Finance

Part 2: The Top Three Private Equity Problems Firms Need To Solve

author Josh Miramant January 30, 2020

The Top Three Private Equity Problems Firms Need To Solve

It’s getting more challenging to win in private equity. Investors come to private equity firms for unique opportunities and higher returns. Companies come to private equity for funding when other funding options are not suitable. To succeed, private equity firms need to land a steady stream of new investment opportunities to meet investor expectations.

The Key Problems Private Equity Must Face

The days of small personal networks dominating private equity are over. According to McKinsey research, there are 8,000 PE-backed companies in the USA in 2017 versus 4,000 in 2006. In terms of private debt fundraising, there were 139 funds in 2018, with an average fund size of $781 million. New firms are hungry for deals to establish themselves. Established firms can no longer assume they will get all of the investment deals they need.

1) High levels of competition from other private equity firms

When a growing company seeks funding to grow, they have no shortage of options. At the small end of the spectrum, the rise of angel investor websites like AngelList make it easy to obtain small amounts. At the larger end of the deal spectrum, there are hundreds of firms sitting on large amounts of capital. Add up these challenges and it is no surprise that a growing number of PE firms are sitting on their capital.  

Consulting firm EY recently summarized the state of the PE market in these terms: “many players chasing too few deals.” Private equity firms have more than $600 billion in capital sitting on their books as of early 2019. As more and more capital sits on the sidelines, return on assets and other financial metrics will start to decline.

2) Difficulty carrying out due diligence processes

Invest in the wrong company, and you will suffer terrible returns and reputational damage. Imagine if you were an investor in Theranos, the failed health technology company that raised $700 million from investors. In private equity, your judgment in selecting investment deals matters. If you are associated with a CEO who ends up facing criminal charges, your investors will ask you tough questions.

You cannot eliminate investment uncertainty in private equity. However, you can take steps to reduce the most common problems with due diligence. On the other hand, private equity firms are under pressure to complete their due diligence process as quickly as possible to close a deal.

3) Difficulty in locating suitable investment opportunities

Information is king in private equity. If you rely on public sources like TechCrunch to find promising companies, you will continuously face deal competition. When your firm competes against other investors, you are going to make hard choices. For example, you might not get the board seats you want. Or you might have to agree to a different valuation. In some hot deals, you might have to accept a smaller allocation than you desire.

What Will Happen If You Ignore These Problems?

Failing to deliver strong returns to your investors means you will face difficult conversations. You may have to take on higher risk deals to meet your returns. Or you may have to pause your plans to raise additional capital while you regroup. Such a move may send unintentional signals to the marketplace that your fund is struggling. Taking on more risk and pressuring portfolio companies for better deal terms are not the only ways to improve returns.

Use Data Strategy To Improve Your Returns

Every private equity firm wants to claim that they are smarter than the competition. If you’re serious about making that claim, you can’t merely point to the number of PhDs you have on staff. Instead, you need to differentiate your PE firm based on data expertise. There are three ways private equity firms can deploy data skills to improve returns.

Identify New Deal Opportunities

Your ability to locate highly promising investment deals before anybody else is a critical way to build your reputation. In addition to relying on your networks, create your database to identify new strategies. Here is a simple illustration to show how to use data to determine investment opportunities:

  • Investment Hypothesis. You start with a tested idea, such as that computer science departments at certain institutions (e.g., Carnegie Mellon and Stanford) tend to produce high potential founders.
  • Data Source. You use data on company founders from Crunchbase and other sources to build a database of founders who share the patterns you identify above.
  • Data Analysis. Use data analytics to identify other patterns behind high growth companies like activity at conferences.
  • Deal Identification. Generate a list of high potential early-stage companies to approach. If you are the first or second investor in a company, you are more likely to land favorable investment terms.

Not sure how data analytics can help you identify deal opportunities? Reach out to Blue Orange to discuss the options.

Reduce Investment Mistakes: Optimize The Due Diligence Process

Warren Buffet’s first rule of investment success is: never lose money.

All investment decisions come with risk. However, you can use data insights to avoid mistakes. Consider the example of meeting a charismatic company founder. Their pitch may impress you so much that you want to charge ahead on the deal. Use a data-based balanced scorecard as a counterweight on the deal. Specifically, you can use data tools to effectively challenge a founder’s estimates of their company growth rates and overall market size.

For guidance on optimizing your due diligence processes without compromising on quality, contact Blue Orange for a free data capability assessment.


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