1999 review of thirty-four frequent acquirers, which focused chiefly on integration, unsuccessful acquirers admitted that they fished in uncharted waters. 12 They ranked "learning about new (and potentially related) business areas" as a top reason for making an acquisition. (Surely companies should know whether a business area is related to their core before they decide to buy into it!) Successful acquirers, by contrast, were more likely to cite "leading or responding to industry restructuring" as a reason for making an acquisition, suggesting that these companies had at least thought through the strategic implications of their moves.
Not that tipping one's hat to strategy is a cure-all. In our work with companies that are thinking about doing a deal, we often hear that the acquisition is intended for "strategic" reasons. That's simply not good enough. A credible investment thesis should describe a concrete benefit, rather than a vaguely stated strategic value.
This point needs underscoring. Justifying a deal as being "strategic" ex post facto is, in most cases, an invitation to inferior returns. Given how frequently we have heard weak "strategic" justifications after a deal has closed, it's worth passing along a warning from Craig Tall, vice chair of corporate development and strategic planning at Washington Mutual. In recent years, Tall's bank has made acquisitions a key part of a stunningly successful growth record. "When I see an expensive deal," Tall told us, "and they say it was a 'strategic' deal, it's a code for me that somebody paid too much." 13
And although sometimes the best offense is a good defense, this axiom does not really stand in for a valid investment thesis. On more than a few occasions, we have been witness to deals that were initiated because an investment banker uttered the Eight Magic Words: If you don't buy it, your competitors will.
Well, so be it. If a potential acquisition is not compelling to you on its own merits, let it go. Let your competitors put their good money down, and prove that their investment theses are strong.
Let's look at a case in point: [Clear Channel Communications' leaders Lowry, Mark, and Randall] Mayses' decision to move from radios into outdoor advertising (billboards, to most of us). Based on our conversations with Randall Mays, we summarize their investment thesis for buying into the billboard business as follows:
Clear Channel's expansion into outdoor advertising leverages the company's core competencies in two ways: First, the local market sales force that is already in place to sell radio ads can now sell outdoor ads to many of the same buyers, and Clear Channel is uniquely positioned to sell both local and national advertisements. Second, similar to the radio industry twenty years ago, the outdoor advertising industry is fragmented and undercapitalized. Clear Channel has the capital needed to "roll up" a significant fraction of this industry, as well as the cash flow and management systems needed to reduce operating expenses across a consolidated business.
Note that in Clear Channel's investment thesis (at least as we've stated it), the benefits would be derived from three sources:
- Leveraging an existing sales force more extensively
- Using the balance sheet to roll up and fund an undercapitalized business
- Applying operating skills learned in the radio trade
Note also the emphasis on tangible and quantifiable results, which can be easily communicated and tested. All stakeholders, including investors, employees, debtors, and vendors, should understand why a deal will make their company stronger. Does the investment thesis make sense only to those who know the company best? If so, that's probably a bad sign. Is senior management arguing that a deal's inherent genius is too complex to be understood by all stakeholders, or simply asserting that the deal is "strategic"? These, too, are probably bad signs.
Most of the best acquirers we've studied try to get the thesis down on paper as soon as possible. Getting it down in black and whitewrapping specific words around the ideasallows them to circulate the thesis internally and to generate reactions early and often.
The perils of the "transformational" deal . Some readers may be wondering whether there isn't a less tangible, but equally credible, rationale for an investment thesis: the transformational deal. Such transactions, which became popular in the exuberant '90s, aim to turn companies (and sometimes even whole industries) on their head and "transform" them. In effect, they change a company's basis of competition through a dramatic redeployment of assets.
The roster of companies that have favored transformational deals includes Vivendi Universal, AOL Time Warner (which changed its name back to Time Warner in October 2003), Enron, Williams, and others. Perhaps that list alone is enough to turn our readers off the concept of the transformational deal. (We admit it: We keep wanting to put that word transformational in quotes.) But let's dig a little deeper.
Sometimes what looks like a successful transformational deal is really a case of mistaken identity. In search of effective transformations, people sometimes cite the examples of DuPontwhich after World War I used M&A to transform itself from a maker of explosives into a broad-based leader in the chemicals industryand General Motors, which, through the consolidation of several car companies, transformed the auto industry. But when you actually dissect the moves of such industry winners, you find that they worked their way down the same learning curve as the best-practice companies in our global study. GM never attempted the transformational deal; instead, it rolled up smaller car companies until it had the scale to take on a Fordand win. DuPont was similarly patient; it broadened its product scope into a range of chemistry-based industries, acquisition by acquisition.
In a more recent example, Rexam PLC has transformed itself from a broad-based conglomerate into a global leader in packaging by actively managing its portfolio and growing its core business. Beginning in the late '90s, Rexam shed diverse businesses in cyclical industries and grew scale in cans. First it acquired Europe's largest beverage-can manufacturer, Sweden's PLM, in 1999. Then it bought U.S.based packager American National Can in 2000, making itself the largest beverage-can maker in the world. In other words, Rexam acquired with a clear investment thesis in mind: to grow scale in can making or broaden geographic scope. The collective impact of these many small steps was transformation. 14
But what of the literal transformational deal? You saw the preceding list of companies. Our advice is unequivocal: Stay out of this high-stakes game. Recent efforts to transform companies via the megadeal have failed or faltered. The glamour is blinding, which only makes the route more treacherous and the destination less clear. If you go this route, you are very likely to destroy value for your shareholders.
By definition, the transformational deal can't have a clear investment thesis, and evidence from the movement of stock prices immediately following deal announcements suggests that the market prefers deals that have a clear investment thesis. In "Deals That Create Value," for example, McKinsey scrutinized stock price movements before and after 231 corporate transactions over a five-year period. 15 The study concluded that the market prefers "expansionist" deals, in which a company "seeks to boost its market share by consolidating, by moving into new geographic regions, or by adding new distribution channels for existing products and services."
On average, McKinsey reported, deals of the "expansionist" variety earned a stock market premium in the days following their announcement. By contrast, "transformative" dealswhereby companies threw themselves bodily into a new line of businessdestroyed an average of 5.3 percent of market value immediately after the deal's announcement. Translating these findings into our own terminology:
- Expansionist deals are more likely to have a clear investment thesis, while "transformative" deals often have no credible rationale.
- The market is likely to reward the former and punish the latter.
The dilution/accretion debate . One more side discussion that comes to bear on the investment thesis: Deal making is often driven by what we'll call the dilution/accretion debate . We will argue that this debate must be taken into account as you develop your investment thesis, but your thesis making should not be driven by this debate.
Simply put, a deal is dilutive if it causes the acquiring company to have lower earnings per share (EPS) than it had before the transaction. As they teach in Finance 101, this happens when the asset return on the purchased business is less than the cost of the debt or equity (e.g., through the issuance of new shares) needed to pay for the deal. Dilution can also occur when an asset is sold, because the earnings power of the business being sold is greater than the return on the alternative use of the proceeds (e.g., paying down debt, redeeming shares, or buying something else). An accretive deal, of course, has the opposite outcomes.
But that's only the first of two shoes that may drop. The second shoe is, How will Wall Street respond? Will investors punish the company (or reward it) for its dilutive ways?
Aware of this two-shoes-dropping phenomenon, many CEOs and CFOs use the litmus test of earnings accretion/dilution as the first hurdle that should be put in front of every proposed deal. One of these skilled acquirers is Citigroup's [former] CFO Todd Thomson, who told us:
It's an incredibly powerful discipline to put in place a rule of thumb that deals have to be accretive within some [specific] period of time. At Citigroup, my rule of thumb is it has to be accretive within the first twelve months, in terms of EPS, and it has to reach our capital rate of return, which is over 20 percent return within three to four years. And it has to make sense both financially and strategically, which means it has to have at least as fast a growth rate as we expect from our businesses in general, which is 10 to 15 percent a year. Now, not all of our deals meet that hurdle. But if I set that up to begin with, then if [a deal is] not going to meet that hurdle, people know they better make a heck of a compelling argument about why it doesn't have to be accretive in year one, or why it may take year four or five or six to be able to hit that return level. 16
Unfortunately, dilution is a problem that has to be wrestled with on a regular basis. As Mike Bertasso, the head of H. J. Heinz's Asia-Pacific businesses, told us, "If a business is accretive, it is probably low-growth and cheap for a reason. If it is dilutive, it's probably high-growth and attractive, and we can't afford it." 17 Even if you can't afford them, steering clear of dilutive deals seems sensible enough, on the face of it. Why would a company's leaders ever knowingly take steps that would decrease their EPS?
