Many investors focus on bond investment and run-of-the-mill stock when choosing how to allocate their personal portfolio, and they overlook alternative investments such as private equity. However, private equity firms can exploit opportunities that aren’t available in the public market and these strategies can turn out to be extremely beneficial long-term investments.
With the capital that is provided by private equity firms, companies can drive their development. Moreover, private equity boutique firms generally bring their contacts and expertise to the portfolio companies which they can use to their advantage.
In order to get the most out of your return potential, choosing the right private equity manager is crucial.
1. Capabilities of the Investment Team
It is essential that you assess the capabilities of the team that will be monitoring, sourcing, exiting, and negotiating the investments of the manager. The experience and the backgrounds of the investment professionals should be investigated by prospective investors, as well as the continuity of the team to working efficiently together.
These individuals will have an important role in the underlying portfolio companies in which they invest, so you need to make sure that the manager’s team is quite solid.
2. Firm Culture
What is the size, vision, values, and history of the firm? How long have the partners been working together? Is an inclusive environment promoted within their portfolio companies and internally? These are some questions regarding the firm culture you need to ask yourself before picking a private equity manager.
Do the principals of the management firm have their own funds at stake in the partnership? What this does is assure alignment of interests between the investors and the manager.
How is the compensation of the general partner shared? Does the leadership of the firm focus more on carried interest from investment success or fee income from larger fund sizes? What other fees are earned by the manager?
4. Value Creation Methods
Private equity managers usually employ all three value creation methods. These attributes should be examined by investors to find consistent patterns and assign the highest value to growth in EBITDA and/or revenue. Below are the three value creation methods explained.
- Multiple expansion happens when a portfolio company is sold by a private equity manager at a higher entry valuation multiple than what they acquired it for initially. This can be proof of an experienced seller who chooses the right time to sell and knows how to optimize value and/or a disciplined buying strategy.
- Financial engineering usually refers to increasing the leverage ratio of a company or adjusting the capital structure to boost equity returns. Leverage magnifies both gains and losses, and even though it can be a useful tool to increase returns, there’s still a risk to it.
- Revenue/EBITDA growth is mostly determined through a combination of organic growth, streamlining costs, add-on acquisitions, and operational improvements. This is a driver that is the toughest to constantly generate and it is the most important one.
5. Track Record
The performance of the private equity manager in the past should be examined using both qualitative and quantitative analyses. You should focus on things like lead investment professionals, source of investment, sector, geography, and equity check size.
Even though on an absolute basis the track record of a private equity manager may be appealing, there might have been favorable market conditions that have resulted in certain vintage years outperforming others. In order to determine relative performance, you need to compare the historical performance of the private equity manager to other funds in the same vintage years that followed a similar investment strategy.
In order for investors to estimate the illiquidity premium that should be expected for private markets structure without daily liquidity investments, past performance should be compared to a relevant public market benchmark.
You need to ask yourself about the overall timeliness and quality of the private equity manager’s financial reporting. What is the quality of the information? Is the level of information sharing adequate for monitoring and due diligence? Is it easy to obtain custom or standard information?
More than just a financier, many private equity managers are active investors, engaging on a regular basis in the mentoring, strategic marketing, and management of their companies, and holding board seats.
The importance of a good personality and philosophical fit between you and your private equity manager cannot be overstated. For this reason, we recommend you follow the tips we shared in this article when you’re choosing a private equity manager.