Formulating an Effective Investment Framework

As discussed in The Golden Rule of Private Equity Investing, establishing an investment framework is a critical first step in the investment process. Without a clearly established framework, its challenging to objectively evaluate investment prospects in a consistent manner.

What is an investment framework?

An investment framework is a structured and systematic approach that guides an investor through the process of evaluating, executing, and managing investments. It establishes the criteria and processes used to identify opportunities, assess risks, allocate capital, and achieve desired returns.

In the context of private company investing, an investment framework defines investment criteria and what a successful investment looks like. It also governs the key elements of the investment process including deal sourcing, prospect qualification, due diligence and post-closing operations, among other things.

What makes strong investment criteria?

Not dissimilar from common goal setting techniques, investment criteria should generally be:

1. Specific & Measurable, to allow for objective evaluation of opportunities

2. Realistic & Achievable, to ensure that they can actually be met

3. Complete & Concise, to ensure they are easily understood by all stakeholders

While investment criteria can vary greatly depending on the investor type, their goals, and their risk tolerance, private equity investment criteria generally have a combination of the the following criteria:

• Binary Criteria: Industry and/or Sector; Geography; Deal Size; Investment Structure and/or Ownership; Investment Horizon

• Quantitative Criteria: Financial thresholds, such as Revenue; Revenue Mix, Concentration & Retention; Growth; Profitability Margins; Return Requirements

• Qualitative Criteria: Industry Dynamics; Product Characteristics; Customer Base; Market Position; Competitive Advantages

A rule of thumb is that an investor might have 5-10 investment criteria in total.

Although investment criteria should be clearly defined, investing also involves an element of art, necessitating some degree of discretion. An investor can accomplish this by distinguishing between required and preferred investment criteria and establishing guidelines for assessing and evaluating imperfect opportunities.

What makes a strong investment process?

Documentation of the investment process should be extensive and, at a minimum, answer how the investor intends to:

1. Source, engage and qualify investment prospects

2. Value opportunities, and formulate and present offers

3. Conduct due diligence and obtain investment signoff

4. Operate the acquired company post-closing

It is crucial to clearly define each element of the investment process, as they are frequently interconnected and reliant on each other. A well-defined sourcing process results in higher quality opportunities and more offers, while a robust due diligence process positions the business operator(s) for success once the deal closes.

What's next?

Once the investment criteria, process and remainder of the framework is established, the investor can:

1. Build a sourcing process to target companies that meet investment criteria

2. Qualify, evaluate and prioritize opportunities against the criteria

3. Run a comprehensive and objective due diligence process

4. Create a post-closing operational plan to drive value

In conclusion, it is crucial to have the discipline to establish at least a basic framework before seriously considering investing in or acquiring private companies.

At M-Squared Advisory, we view every client project through the eyes of an investor, drawing on past transaction experience. We have the expertise to help clients define their investment criteria, build and optimize their investment and due diligence processes, and properly document their investment framework.

If you are thinking about investing in private companies or need help formulating your investment framework, we can help. Reach out here.