The answer, of course, is to invest for the future. As part of the research leading up to this book, Bain looked at a hundred deals that involved EPS accretion and dilution. All the deals were large enough and public enough to have had an effect on the buyer's stock price. The result was surprising: First-year accretion and dilution did not matter to shareholders. In other words, there was no statistical correlation between future stock performance and whether the company did an accretive or dilutive deal. If anything, the dilutive deals slightly outperformed. Why? Because dilutive deals are almost always involved in buying higher-growth assets, and therefore by their nature pass Thomson's test of a "heck of a compelling argument."
Reprinted with permission of Harvard Business School Press. Mastering the Merger: Four Critical Decisions That Make or Break the Deal , by David Harding and Sam Rovit. Copyright 2004 Bain & Company; All Rights Reserved.
[ Buy this book ]
David Harding (HBS MBA '84) is a director in Bain & Company's Boston office and is an expert in corporate strategy and organizational effectiveness.
Sam Rovit (HBS MBA '89) is a director in the Chicago office and leader of Bain & Company's Global Mergers and Acquisitions Practice.
10. Joe Trustey, telephone interview by David Harding, Bain & Company. Boston: 13 May 2003. Subsequent comments by Trustey are also from this interview.
11. Accenture, "Accenture Survey Shows Executives Are Cautiously Optimistic Regarding Future Mergers and Acquisitions," Accenture Press Release, 30 May 2002.
12. John R. Harbison, Albert J. Viscio, and Amy T. Asin, "Making Acquisitions Work: Capturing Value After the Deal," Booz Allen & Hamilton Series of View-points on Alliances, 1999.
13. Craig Tall, telephone interview by Catherine Lemire, Bain & Company. Toronto: 1 October 2002.
14. Rolf BÃ¶rjesson, interview by Tom Shannon, Bain & Company. London: 2001.
15. Hans Bieshaar, Jeremy Knight, and Alexander van Wassenaer, "Deals That Create Value," McKinsey Quarterly 1 (2001).
16. Todd Thomson, speaking on "Strategic M&A in an Opportunistic Environment." (Presentation at Bain & Company's Getting Back to Offense conference, New York City, 20 June 2002.)
17. Mike Bertasso, correspondence with David Harding, 15 December 2003.
A playbook for newly minted private equity portfolio-company CEOs
CEOs who helm companies owned by private equity (PE) firms face a leadership challenge unlike any other. They must master everything a great public- or private-company CEO does, all while operating at a higher metabolic rate. A newcomer to PE also faces the conundrum of having limited access to insight about the road ahead, because there is so little specific guidance in print about the portfolio-company CEO role. Its unique demands and nuances, however, need not be a mystery.
The world’s top PE firms can’t afford to skimp on CEO talent. The partners who hire, manage, and sometimes dismiss their portfolio-company CEOs think deeply about what sets their investment philosophy and ideal leaders apart.
“In short, we are constantly looking for the CEO with an ownership mentality,” said one PE-firm executive in Asia. In the interview process, this executive hopes “they will ask, ‘What is your underwriting base case and expected holding period? How much value do you expect to generate?’”
Executives at other PE firms highlight additional traits they consider essential to the CEO role, including nonhierarchical thinking, an instinctual grasp of financial metrics, and superlative team-building skills. These executives collectively emphasize the abundant support large PE firms offer their leaders, including operations teams, functional experts, senior advisers, trusted confidants, and a network of other CEOs within their holdings. The ability to derive benefit from these allies is a key leadership strength. In the words of one PE partner, “If they have the art to leverage the network to their advantage, they will be successful. Those who just use their wits will not be as successful.”
The lore of great public-company CEOs is so embedded in business culture that our definitions of leadership itself largely come from their experiences. However, at a time of unprecedented PE deals, more companies require leaders attuned to a portfolio company’s specific mission and pace, making it increasingly urgent to generate a body of knowledge about the CEO role. After massive COVID-19-related disruptions in the second quarter of last year, global PE deal flow increased 35 percent in the third quarter, compared with the prior quarter, and another 15 percent in the fourth quarter. Despite the pandemic, PE firms closed more than 3,100 deals in the fourth quarter, the largest count of any quarter to date. 1 McKinsey analysis of custom data provided by Pitchbook. More is likely to come: global PE uncalled capital has reached $1.4 trillion, an early sign that 2021 may be a banner year for deal flow.
In 2020, PE firms paid higher purchase multiples in the United States than during any year in history, rising in one year from 11.9 times to 12.8 times. To put the multiples growth into context, an investor in 2020 paid 30 to 40 percent more than a decade ago to acquire the same earnings before interest, taxes, depreciation, and amortization (EBITDA). To create alpha in their portfolios and justify higher multiples, PE firms are increasingly moving to an even more hands-on engagement model.
This article, informed by our work and several recent interviews with PE executives, intends to pull back the curtain on how to be great in this role. We speak directly to you, the newly minted CEO at a PE-owned company. We consider the unique challenges you face and offer a set of actions to guide you through them.
What makes this role different
The CEO role is peerless, exciting, rewarding—and notoriously all-consuming. McKinsey’s research highlights the mindsets and practices of the best CEOs . Portfolio-company CEOs need to master not only these dynamics but also add to them another layer: delivering a broad and challenging agenda within a short time frame. In short, these leaders must train for a sprint and a marathon at the same time. Typical CEOs look at their calendars to prioritize their week, while portfolio-company CEOs look at their watches.
Working with a hands-on portfolio-company board
Oversight of the portfolio company is the PE board’s day job , not just a fiduciary duty. This means that it’s more actively involved; in many ways, it works more like a “super management team,” at least about a quarter of the time. A PE board may require monthly in-depth financial reviews, a subset of the board may intervene when plan deviations occur or progress does not happen fast enough, and the board may be closely involved in helping select the management team.
Even when they are not engaging this deeply, high-functioning board members will behave like “cooperative skeptics” 2 Kathy Kantorski, “Primed for the boardroom,” Hispanic Executive , April 1, 2019, hispanicexecutive.com. —meaning they will ask probing questions and defend against errors and assumptions. It is best, therefore, to design an engagement model that will allow you to get the best out of this active board construct.
“They have to understand that the board is not just a formality; they are a real forum that the CEO can use as a thought partner, and the board is in the driver’s seat,” said a PE executive who routinely hires CEOs. Her advice? Give newcomers books about the PE industry so that they understand its history and language, which makes it easier to communicate with the board.
An executable investment thesis is the top priority
CEOs in PE face a paradox: the business plan is often “written in blood,” and thus, decisions and actions must align with the investment thesis. On the other hand, the CEO must simultaneously be creative, always looking for new ways to underwrite and expand the value-creation plan. The role of the CEO as a strategist is trumped by the need to execute the investment underwriting.
Executing based on a preset plan requires you to understand the deal thesis in both its essence and details and be on top of the numbers and value-creating levers more than any other type of CEO. This granular insight is vital because injecting more capital or time to absorb a mistake can be a problem for the PE firm’s returns and credibility.
The best CEOs “care about how well the finance team is pulling the data for them, giving them visibility into the business,” said a PE executive based in Asia who specializes in hiring.
“In a public company, the CFO will drive all that, but in PE, the CEO has an equally strong grasp of the financials,” said another partner, echoing a common refrain among PE experts: silos between departments and functions have no place in a PE-backed company. Portfolio-company CEOs need to get comfortable with a nonhierarchical, horizontal culture.
