Finding suitable investment targets is difficult enough amid the information overload of the public equities markets. There, seasoned investors have almost too much to go on, and the signal all too often gets drowned out by the noise.
The world of private placements certainly isn’t characterized by a lack of information, but quality information is indeed more difficult to come by here. Hard numbers — analytics, models, projections — are no less important for private investors either, even if with considerably less certainty around them.
But investors in private companies, especially those in the earliest stages of growth, can’t rely on the numbers to the extent they’d prefer. If they want to make fewer mistakes, they need to look beyond the quantitative case and apply some universal tests — both to the companies they are targeting and to their own private portfolios.
1. They Complement Your Existing Investment Portfolio
Diversification is helpful, even advisable, but it’s not the highest and best purpose of a private equity portfolio. Private offerings demand far more due diligence than market-traded securities, which means PE investors can and should focus their energies on industries they know well.
Among other benefits, this strategy makes it easier to cut your losses. As an example, the back-to-back sales of two peripheral divisions of French building envelope solutions firm SMAC by Andrew Nikou’s OpenGate Capital freed up resources for what Nikou called “potential add-on investments” more closely related to SMAC’s core business lines. Nikou’s team might not have pulled the trigger on those sales if it hadn’t known the construction business and seen the writing on the wall — that SMAC was stronger without excess baggage weighing down its wings.
2. They Add Exposure to an Industry, Segment, or Geography You Currently Lack
Is this guideline in tension with the one above? Not necessarily. Again, diversification is helpful, even advisable, for private equity investors, even those who can count their active investments on one hand. While making allowances for potential synergies, you want to keep your portfolio’s overall correlation low. That means selecting for a variety of industries, lifecycle stages, and geographies.
3. Their Founders and/or Key People Are Assets, Not Liabilities
Sometimes it’s not the business idea that’s the problem — it’s the person with the idea. The most devastating recent example of “founder risk” involves WeWork and its charismatic but wildly overmatched founder Adam Neumann.
Neumann convinced SoftBank CEO Masayoshi Son, a noted iconoclast with excessive tolerance for risk, to write a blank check for Neumann’s solid-seeming coworking business. When reality caught up with Neumann’s high-flying promises, Son’s company was left holding the bag, its investment in ruins.
A more skeptical Son might have avoided the mess entirely, or at least cut its losses before the whole thing blew up. And his experience shows that even seasoned investors can be taken in. As an investor, it’s on you to seek empirical validation for every promise you hear, however reasonable it sounds in the moment.
4. They Have a Clear Growth Strategy
Your would-be portfolio companies should have a clear and detailed growth strategy, too. How will they reach their revenue and customer acquisition targets for the coming quarter? The coming year?
And what does success look like for the enterprise, really? “We will be profitable in 24 months, and we will achieve this by executing on our current strategy” is not a suitable level of detail. You want hard, fully modeled numbers and clear, measurable steps.
5. They Have a Clear Exit Strategy
Good private equity investments know what they want from the arrangement. More important, they know how they’re going to get out of the arrangement — and out of the business entirely.
That might look like an outright buyout by your firm or someone else. (If you’re not interested in that, it’s good to know early on.) It might look like an IPO. It might look like a strategic partnership.
The details are less important than the fact that there’s a plan in place. For everyone’s sake, you want to work with founders who know what they’re working toward.
Do Your Due Diligence
Every investor understands the importance of due diligence. Those that don’t tend not to last very long.
Unfortunately, many investors — retail and institutional alike — treat “due diligence” as the rough equivalent of “looking at the numbers.”
That’s certainly important. The numbers don’t lie, unless they’re not an accurate representation of the underlying facts. But they’re not the whole story either. Comprehensive due diligence means going beyond the numbers and examining the subjective aspects of an investment opportunity as well, from founder quality (or risk) to exit-related considerations.
This more expansive definition of due diligence does not guarantee success for private placement investors. Nothing does. It does ease the mind, though.