Every fund is different, and each fund manager has their own investment strategy based on their own market research. A manager's investment approach will vary depending on market dynamics, fund size, and their team's specific skills, knowledge, and network.
On top of defining a clear investment strategy, most funds also have a checklist or set of criteria they look for in a company before investing. Some of the criteria on this list - like the size of the target, year-on-year growth, or geography of operation, are there to quickly filter out the investment opportunities that do not qualify as qualitative deal flow.
Other criteria can be designed based more on experience and historical data for what, statistically, makes a company successful. This is where you'll hear about more subjective measures like "level of innovation" or "management execution capabilities."
Once the criteria and investment thesis are adequately defined, then comes the challenge of scouting the right companies. There are plenty of fish in the sea, especially for start-ups looking for fundraising. Still, given the high chance of start-up failure, managers must select only the best companies to deliver above-average returns for investors.
VCs can receive thousands of opportunities each year; that's an average of 4 opportunities to review per working day! On top of that, the competition with other VCs is fierce, so firms must be able to select the most promising venture. They also must win the venture over.
Independent sponsors and PE investors focusing on more mature companies generally have a smaller deal flow, so they will spend less time filtering out inbound opportunities. However, they may need to put more effort into building their network to come across new deals. Sourcing platforms like Axial have lowered the barrier to entry for newer sponsors.
The holy grail of private deals are typically ones that are not brokered or on the open market. Institutional investors often pursue these deals. VCs hire scouts whose only job is to find promising start-ups needing capital. Buy-out firms may do their own outreach to companies that fit.
But what's the best way to uncover companies that are most likely to succeed? No matter the industry or the size of the fund, there are several factors and attributes that any investor or independent sponsor would want to look at to select the best companies to invest in. Taking note of these factors is also crucial for ensuring they can spot potential red flags early on to (hopefully) avoid a preventable disaster down the line.
To find a gem in a vast ocean of companies looking for funding, you'll have to do extensive research. Here is a list of criteria to consider when selecting your next portfolio business.
VCs and private equity investors often consider the team as the most essential attribute of a target company. While outperforming venture capital portfolios are made from great ideas, it all typically stems from great founders. More specifically, the following points are worth spending time assessing:
As a rule, VCs and Private Equity managers want their PE target companies to be innovative market disruptors or their portfolio company to be led by a solid execution team iterating on an existing concept but executing better than other players. The latter corresponds to the business model rocket internet has built its success on.
Before investing, it's great to spend time understanding what has been achieved, but it is also essential to assess the whole vision of the founders and whether the path they intend to take to get there is realistic. Their plan should be able to be broken down into actionable steps.
Many companies pitch nonspecific goals like “we’ll get 1% share of the market in the next three years” or that they will “onboard B2B customers by investing in sales and marketing". Still, they don't seem to know what the exact steps are to get there, or they do not know how to communicate them.
Even the best business model with the most precise roadmap isn't enough. What if the entire market changes? It likely will, and sometimes faster than anticipated. This is why assessing your target's ability to think on their toes is also essential. They must have the capacity and agility to pivot when facing adversity or transition to a plan B altogether when the newly available data shows management should pursue a better strategy. After all, Twitter started as a podcast network and Nokia as a paper mill!
The fact that huge publicly traded companies like Uber are still not profitable shows that focusing on investing in companies with a clear path to profitability may not be that obvious. However, before making a private equity investment, it is crucial to understand what it will take for the company to make real money and challenge management's assumptions to ensure they are realistic.
For a VC fund looking at a target, traction is a good indicator of whether the company seems to be on the right path to market fit. However, ensuring management knows how to turn that traction into a profitable business model is also essential.
Not every investor follows this principle. The VC model tends to focus primarily on rapid top-line growth, assuming that monetization will follow once the company is in a dominant position. However, investing in companies with a clear roadmap and monetization strategy is a more sustainable way to reduce the risk of failure (for everyone involved).
We mentioned earlier that the team is the most important factor for professional investors to invest in a company. Market is generally a close second.
To assess the potential of a target you consider investing in, you will want to look at the market from different angles.
While looking at the market, you'll also want to look at different factors that may make the company more or less attractive. These are well documented by strategy consulting firms like BCG or McKinsey.