Speed to value is prized over meticulous planning
Arguably, the biggest concrete difference between the role of a CEO in PE and any other type of CEO is the pace. Capital in PE clocks at 20 to 25 percent a year, and every month of delay burns returns. PE firms operate with strict timetables for when a company should deliver against its deal thesis, which means that urgency is a way of life for leaders. In the words of a PE director, “A lot of [CEOs] come to the realization that the performance pressure is for real.” (For a look at other psychological challenges that can accompany this role, see sidebar “Coping with the pressure: The inner life of a portfolio-company CEO.”)
Coping with the pressure: The inner life of a portfolio-company CEO
“It’s a combination of insecurity, imposter syndrome, ego issues, all of that,” said one PE director when asked to name the biggest psychological challenges portfolio-company CEOs face. Then there’s the pressure of interacting with the board, coupled with very little time to figure out how best to present earnings, strategies, or other crucial issues, as expressed recently by one of her CEOs: “I used to deal with my public shareholders every quarter. I thought working for you would be easier, but you guys are looking at us on a monthly basis, and I have very little room to massage the numbers or get the story lined up.”
Some leaders struggle with the pace. After two dissatisfactory quarters, a PE board is likely to get deeply involved in solving the problem. That alacrity can surprise newcomers and may prompt rash decision making. One PE partner who acts as a mentor to several CEOs said he often counsels them to make lists, consider options, and run scenarios.
Another struggle for some CEOs is maintaining a sense of conviction in the face of a deeply embedded PE board and operating team. Too much acquiescence, however, is a mistake: “We had a CEO who said yes all the time, and we fired him,” said one PE partner. “They have to have their own point of view, be able to defend it with logic and numbers, and be able to have a constructive debate with us,” he said.
Our research indicates that inertia will stick out like a sore thumb. You will be compared to other CEOs across your PE owners’ portfolio, and partners won’t show the patience corporate boards or shareholders might.
“The honeymoon period is short, and we encourage the CEOs we hire to make talent decisions very quickly,” said the PE executive who specializes in hiring. “Don’t wait for the first board meeting.”
Newly minted portfolio-company CEOs: Four ways to succeed
Any CEO must know their stakeholders, assemble a great executive team, make plans, and develop a network of trusted advisers. Each of these standard leadership tactics will be more important and more nuanced in your new life as a private equity portfolio-company CEO. To develop mastery in each area, we suggest breaking down the challenges by taking stock, taking action, and, ultimately, taking control.
Build a relationship with the board
As discussed above, a PE board will be engaged in a more intense, hands-on way than any board you have encountered previously. An essential part of your job is to build a good relationship with each board member and shape your license to operate.
As PE firms develop and refine their active management strategies, they are building boards in new ways. Two prominent PE players in Asia recently began to include one or two nonexecutive, independent industry experts on their boards. An executive at one firm said, “We have found that they bring a very refreshed perspective, particularly in areas like environmental, social, and governance [ESG]; accounting; and controls.” It’s essential to understand what each board member brings to the table and how they can help you.
Be on the lookout for common misalignments. It’s possible, for example, that deal partners hold different views of how M&A fits into the company’s future. An operating partner may have been through an analogous situation that informs their ideas about what commercial levers can be pulled and in what sequence. Deal teams may have identified what they view as critical gaps in the company (such as supply-chain, cybersecurity, or ESG risk). It’s essential that you know what people think and why. Aim for “zero daylight” between each stakeholder’s point of view and your plan.
- Take stock . Make sure you understand the expectations of the sponsor and board, what they view as priorities for the business, and the skills and experiences you and they bring to the table.
- Take action. Establish a structured and frequent cadence of informal conversations and formal reviews, especially with your operating partner. Do you need to check in once a week? Once a month? Enroll critical players in your decision making and determine who you can count on for honest feedback.
- Take control. Come to your owners with ideas. Put forward a point of view on organic and inorganic growth. Your job is to constantly search for new sources of value, act at pace, and use informal and formal communication channels.
Quickly assemble an A-team
Team-building skills are paramount in this job. Many PE investments involve turnarounds in which the new CEO must partially or fully rebuild the C-suite. Furthermore, because portfolio companies are typically smaller than publicly traded companies, CEOs will spend much of their time working alongside their team rather than providing more distant guidance. 3 Tom Redfern, “How private equity firms hire CEOs,” Harvard Business Review , June 2016, hbr.org.
Our research shows that effective talent management drives financial outperformance. Companies that reallocate talent frequently are 2.2 times more likely to outperform their peers, and those that get talent right in the first year achieve 2.5 times the return on initial investment.
It’s more than a matter of hiring the CFO or COO with the right résumé. Typically, we find that new portfolio-company CEOs need to fill about 30 to 40 percent of “level two” positions, including heads of finance, human resources, procurement, and revenue, and roughly 50 to 65 percent of “level three” positions, which are typically at the vice president level.
- Take stock. You’ll be able to figure out what roles need what talent by getting closer to the investment thesis and sources of value.
- Take action. Swiftly assess your direct reports and move quickly on anyone whose performance is questionable. If you’ve confirmed a problem after 90 days, it’s too late: others will assume it’s your problem. Be sure you’ve got your A-team in place before working on esprit de corps . Push for diversity on your management team and board to support internal challenge and healthy debate, improve decision making, and strengthen customer orientation.
- Take control. In making a commitment to diversity, arm yourself with the data that prove it is the right business strategy. For example, in an examination of its portfolio companies, the Carlyle Group found that organizations with diverse board members achieved 12 percent higher earnings growth compared with boards that are less diverse. 4 Lauren Hirsch, “The Carlyle Group ties a $4.1 billion credit line to board diversity,” New York Times , February 17, 2021, nytimes.com.
Launch an achievable 100-day program
Your plan for the first 100 days will depend on the complexities of your business and other issues that are too numerous and nuanced to cover comprehensively in this article. Instead, we highlight below some of the most important factors to consider throughout this crucial period.
A feasible plan with bankable projections is of critical importance. This road map needs to be grounded in a keen understanding of trends, team capabilities, and potential for success. Unrealistic, overly optimistic plans are perilous, while realistic goals are central to aligning the portfolio-company board and management. Confirm the plan’s feasibility early in the process.
Never “fall in love with the asset.” Instead, continually conduct mental acid tests: If you were a venture-capital or PE firm, would you buy the business and keep your talent? In short, be open to possibilities and move fast to capitalize on opportunities.
- Take stock. Develop an employee experience that attracts the best thinkers and doers. Identify three to five strategic priorities and set the team on task. Secure external expertise to support change initiatives. Put comprehensive reporting tools in place for monthly financial and operating metrics tied to strategy.
- Take action. Maintain an expansive mindset that encompasses all potential levers for value creation , including potential profit or balance-sheet improvements, working-capital optimization, product innovation, customer partnerships, regulatory actions, M&A opportunities, and the right exit strategies.
- Take control. Once you have identified the potential levers for value creation, the next challenge is to deliver this broad agenda in record time. Design your governance setup around a cadence of interactions to deliver the company’s full potential, which should include special sessions with the board to discuss M&A and/or divestiture options and intensive sessions to look at innovation opportunities.
Leverage the resources your PE sponsor has to offer
Today, top PE firms are building internal operating groups and developing more resources to help improve the operating performance of their companies. Some PE firms are staffed with functional experts with deep knowledge of e-procurement, data analytics, leadership development, and enterprise support, among other topics; these experts don’t join company boards but instead work with portfolio companies as needed. In addition to their own operating partners, PE firms may have access to senior advisers with deep experience on specific topics, such as inflation, or relationships with trusted consultants. CEOs of other portfolio companies are another consortium from which you can draw counsel.
- Take stock. Identify key resources within your PE sponsor and determine how to integrate them into your operating model. Consider which networking events with peers will most help you. Be open to receiving and acting on constructive criticism and advice.
