How Private Equity Investors Find Great Businesses

Summary

This video explores the five key factors private equity (PE) investors look for when assessing potential investments: a large and growing target addressable market (TAM), a strong competitive moat, a solid financial profile, robust unit economics, and a capable management team. It also highlights the importance of having a viable exit strategy for PE firms to ensure a return on investment. Additionally, the video provides valuable insights for those interested in breaking into private equity and investment banking, offering advice from the speaker’s own experience and educational opportunities.

Takeaways

• 😀 PE investors look for large and growing Total Addressable Markets (TAMs) as a key factor in determining investment potential.
• 😀 A shrinking market is a red flag for PE investors, as seen in the decline of cable companies with the rise of streaming services.
• 😀 A strong competitive moat, such as brand strength, proprietary technology, or cost efficiency, is crucial for long-term success and protection from competitors.
• 😀 Companies without a competitive moat, like Blackberry, risk being overtaken by disruptive competitors, which could result in failed investments.
• 😀 A strong financial profile, including stable cash flows, high free cash flow conversion, and low capital intensity, is essential for PE investments.
• 😀 PE investors dive deeply into financials, evaluating growth, pricing trends, margins, and revenue breakdowns to assess financial health.
• 😀 Strong unit economics are key to scalability, with successful companies like Shopify showcasing the ability to grow efficiently without high incremental costs.
• 😀 PE investors evaluate unit economics to ensure businesses can scale effectively, asking about customer retention, upsell opportunities, and fixed vs. variable costs.
• 😀 A credible and capable management team is crucial for the success of any business. PE investors assess the team's strengths, weaknesses, and vision for growth.
• 😀 PE investors continuously interact with management teams throughout the due diligence process to assess their ability to drive business growth and navigate challenges.
• 😀 A viable exit plan (M&A or IPO) is essential for PE firms to realize returns on investment, regardless of how great the business may be.

Q & A

What is the importance of Target Addressable Market (TAM) for PE investors?

PE investors prioritize businesses with a large and growing TAM because it indicates potential for future growth. A shrinking market could mean a poor investment even if the business is strong, as it would face declining demand over time.

Why is a competitive moat important in private equity investments?

A competitive moat protects a business from competitors, ensuring long-term profitability. Without it, a business is vulnerable to being overtaken, especially in fast-evolving industries like technology or smartphones.

What are the three key financial criteria PE investors look for in a company?

PE investors look for stable cash flows, high free cash flow conversion, and low capital intensity. These factors ensure that the business can service debt, reinvest for growth, and scale effectively without requiring heavy capital investment.

How do unit economics impact the decision-making process of PE investors?

Unit economics evaluate how efficiently a company generates revenue relative to its costs per unit of product or service. A business with strong unit economics, like Shopify, is more scalable and profitable, making it an attractive investment.

Why do PE investors place such importance on the management team of a company?

The management team is crucial because their vision, strategy, and ability to execute can determine the success or failure of the business. PE investors assess the team's capabilities and credibility to ensure they can drive the company forward.

What role does a viable exit plan play in private equity investing?

A viable exit plan, such as an M&A or IPO, is essential for PE investors to realize returns on their investment. Without a clear exit strategy, the business could fail to generate any returns, rendering the entire investment unsuccessful.

Can you provide an example of a business with poor unit economics?

WeWork is an example of a company with poor unit economics because its revenue per building is fixed and not scalable, and the company faces high costs for leasing and renovating buildings. This makes it harder to generate profitability compared to businesses with better scalability.

How do PE investors evaluate a company’s competitive landscape?

PE investors assess the competitive landscape by asking questions about the company's primary competitors, the intensity of competition in the sector, whether the company has a cost advantage, and whether its brand or technology provides a barrier to entry for others.

What does the phrase 'low capital intensity' mean in the context of private equity investing?

Low capital intensity refers to a business model that requires minimal investment in capital expenditures to generate revenue. This leads to higher profitability and scalability, making it a desirable trait for PE investors.

How do PE investors ensure a company’s market position and growth potential?

PE investors look at factors like market size, growth rate, the company's market share, and its ability to serve the market. They also analyze the company's go-to-market strategy and the impact of economic or technological changes on the industry.