Try analyzing the market under the framework of Michael E. Porter, known as the 5 Porter’s forces (Bargaining power of buyers, Bargaining power of suppliers, threat of new entrants/barriers to entry, threat of a substitute product and Intensity of the competitive landscape)
Especially in today’s troubled time, understanding how resilient the target company is to macro-economics and societal change has a massive impact on the risk/reward assessment of the investment.
For instance, is the target’s product hype-driven (think Cannabis, cryptocurrencies, or companies like Peloton), or does the company sell products that people are doubtful to stop paying for (e.g., toilet paper or tombstones)?
Each industry will have specific KPIs that will help any seasoned investor compare the performance of the target vs. its peers. However, overall, there is a list of general KPIs that we can track for almost any type of company.
With the internet now an integral part of our lives, it would be a mistake not to google the target and look up customer reviews, complaints, and the overall public sentiment on social media regarding the brand. If customers already love the brand and the product, you're a step ahead. While reviews aren’t necessarily everything, 2-star reviews on Google, Capterra, or Trust Pilot will only cause problems and may directly reflect underlying issues within the organization.
It might be difficult to find customer feedback for a company that doesn't have a significant online presence (though a rarer scenario today). Additionally, if there is a suspicion of competitors purposedly posting negative reviews of the company, asking to speak with some of the target’s customers is a great way to get additional information to uncover what needs attention.
No PE investor expects management to deliver an exact replica of their business plan. However, making sure management understands what it takes to deliver on their revenue target and what will be the impact (on net working capital, on the evolution of fixed costs and Opex, on what hiring is required, etc.) is critical.
As for the product and strategy roadmap, you want to make sure the founding team uses realistic assumptions for the basis of their forecast and that their projection makes good business sense. If not, you cannot trust that they’ll make the best decisions for the business in the long run or accurately assess the company's expected value.
One other thing to look at to assess how likely management is to deliver on their 3- or 5-year forecast is to do a budget accuracy analysis. In other words, look at historical budgets and compare them to actual results to assess how accurate management’s budgets were in previous years.
If they hit their target every year, it is generally a good sign that shows they understand how their business is trending. If managers prepared the 5-year forecast similarly, it is more likely to be achieved.
As a rule, owners will try to sell at the best time possible (for them). Make sure you understand what motivates a sale and if the timing is right for you to come in. You do not want to buy a growing company and be the victim of backlash a few months after you take over.
To avoid these issues, look for recent trends in the business. Either for a switch like revenue, a change in the amount of marketing spend that may have driven a one-off spike in sales, or assess the impact of the pandemic on the business, which has drastically boosted several types of businesses like mask manufacturing (and less obvious ones like the sales of puppies for instance)
An excellent way to do that is to not only rely on annual financial statements but also to look closely at the latest months available. Calculate a run rate that considers the business's seasonality to ensure the most recent trend matches the historical trend.
Looking up or asking for the number of years a company has been operating is a good reflex. The conclusion will depend on the context of the investment but in any case, having that information in mind is always valuable (you absolutely must have this information).
As a rule of thumb, a company that has been in business for more than five years and is still profitable and growing is an excellent sign to de-leverage the risk that the company will fail. However, for more growth-aggressive types of investors like VCs, if a company has been around for too many years without entering fast growth, it may not qualify for a VC round.
An additional benefit of having a long historical track record of the business is that you can get more feedback from management about what worked, what didn’t, and what insights were gathered from mistakes made along the way.
Investing in a company over three years old will also reduce the chance that the traction that the target has seen was driven mainly by some hype effect (e.g., one-time press coverage) which may soon fade away.
A company with historical data also provides more reliable and richer information to analyze (for instance, how long customers stay on average, what is the seasonality of the business, what was the level of consistency of growth/profitability)
Different fund managers will weigh the above factors differently. Still, the team's quality, the founders' capacity to retain talent, and the market dynamics will always remain the most important attributes investors look for.
We are also seeing an increasing number of data-driven investment managers leveraging Machine Learning and AI. However, the availability and collection of clean data is still the main obstacle to that approach today. However, most investors highlight the importance of soft skills and interpersonal fit.
At the end of the day, whether you are a PE firm, a Venture Capitalist, or an independent sponsor, selecting and working with people you respect and get along with will make it much easier to build a successful venture.
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