- Take action. Design your interventions with the capabilities and oversight you have identified in mind. Clarify mentally the type of leader you want to be (for example, inspirational visionary, disruptor, execution driver, among others). Have a personal reckoning to decide whether this is a capstone to your career or if you are positioning yourself for something else. If it’s the former, focus on contributing back to the PE-firm repository by coaching other potential CEOs. If it’s the latter, decide on the impact you intend to have as CEO, hold yourself accountable, and never lose sight of the fact that you will eventually transition.
- Take control. Know what leadership behaviors your team and the company need from you, and model them daily. Be vigilant about your personal boundaries, making sure to manage your most valuable resource—your time 5 Michael E. Porter and Nitin Nohria, “How CEOs manage time,” Harvard Business Review , July–August 2018, hbr.org. —for maximum efficacy.
The role of CEO of a PE-portfolio company stands apart from other leadership opportunities. From 1996 to 2015, the number of publicly traded companies listed on US stock exchanges alone declined by nearly 50 percent. Some of this shift resulted from company bankruptcies, failures, or mergers—but in most instances, the delisting came from publicly traded firms going private. 6 Luminita Enache, Vijay Govindarajan, Shivaram Rajgopal, and Anup Srivastava, “Why we shouldn’t worry about the declining number of public companies,” Harvard Business Review , August 27, 2018, hbr.org.
Despite the growing predominance of PE-owned companies and the CEOs who steer them, playbooks for this type of leadership have previously been scarce. The guidance here provides the latest thinking by major players in PE who scrutinize leadership practices daily. Absorbing these winning strategies into your muscle memory will help you meet the challenges of this demanding and rewarding role. It is a form of leadership better aligned with the way a growing number of companies are financed, run, and valued.
The authors wish to thank Ivo Bozon, Carolyn Dewar, Anand Lakshmanan, and Gary Pinkus for their contributions to this article.
This article was edited by Katy McLaughlin, a senior editor in the Southern California office.
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The mindsets and practices of excellent CEOs
Climbing the private-equity learning curve
Private equity operating groups and the pursuit of ‘portfolio alpha’
A Guide for Impact Investment Fund Managers
A step-by-step resource to creating and managing a private equity impact fund
Creating a Strong Investment and Impact Thesis
The number of investment funds increases every year according to the GIIN’s Annual Impact Investor Survey , making it all the more important for a fund to differentiate itself through a compelling investment and impact thesis . A clearly articulated thesis is coherent and evidence-based, stands out among competitors in the market, and can be distilled to a concise and persuasive pitch.
A well-crafted, coherent investment and impact thesis integrates all the pieces of a complex investment strategy into a single narrative that is thoughtful, thorough, and supported by data and other evidence. Impact investment funds have more complex stories to tell than traditional funds, which makes it especially challenging to develop a coherent fund narrative. From the outset, fund managers should have a clear sense of their fund’s intended impact in the context of their investment strategy and managers should be prepared to share it externally.
In crafting a clear fund thesis, fund managers might ask themselves: What existing need in the market does my investment thesis address? What is the evidence that the need exists, and what is the extent of the need? What is the theory of change ? What underlying assumptions does the thesis imply? Do my proposed sector of investment, deal size, and deal type fit existing market needs? Do the expected returns and exit strategies seem realistic and appropriate given the market, investee potential, and investor expectations?
Demonstrating how a fund fits into the competitive market landscape is an important part of a coherent story. Fund managers might ask themselves: Would the fund be unique in the marketplace? How is it unique? What would make the fund compelling to investors? How does the fund’s impact strategy compare to others in the market? Answers to these questions influence key fund management practices, such as which types of LPs to target or investee businesses to approach given their capital requirements. For example, a venture capital fund that focuses on early-stage companies in the concept phase expects high risk and high return. The fund management team must also be assembled carefully, as team members’ individual experiences in a given sector or industry and their local relationships can make or break a fund’s success.
A public good managed by the GIIN, IRIS+ is the generally accepted system for measuring, managing, and optimizing impact. The system, used by thousands of investors around the world, provides a pathway to translate impact intentions into real impact results. With IRIS+ investors can:
- Frame their goals in a common way, following generally accepted investment themes (such as Financial Inclusion or Clean Energy Access), the UN Sustainable Development Goals (SDGs), or both;
- Review existing research and evidence base to inform their impact thesis and theory of change.
- Identify key indicators to track in order to assess progress towards their goals in a way that produces clear, consistent, and comparable data (IRIS+ Core Metrics Sets and IRIS Catalog of Metrics); and access best-in-class resources and practical “how-to” guidance to improve their impact measurement and management practice.
- Emerging Managers: How to Analyze a First-Time Fund, Probitas Partners
- Being the Early Bird: Re-Focusing Emerging Manager Programs on Debut Funds and First Closes, Morgan Creek Capital Management, LLC
- Preqin Special Report: Making the Case for First-Time Funds , Preqin
- Introducing the Impact Investing Benchmark , The GIIN
- Great Expectations , Wharton Social Impact Initiative (WSII)
- Impact Investing Finds Its Place in India , McKinsey & Company
- 2017 Symbiotics MIV Survey , Symbiotics
- Benchmarking Impact: Australian Impact Investment Activity and Performance Report , Impact Investing Australia
- The Social Investment Market through a Data Lens, EngagedX
- A Tale of Two Funds , Boston Consulting Group (BCG)
- Christian Super 2023 Annual Report
- Microfinance Equity Exits: Data on Company and Fund Level Returns , Grassroots Capital Management
- Gray Ghost Microfinance Fund: Building the Bridge to Impact Investors , Gray Ghost Fund
- Evolution of an Impact Portfolio: From Implementation to Results , KL Felicitas Foundation
- Triodos Renewables Europe Fund: A Sub-Fund of Triodos SICAV II , Triodos Renewables Europe Fund
- 2017 Annual Impact Investor Survey
- The Landscape for Impact Investing in Southern Africa
- The Landscape for Impact Investing in East Africa
- The Landscape for Impact Investing in West Africa
- The Landscape for Impact Investing in South Asia
In addition, The Aspen Network of Development Entrepreneurs (ANDE) , together with the Latin American Private Equity & Venture Capital Association (LAVCA) and LGT Impact Ventures , published a report about the growing landscape of impact investing in Latin America .
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About the Global Impact Investing Network
The Global Impact Investing Network is the global champion of impact investing, dedicated to increasing its scale and effectiveness around the world. Impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.
S T R E E T OF W A L L S
Building an investment thesis.
Now that you understand what characteristics make up attractive long and short ideas, it is time to explain how to formulate an investment thesis. Being able to construct a real and actionable investment idea is in the heart and soul of an analyst’s work in the hedge fund industry. Building a successful thesis begins with (1) rigorous due diligence at the Micro level, (2) aligning that view with the Macro environment, and (3) understanding the overall trade setup.
Good Company Qualities
- High return on capital
- Barriers to entry
- Growing industry
- High margins relative to competition
- High insider ownership
- Well respected
- Clean accounting
- Infrequent restating of earnings
- Not overly promotional
- Good allocators of capital
All of these qualities are obvious and won’t differentiate your pitch, but they are qualities you will have to talk about, so make sure you understand them well.
Target Price = Your Earnings Estimate × Multiple
- Will the company beat earnings expectiations in the next quarter or in the next year?
- If so, what are the catalysts that will cause the Company to beat earnings (e.g., higher revenue, higher margins, lower interest expense, share buybacks, etc.)? Paint the picture of how, when, and why there will be a catalyst that supports your view. Providing an opinion without fully understanding and explaining the relevant value drivers will be a recipe for failure.
- What’s your confidence the company will beat earnings? What’s the probability?
- What’s your margin of safety? What can go wrong?
- Does your pitch rely on multiple expansion? Why? Where is the company trading relative to its historical multiple? Should the multiple trade at a premium or discount given how the company has changed over the years, and where we are now in the business cycle?
- Where is the company trading relative to its peer group? If the entire market has seen multiple expansion, then is it fair that this company should too? In other words, is it expensive or cheap relative to itself historically and/or its peers, and can you explain why this might be wrong?
