Private Equity is undoubtedly a competitive industry. While private equity has traditionally been known as a cutthroat business focused on cost cutting and profit-generation, this trend has slowly shifted in recent years. Private equity firms are looking towards long-term value generating propositions to drive acquisitions.
For this reason, it is especially relevant to understand the major market factors that have an impact on the target companies for private equity firms. Here we'll provide you with a quick overview of these factors and detail how private equity firms monitor them, including the use of a due diligence platform.
Every company is directly affected by the condition of the market in which it operates. Generally, market conditions are factors that affect a market or industry as a whole, and in turn, the individual companies within it.
When a private equity firm monitors a potential acquisition, it will simultaneously analyze market conditions to determine if the company retains a sustainable outlook. This private equity investment analysis is a critical step in the valuation process. The following 7 factors have a major effect on whether a private equity firm will move forward with an acquisition.
The competitiveness of the market will have a major effect on the potential for an individual company to achieve sustainable growth. Generally speaking, a highly competitive market with a large number of companies offering similar products may be less profitable.
This is not to say that private equity firms should refrain from acquiring companies that operate in markets that are highly competitive. Instead, they should simply monitor this market factor when targeting a company.
Harvard Professor Michael Porter outlined five forces that determine the competitiveness of an industry which are widely applied today:
While these five forces represent a traditional approach to monitoring competitiveness in a specific market, they have been consistently applied when considering the efficacy of a leveraged buyout.
The potential for growth within the industry is a major factor when determining the suitability of an acquisition of a target company. It is unlikely for a private equity firm to invest in a company that operates in a declining industry.
Building on that, private equity firms tend to value industries that retain multiple paths for growth. Some key consideration factors include:
Private equity firms increasingly value industries that can achieve growth in multiple ways and look for companies where they can inject both financial and organizational capabilities.
Like achieving growth, private equity firms also invest in markets that have untapped value creation potential. Some examples of value creation potential include:
If companies operate in a market that has untapped value creation potential, it will be more attractive to private equity investment. These firms value the ability to cut costs and expand existing capabilities to other revenue sources, so industries that retain this potential will be a major target of a private equity firm.
Private equity firms tend to avoid (or under-value) industries that require high levels of capital expenditure. This factor can also vary depending on the company.
If a potential acquisition operates in an industry that will require a high level of initial investment, a private equity firm will see this as a negative factor and effectively want to pay less for the company.
Conversely, if a company already owns the necessary capital to conduct business and grow, a private equity firm will be willing to pay more for the acquisition.
From an industry perspective, some markets require a higher initial investment to either achieve growth or move into other markets. Private equity firms will assess this requirement when determining their offer to invest in a company.
Environmental factors can also have a major effect on how a private equity firm valuates an acquisition. Many industries operate in a seasonal pattern where cash flows fluctuate greatly.
As a general rule, private equity firms value industries that have stable year-round cash flows with limited exposure to long periods of decline.
The recent trends in the industry and potential for growth have a major effect on the valuation of a specific company.
If an industry is expected to grow rapidly, is seen as especially innovative, or requires a specific technical capability that is difficult to acquire, companies that operate in the market will be more sought after from the perspective of private equity firms.
Lastly, regulatory hurdles and costs can have a major effect on the value of companies that operate in a specific industry. If there are increased tax burdens or the potential for negative public perception, private equity firms will consider this when making a bid.
When conducting due diligence, a private equity firm will look at three main areas to determine how market conditions affect a specific acquisition moving forward: commercial, financial, and legal due diligence.
There are usually disparities between what the management team of a given acquisition company provides to private equity firms and the actual expected results, making the due diligence process especially important in valuing a company prior to purchase. Market factors play an important role in this process.
To determine how many of these market factors affect a specific company, private equity investors will conduct commercial due diligence to uncover any potential risks to the business prior to an acquisition.
Commercial due diligence will generally look at the context of the company within several key areas of the wider industry.
Every private equity firm will also conduct a detailed audit of a company prior to moving forward with an acquisition. While many firms outsource this process, they generally work closely with auditors when conducting financial due diligence.
Financial due diligence can be an extensive process and typically includes several key investigations.
The legal due diligence process takes an investigative approach to any legal costs or lack of compliance that was missed in initial negotiations. In broad terms, this process looks to uncover any potential liabilities that could arise post-acquisition.
While market factors have a major effect on how private equity target companies are assessed, the application of these factors to the specific company is more important when valuing an acquisition.
However, industry trends and norms have a major effect on how a company operates, forcing private equity houses to constantly monitor the wider industry for all current and potential portfolio companies.
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1. Forbes. How Private Equity Is Shifting From Cost Cutting To Growth.
2. Harvard Business Review. Private Equity's New Phase.
3. Investopedia. Porter's 5 Forces.
4. Street of Walls. Private Equity Investment Criteria.