- What catalyst is going to cause this multiple to start expanding? Again, paint the picture of how, when, and why there will be a catalyst that supports your view.
- What is your confidence in multiple expansion? What’s the probability?
Your target price is the product of a forecasted earnings metric multiplied by the expected multiple. This multiple can be P/E, EV/EBITDA, EV/Sales, FCF/Market Cap, or any other reasonable metric. Some metrics are industry-specific and more valuable for those industries than the aforementioned general ones.
Regardless, if you provide a target price, you need to explain how you arrived at this target, and the stages of your thought process to get there. for example, if you claim that a stock is going to have +50% upside, but feel they won’t beat consensus earnings, then you are calling for +50% multiple expansion, pure and simple.
Although not ideal, stocks in industries with bleak macroeconomic outlooks can still be good investments. It is important to understand what is taking place at the company level, sub-sector level, industry level, and national level. This approach will help you determine whether you are investing in a “good house in a bad neighborhood.”
- How has the stock performed heading into the catalyst, i.e, before you put the trade on? If it has already gone up 10% recently, for instance, it will be much harder to outperform on the catalyst.
- How crowded is the trade? Are a lot of hedge funds already invested in the name? One easy way to determine this is to speak to a sell-side research analyst and ask whether they are getting a lot of calls from other funds regarding the company.
- Is the general public bullish or bearish? If you are researching a short pitch, it is key to check for existing short interest (SI function on Bloomberg). If it is a long, you should review the list of major holders of the stock (HDS function on Bloomberg). If the top holders are several hedge funds, then the stock pitch is likely overcrowded and may not be actionable. One of the biggest mistakes in a hedge fund interview is to pitch a stock that every hedge fund has already heard of and evaluated.
Crowded names can still work, but investors must tread lightly. When the market sells off or there is a change in sentiment, crowded names typically perform the worst. To check this, there is an index on Bloomberg of high hedge fund ownership stocks; you can use it to see whether your idea is on that list to make sure it isn’t already an overcrowded trade idea.
Other technical tools that can help evaluate the setup for a stock include RSI (relative strength index) and moving averages. The RSI is a momentum indicator—below 30 is considered oversold and above 70 is considered overbought.
Ideally, you want a stock that has recently underperformed its peers, is lightly owned by hedge funds, and is heading into a catalyst that you think will have a positive surprise . By contrast, a crowded name that has already outperformed based on the expectation of a positive catalyst will likely get a limited reaction if and when the catalyst does occur. For example, it is very common for companies to beat earnings expectations but not to experience an increase in their stock prices, because the general public or hedge funds are already expecting the earnings surprise. In today’s hyper-competitive market, one needs a truly different variant perception in order to outperform the market.
Other Investing Thoughts
- What constitutes a good investment idea? What does that phrase even mean? The answer is that it means something different to every person–that is what provides opportunities in a market. That is why some investors own a stock and others short it. If everyone agreed on what makes a good investment then everyone would own the same stocks.
- How much should you make per idea? Investors do not even agree on this principle. Developing frameworks for investing will help you follow a set of guidelines that you can refine over the years through experience, and as part of that, you will learn to determine what the expected profit and acceptable risk for a particular investment are.
Value Investing Framework
- Benjamin Graham defined the first basic tenant of value investing as follows: when the price of a security diverges from its intrinsic value (its corresponding cash flows), a value investor should work to exploit that divergence.
- The second basic tenant of value investing is the margin of safety: a security should preferably be purchased at a deep discount to its intrinsic value, to help limit the amount of downside risk the investment has.
Street of Walls Investing Framework
- It is very easy to get ideas from other investment professionals, but it will be very obvious in your pitch whether you have done the analytic work yourself or not.
- This is typically discovered when you are questioned on your assumptions in the model. If you built the model yourself, you can likely defend the assumptions much more intelligently.
Market size and growth.
Study the market size and growth of the company’s core industry. Even though you may be studying the beverage industry, the manufacturing companies and distribution companies have very different dynamics. The beverage manufacturers may not be growing much faster than CPI, but the distributors may be going through a massive consolidation period and therefore have earnings that are growing at a much faster pace.
Historical Industry Returns
A security may be cheap and look attractive, but that may be because the returns of the company and the industry are not attractive. For example, the stock Owens Corning (OC) traded at 8x earnings for a long time. This sounds inexpensive, but it was ultimately justified because operating margins were in the single digits. Eventually, however, industry did consolidate and operating margins expanded to 20%. Thereafter, the company’s earnings multiple expanded into the low teens.
Most bottom-up, fundamental analysis is used to study the unit economics of a company. For example, what does it cost to make and sell one unit of output, and what is the profit on that unit? What are the pricing and volume trends? It is important to understand the value drivers clearly in order to build a detailed operating model for your pitch.
- Do certain companies control industry pricing?
- How sustainable is the company’s competitive advantage?
- Are there high or low switching costs?
- Does branding matter
- Are there regulatory protections, such as tariffs?
- What important considerations are there with respect to the company’s customers and suppliers?
Cyclical / Seasonal
An industry may be in a strong growth period and look very attractive, but it may also be at the peak of a cycle that is possibly about to turn substantially negative. For example, the housing industry looked extremely attractive in the early 2000s, but crashed and was extremely unattractive into the late 2000s and beyond. This is due to both an economic downturn and a systematic overbuilding of homes that collapsed in the middle of the decade. In addition to the economic/business cycle, certain industries have drivers of cyclicality that are very specific. One example of this is the Oil & Gas industry—the price of oil alone can have a huge impact on a Oil & Gas company’s earnings potential.
It is also important to understand the seasonality of the business. Retailers tend to sell more product during the fourth quarter of the year, because of the holiday shopping season. Therefore, it may be wrong to extrapolate a trend in March and April if the majority of the company’s sales take place in the later months.
When you start working for a hedge fund you will quickly learn that each fund has their own unique investment style. Some hedge funds simply will not invest in companies that have weak management teams. It does not matter how attractive the opportunity or valuation is—the fund simply won’t invest. This principle often results from an investor getting burned from a bad management decision, such as a bad acquisition, or a focus on short-term earnings at the expense of long-term objectives. After gaining experience analyzing companies, you will eventually develop your own philosophy. Still, bear in mind that other investors may have an opinion on this topic that differs from yours, and you need to consider the philosophies of your teammates when evaluating an investment idea.
In studying management teams, you should look at the management team’s track record and understand both the buy-side and sell-side opinion on the management team. Study the company’s internal philosophy: how do they allocate capital? Is the current management team following what the company has always done? Another key to understanding how a management team will probably act is to study how the members are compensated. Is their compensation tied to revenue or earnings, return on capital, or some other metric? How much stock does the management team currently own? How much risk are they taking? Are they buying or selling stock? How many options do they have outstanding?
Study both relative and absolute valuation. A stock may appear cheap when compared to a stock in another sector, but very expensive against its peers. Thus, different investment situations call for different valuation metrics to be used.
One example of this principle is that it is completely unhelpful to use P/E if the company has no earnings (or negative earnings). You should also study the rate of growth of the earnings metric you chose. A company may look expensive at 30x earnings, but if it is doubling revenue every year and tripling earnings, it may not be so expensive after all. In fact, if you believe that this trend can continue, it may be an excellent long investment idea.
- Is there a difference between your earnings estimates and those of the street?
- If not, is your thesis really interesting, or is it just a “consensus trade”?
- What are the key events that the street will care about? Is it an earnings release, a new product release, or something more unusual?
- Does the street care about what happens next quarter or are they more focused on the potential signing of a big contract that could take place at any time?
Donald Rumsfeld once said there are “Known unknowns and unknown unknowns.” Some risks are riskier than others. How does the company control for this? How do you as the investor assess the downside risk from this?
- What has to happen for the downside case to play out?
- What has to happen in order to lose some benchmark amount, say 20% or more?
- If that event plays out, what will happen to the multiple? Will it go down or actually expand?
- All in all, what is the probability of a downside event and what is the maximum potential loss you might face in such a scenario?
Catalysts are extremely important in identifying when you are going to “get paid.” This is a crucial factor in sizing positions. If a catalyst is expected to take place in the near future, you probably want to have your position fully sized immediately. If not, it may make sense to taper into a position.
Framework for Investing: Large Market Movements
Rising Markets: The typical reaction to a rising stock price is to “chase” the returns. That means when a stock continuously goes up, day after day, the investor feels like he or she is missing an opportunity, and will be inclined to buy the stock. This pile-on mentality causes more investors to become a part of the action. This is a classic, human reaction to a strongly outperforming stock, and it can often lead to poor returns due to an undisciplined approach and the fickle nature of the market.
The same thing can happen when a stock continues to drop in price. Investors tend to panic and sell at exactly the worst time. During the heat of the battle, people tend to get emotional and sell their best stocks out of fear.
- Tell yourself it is normal to react this way when you are losing a lot of money. Fear is normal: both the fear of missing an opportunity and the fear of continuing to lose more money.
- Ask yourself, “Has my investment thesis changed?” If it has, then sell, but if it has not, then ignore your fears and hold the position.
- Have strict target prices in place. This will help you exit a position once your target has been achieved, and thereby avoid the trap of trying to “ride a winner.”
Here is a related excerpt written by Benjamin Graham, from The Intelligent Investor:
- “Imagine that in some private business you own a small share that costs you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects, as you know them. Often, on the other hand, the value he proposes seems to you a little short of silly.
- If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”
The liquidity of a single stock is not a reason for a fundamental investor to buy a stock, but it can definitely be a reason for an investor not to buy a stock. The less liquid a stock is, the riskier the position becomes, as it is difficult to exit an illiquid position—especially during turbulent market conditions, when liquidity is often demanded.
In order to determine how liquid a stock is, you need to see how many shares trade on a regular basis. For example, if the average daily volume of a $10 stock is 1 million shares, then the stock trades $10 million per day. If you have a $1 million hedge fund, and you want to take a 10% position, you will need to buy $100,000 worth of stock, or 10,000 shares. If you wanted to buy all of that stock in 1 day you could, as you would only account for 1% of the daily volume ($100,000 in stock to be purchased ÷ $10,000,000 daily volume = 1%). A reasonable rule of thumb is that you do not want to account for more than 10-15% of a stock’s daily trading volume if you do not want to influence its price. So in this example, you could buy up to $1,500,000 worth of stock per day without moving the share price. If you were to buy $2,000,000 of stock in 1 day, or 20% of the daily volume, you would likely cause the stock price to increase (at least temporarily). If your desired position is much larger, then it could take many days to accumulate the desired position – and similarly, it could take a long time to unwind the position when you want to exit. This makes the investment much more risky.
Therefore, a stock may have fantastic management, excellent earnings growth, and an attractive price, but if there is no liquidity you probably simply cannot buy it.
You may think that you have found a gem: a rare and precious investment opportunity that no other hedge fund is talking about. Fortunately, that notion is relatively easy to confirm or disprove. To check and see whether other sophisticated investors are involved in the company you’re researching, you can pull up the company’s quarterly holdings report on Bloomberg and see who the largest shareholders are.
For example, suppose that W.R. Grace (GRA) offers an exciting investment opportunity, according to your analysis. However, looking at the holders list, you determine that other hedge funds are well aware of this opportunity, as the top shareholders include large hedge funds such as Lone Pine, York Capital, TPG Axon, and Hound Partners.
It may not be a bad thing that other hedge funds are involved. You will probably be invested in a good company in this case, as large hedge funds rarely get involved in unsound investment ideas. That being said, crowded trades can, again, be very risky. First, if the market is already anticipating good news, it may be that the good news is already baked into the stock price. Second, if bad news comes out, then everyone will likely be forced to run for the exits at the same time. This will lead to adverse price movement that could destroy your holding.
Hedge funds in general tend to be short-term focused, so it could turn into a situation where one investor exits swiftly and triggers a domino-effect panic, crushing other investors in the wake.
Looking at charts can be very deceiving and can create misleading signals. For example, the stock chart below shows a quickly rising stock price, but that does not mean it is expensive. It may be cheap relative to its own history, the rest of the sector, or the market as a whole. The entire stock market might have been going up rapidly, or the sector as a whole might have had a big rally, and relative to the sector the stock underperformed, so it may actually be cheap on a relative basis.
You may also want to compare several valuation metrics simultaneously. For example, a company may look expensive on a Price/Earnings basis but cheap on an EV/EBITDA basis.
In the graph below, you can see that Factset Research Systems (FDS) is trading at 20x P/E. Relative to the market that is high, but relative to its own history, that is a normal trading ratio.
Business Model Questions
It is just as important to understand the industry in which a company operates as it is to understand the company itself. For example, if you are studying a homebuilder, it is important to understand the companies the homebuilders buy supplies from. If the building products companies are raising their prices and the homebuilder cannot raise prices, the builders are going to see their margins compress. Therefore, it is important to scan what is happening with related companies across the industry and sector to get a sense of the overall dynamic affecting the company’s earnings potential.
Homebuilding Industry: Related Participants
- Building Materials – USG, EXP, VMC, SHW
- Home Builders – LEN, DHI, KBH
- Building Products – WHR, MAS
- Furniture – TPX, LZB, ETH
- Extensions – Lawn care – SMG
- Mortgage Originator – BAC, C
- Insurance Provider – PRU, MET
A change by the mortgage originator will likely have an impact on the entire industry. If Bank of America (BAC) tightens its origination standards, then people will buy fewer homes; homebuilders will buy less carpet to go inside the homes; fewer beds will be sold; etc. Therefore, before considering an investment in a homebuilder or related entity, it would behoove you to perform checks to see what else is occurring in related industries and sectors across the value chain.
Business Model Advantages
Barriers to entry.
Companies with barriers to entry have a huge advantage relative to companies that do not. These barriers can occur for a variety of reasons, but some of the most common include economies of scale, substantial investment requirements, technological innovation, favorable government regulation, and networking effects. eBay, for example, is an extremely difficult company to compete against, because the company has established a formidable position as the largest Internet-based auction site available. Both buyers and sellers are unlikely to go to other sites, because both realize that eBay offers more individuals on the other side of the aisle to transact with. This makes it hard for new auction companies to compete with eBay effectively.
Companies in most industries will claim that they have high barriers to entry, but time will often show that a company earning significantly higher than its cost of capital will attract competitors. Put simply, if the company is earning outsized returns on the capital it invests, then it will attract competitor investment seeking to earn comparable returns. This competitive investment will result in increased production and sales competition, and diminished profit-earning potential will surely follow in the future.
The low-cost producer can have a huge advantage over its competition. In industries with large legacy assets, such as cement or coal production, the players with the newest assets are typically the lowest cost providers, and that allows for lower pricing often results in greater market share.
Alternatively, there is also a learning curve that can create the reverse effect, wherein the older industry participants have lower costs as the newer players are still “figuring it out.”
Repeat purchase items, such as paper or office supplies, can create a strong advantage for the producer. The more entrenched companies become within their customer bases, the higher the switching costs for those customers. For example, a large technology roll-out may effectively lock a customer in to the provider’s products, as it costs too much to execute a complete technology overhaul to switch to a different vendor.
Economies of Scale
Companies with large fixed costs need scale in order to make a profit. The larger the fixed costs, the larger the scale needs to be. Incremental margins can be very high once a company crosses a certain threshold and is able to sufficiently leverage its cost base. This can make a company highly attractive and cause a company to trade at a high multiple, once the threshold production level has been achieved. This phenomenon is sometimes referred to as “operating leverage.”
Oligopolies, or Monopolistic Competition
Functioning oligopolies can act similar to monopolies, in terms of locking in outsized profit margins from its business. These situations should not take place for long according to basic economic theory, but they can and quite often do. For example, the roofing industry has greatly consolidated in recent years, so that four players currently control 80% of the roofing shingle manufacturing market. When one of the four manufacturers raises its prices, the other three can easily follow. For the past five years, none of the players has broken from the pack and tried to steal market share from the other three by offering a lower price. As a result, the industry has seen its operating margins grow from 8% to 20% in recent years. Whether this increase in margin is sustainable over the long term remains to be seen.
What is a “good” return for a portfolio? How do you know? What is a good return for an individual investment?
The Academic Approach
Expected Rate of Return = Risk-free return + Beta × (Expected Market Return – Risk-free return)
This is the equation from the Capital Asset Pricing Model (CAPM), which you will learn in school—but try pitching this to a portfolio manager at a hedge fund. He or she will likely tell you to get lost!
Theoretically this makes perfect sense, but most hedge funds don’t use this as a hurdle rate. Most funds target a 20% return—though very few are capable of actually achieving that return consistently.
The Practical Hedge Fund Approach
A more practical approach is to study what percentage of the time you will make money and lose money on your investments. From there, you need to understand how much you make when you are right and how much you lose when you are wrong. Here is an example of this framework:
As you can see:
Average Return per Idea = (% Right × Avg. Return When Right) + (% Wrong × Avg. Loss When Wrong)
% Right is often referred to as your “Hit Rate,” and Average Return When Right is often referred to as your “Slugging Rate.” The magnitude of your wins relative to that of your losses is referred to as your “Win/Loss Ratio.”
The best analysts are right about 60% of the time. Most people think they will be right closer to 75%, but the sad truth is that most investors will not do much better than 50%. You can still make money being right only 50% of the time, but you have to be very disciplined about cutting your losses. That is why maintaining a 2-to-1 Win/Loss ratio is so important.
Here is what is so troubling about the example given above: a fantastic analyst who is right 60% of the time, makes a 30% return when right, and maintains a 2-to-1 Win/Loss ratio, will only earn an average return of 12% per idea. However, as we noted, most hedge funds try to earn 20%, so how can they do this?
One possible solution is to employ leverage, but from an analyst’s perspective, he/she typically does not have control over this. So how can an analyst generate a higher return per idea?
A higher Hit Rate is very difficult to achieve. Also, achieving greater than a 2-to-1 Win/Loss ratio is also not realistic, as it would require tighter stop-loss controls that may result in the premature exit of lucrative investments simply because they took an initial “hit” before panning out.
Therefore the only real area to control is the Slugging Rate. If this is the lever, then the analyst cannot afford to invest in stocks that will only earn 10%, 20%, or even 30%. It is just not a high enough annualized return. At a 40% Slugging Rate, the analyst can get closer to the elusive 20% total return hurdle.
40% thus tends to be a “sweet spot” for many hedge fund analysts, as a minimum hurdle rate of return for putting on a position. If the investment only has a 6-month duration, then the return only needs to be 20%, which is roughly 40% on an annualized basis.
Searching for 40% Returns
What needs to happen in order for a stock price to increase? Either earnings need to expand, or the multiple needs to expand, or a combination of the two. The first step is to look at where the sell-side estimates are for the current year and two years into the future. If AAPL is trading at $611 today and is expected to earn $54 in 2013 and $63 in 2014, it is trading at 11x P/E and 10x P/E in 2013 and 2014. In order for the stock to reach $855, or 40% higher, you might project earnings to be 20% higher than the street in 2013 at ~$65, and for the multiple to expand by 20% to ~13x. Or, you might predict stronger earnings growth and less multiple expansion, or vice versa.
As you can see, it pays to think through different scenarios needed to achieve your target return.
A common mistake analysts make is to say that they believe a stock will appreciate by an amount but have earnings expectations that equal or are very similar to those of sell-side earnings estimates. That means that for the investment thesis to prove correct, the stock must increase entirely due to multiple expansion. That is generally viewed as a “low-quality” thesis, as expansion in a valuation multiple is more difficult to predict and gain confidence in than is growth in earnings.
How to Create an Investment Thesis
by Admin | Feb 5, 2021 | Angel Investing , Finance , Venture Capital | 0 comments
One of the essential elements in a venture capital firm is the investment thesis. The thesis can come in many varieties, from broad and loosely defined focuses to a specific vertical and company stage. On the other hand, some investors choose to allocate capital without a core thesis driving their decisions and see success in this strategy. This post will define an investment thesis, why investors decide to develop one, and some tips on creating one.
What is an investment thesis?
Simply put, the investment thesis is an assumption made about a market, vertical, or trend that will drive the strategy for a particular firm or fund. Just as a startup will assume a problem or market need and build a product around solving that problem, an investor will consider various markets and trends and develop an investment strategy focused on that assumption.
Why develop an investment thesis?
The thesis is the driving force behind what a firm chooses to focus on to generate returns. It will be a fundamental part of how VCs decide what to look for in specific markets, source deals, and where they ultimately decide to invest their capital. The thesis helps keep a firm focused, allowing investors to work within particular parameters when they go about their business.
There are a couple of advantages to having a thesis-driven approach as a venture capital firm. It will drive relationships that the firm pursues. This relationship driver applies to how firms source deals from an investment standpoint and choose their limited partners. These relationships with experts in a particular vertical will help portfolio companies with mentorship, independent board seats, and talent sourcing.
A thesis compels VCs to be experts within their particular field. If a firm bases its thesis around FinTech, it will most likely have some expertise in that field. This knowledge will help them understand the marketplace, specific problems a startup is trying to solve and judge founder talent. The firm will also be a thought leader in the space by releasing analysis and reporting trends in the industry. Lastly, the firm’s partners will be a better value-add to the companies within their portfolio, paving a quicker path for a startup’s growth and success.
Example of a thesis
A16Z , a prominent Silicon Valley firm, has several different areas they invest in, from FinTech to Growth to Consumer focused startups. Below is their investment thesis for their FinTech portfolio:
“Fintech companies are innovating across broad categories — in banking, lending, insurance, real estate, and investing — both on the customer-facing side and in core infrastructure. We believe the combination of mobile, digital money, machine learning, and new data sources offers startups a unique opportunity to leapfrog outdated infrastructure and compete with incumbent financial institutions to reimagine the way we manage our finances.” Source
We understand that the firm focuses on startups that use mobile and machine learning to innovate on financial management through this statement. This thesis has helped drive the firm’s investments in Stripe (now valued at $36B) and Carta (currently valued at $3.3B).
For an awesome hub of investment thesis examples, check out this link !
How to build an investment thesis
When developing a thesis, there are vital things to keep in mind:
Markets : Start with market sizing to make sure that a particular industry is worth pursuing. We will discuss market sizing strategies in a future post.
Trends: Understand macro trends impacting the markets and industries that you determine are big enough to pursue.
Companies : Break down each company within a market that has upside potential. Look at recent companies that have seen success within your specific industry focus.
Exits : Make sure there is an exciting exit environment for companies in that particular segment. You want your investments to see a return through going public or M&A activity.
Tips on the above:
Things to think about defining in a thesis would be company stage, geography, vertical, or market.
People tend to want a fully-formed thesis right off the bat, but it’s an iterative process. The scrum process might be three months, but the full process can take a year before talking about a thesis publicly.
Have a hunch on something that isn’t fully formed and then test it out:
Go out and talk to entrepreneurs.
Talk to buyers of the technology.
Form relationships with ecosystem partners.
Incrementally improve your thesis based on feedback and results.
For some more tips and strategies on creating a thesis, check out this informative Medium post .
The thesis can help you stay focused and is your north star. For startups, it will help them target your firm. For LPs, it will help them judge your conviction and investment strategy. When developing a thesis, think about taking on big problems and big ideas. There are so many significant issues to be solved globally, and we have a golden opportunity to help solve them. Think big, and don’t limit yourself only to ideas on making returns for investors, but how to impact the world.
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PE Investment Memo Examples?
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Fellow monkeys: Does anyone have an example of a PE investment memo that they can share? Ideally, I'd like to see one from a prior case study when you guys went through buy side recruiting.
If nothing else, can someone give me an outline of some of the most relevant topics that I should hit upon when I (hopefully) go through recruiting? Appreciate any help, thanks.
Private Equity Investment Memo's
Here's the basic structure of a private equity investment memo as laid out by a certified private equity user. attached is an investment memo from blue point capital group.
from certified user @Minnow4"
Business and Transaction overview Financial Performance/Customer Data Industry Overview/Competitors Management Team Strategic Plan/Thesis Exit strategy Summary of Returns
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The following would be the general outline of an investment memo based on what I saw.
- Executive Summary -> investment thesis, why the company, industry average growth rate, brief growth strategy and exit strategy
- Source of deal - Background of seller and reason for sale (retirement/spin off etc)
- History of the business
- Products and Services - Top products, their margins and % of total revenue
- Suppliers and customers - % of total revenue
- Detailed breakdown of company's daily operations and how they go about doing things e.g. sales and marketing (what are their plans/processes)
- Org chart + Management team + scoring/review
- Detailed Industry overview - Industry growth and growth drivers. Competitive landscape
- Detailed growth strategy e.g. what you plan to do with the company after buying it to get your IRR
- Investment risks e.g. FX
- Company financials - projections + public comps + M&A comps + lbo (base case, management case and what you think is right/your company)
Extra things that you can add in. 1. Overview of country if you are entering a new market 2. FX graphs 3. Overview of economic policies and political issues in the country 4. Any potential CEO/CFO lined up through headhunters 5. DD process timeline and expected completion date 6. Financing of the deal 7. Potential targets if your company follows a "buy and build strategy"' 8. Sensitivity tables
Woozy: The following would be the general outline of an investment memo based on what I saw. 1. Executive Summary -> investment thesis, why the company, industry average growth rate, brief growth strategy and exit strategy 2. Source of deal - Background of seller and reason for sale (retirement/spin off etc) 3. History of the business - how it had started off 4. Products and Services - Top products, their margins and % of total revenue 5. Suppliers and customers - % of total revenue 6. Detailed breakdown of company's daily operations and how they go about doing things e.g. sales and marketing (what are their plans/processes) 7. Org chart + Management team + scoring/review 8. Detailed Industry overview - Industry growth and growth drivers. Competitive landscape 9. Detailed growth strategy e.g. what you plan to do with the company after buying it to get your IRR 10. Investment risks e.g. FX 11. Company financials - projections + public comps + M&A comps + lbo (base case, management case and what you think is right/your company) Extra things that you can add in. 1. Overview of country if you are entering a new market 2. FX graphs 3. Overview of economic policies and political issues in the country 4. Any potential CEO/CFO lined up through headhunters 5. DD process timeline and expected completion date 6. Financing of the deal 7. Potential targets if your company follows a "buy and build strategy"' 8. Sensitivity tables
jesus christ this is not a CIM . your memo should be 2-3 pages MAX
Very helpful; thank you.
Thank you very much. Now please, can you tell us what's the diference between an investment committee memorandum and an information memorandum?
Thanks Woozy seems pretty detailed. Whiskey5 anything to add? Or delete in your opinion?
- Business and Transaction overview
- Financial Performance /Customer Data
- Industry Overview/Competitors
- Management Team
- Strategic Plan/Thesis
- Exit strategy
- Summary of Returns
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Lessons from Private-Equity Masters
- Paul Rogers,
- Tom Holland,
Private-equity firms routinely achieve eye-popping returns on the businesses they operate. Their secret? A relentless focus on four management disciplines.
Going private was the making of auto parts manufacturer Accuride. For years, the enterprise had struggled as a unit within the giant Firestone Tire and Rubber Company (now Bridgestone/Firestone). Because Accuride’s business—making truck wheels and rims—was peripheral to Firestone’s core business, it found itself starved for resources and managerial attention.
- PR Paul Rogers ( [email protected] ) is a partner who leads Bain’s London office; he formerly led Bain’s Global Organization Practice. They are coauthors of the forthcoming book Decide and Deliver: Five Steps to Breakthrough Performance in Your Organization (Harvard Business Press, 2010). Portions of this article are adapted from the book.
- TH Tom Holland, a director in San Francisco, helps lead Bain’s Private Equity Group.
- DH Dan Haas ( [email protected] ) is a partner in Bain & Company’s Retail practice.
Essays on private investments in public equity
- Panetsidou, Styliani.
- Strathclyde Thesis Copyright
- University of Strathclyde
- Doctoral (Postgraduate)
- Doctor of Philosophy (PhD)
- Department of Accounting and Finance.
- This PhD thesis, comprised of 3 essays, assesses the activity of Private Investments in Public Equity (PIPEs) and provides new insights on PIPEs behaviour. In the second chapter, I document PIPEs performance around the world and assess whether cross-country regulatory and institutional differences can explain the variation in PIPEs valuation. I document a significant decline in the market valuation around the announcement of PIPEs, especially from 2004 to 2015 and find that firms participating in the PIPE market during these years have worse fundamentals in terms of size, profitability and operating performance. I further find that PIPE issuers are followed by a significant long-term underperformance globally. Finally, consistent with the Law and Finance theory, I show that country governance quality matters, as issuing firms operating in countries with better regulatory quality and higher law enforcement outperform others. In the third chapter, I examine the stock returns and volume prior to PIPE announcements, to document whether there is a price run ahead of the public announcement of the issues. Focusing in the UK and the US, that both have high levels of PIPE activity but differ in the PIPE regulatory environment and insider trading treatment, I assess whether the price run patterns are affected by regulatory differences. In addition, assessing the contemporaneous relationship between abnormal returns and volume, I examine whether the price runs can be explained by leaked information. I find abnormal returns and abnormal volume prior to the announcement of PIPEs in both markets. I further find support of the information leakage hypothesis for US issuers. In the fourth chapter, I assess registered insider trades around PIPEs in the UK. I examine whether insiders adjust their trading strategies before the PIPE issue. I find that insiders significantly increase their net sales in the pre-announcement PIPE period, with the results being robust after controlling for time effects and comparing with a matched sample of control firms.
- Andriosopoulos, Dimitris
- Doctoral thesis
German FDI to China hit record high
German foreign direct investment (FDI) in China reached €11.9bn ($12.76bn) in 2023, with companies there reporting a similar rise in equity capital (€4.8bn).
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German FDI in China climbed by 4.3% and hit a record high of €11.9bn last year, official Bundesbank data cited by Reuters shows.
According to a press release from the Bundesbank, German direct investments abroad increased by €9.7bn last year due to a rise in the number of transactions. In addition, German companies reported €4.8bn more in equity capital abroad.
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“Foreign companies also provided additional direct investment funds to affiliated companies in Germany (€5.9bn),” the statement published on Tuesday reads. “They increased equity capital by €2.6bn and expanded the loan volume by €3.3bn.”
The latest figures come at a time when German and European officials are urging companies to reduce their exposure to the Chinese market. Tensions between Brussels and Beijing are at an all-time high after, in October last year, EU Commission President Ursula von der Leyen announced the launch of an investigation into Chinese subsidies for electric vehicle (EV) imports into the EU.
News about an increase in FDI outflows follows a survey published in November 2023, when one-third of the 3,600 German businesses interviewed reported plans to expand investments abroad in the next 12 months.
However, according to GlobalData’s FDI Database, the number of German FDI projects announced in China has gone down since pre-Covid levels. In 2019, German businesses reported 112 new investment projects across China’s territory, which dropped to just 60 in 2020 and has since tumbled down to 50 in 2023.
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In the past four years, German companies in China financed their projects by reinvesting profit and withdrawing capital, showing a much more complicated picture.
Juergen Matthes, an economist with the German Economic Institute, said in a report: “We can assume that there remains a split between the few big companies and the majority of small and medium-sized enterprises.
“Other studies and anecdotal evidence support the thesis that some medium and small-sized businesses are seeking to reduce their engagement with China or even to exit entirely,” he continued.
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