The Golden Rule of Private Equity Investing

What is the key to success in private company investments?

Although there are various ways to answer this complex question (including with popular buzz words like synergies, value creation, and arbitrage), one factor stands out among the rest: investment discipline.

Those who have been through the ups and downs of any kind of investing can usually attest to this. Renowned investors such as Benjamin Graham and Warren Buffet consistently emphasize(d) discipline as a crucial factor for success.

What leads private equity investors to be undisciplined?

Based on our experience, this is frequently attributed to one of three factors:

1. Inadequate investment framework

2. Insufficient pipeline of investment opportunities

3. Lack of an appropriate due diligence process

The significance of the investment framework

It's quite straightforward. Without a clearly established investment framework, it becomes extremely challenging to impartially evaluate investment prospects. The investment strike zone either remains undefined, expands excessively, becomes overly flexible, or shifts unpredictably.

Establishing a well-defined investment framework and a defined set of investment criteria is crucial for achieving success. This enables investors to promptly and objectively evaluate investment opportunities and provides a consistent benchmark to refer to throughout the entire due diligence process.

The importance of having an adequate pipeline

I have witnessed this scenario before. In the absence of enough alternative investment options to rely on, even rational investors may convince themselves to settle for subpar investments. They might say, "If we don't proceed with this one, what other choices do we have?" or "We have to close this deal to meet our targets for the year."

Having a sufficient pipeline enables investors to reject subpar deals when they deviate too far from their criteria. Walking away from an opportunity is never simple or enjoyable, but it becomes more manageable when there are other prospects in the pipeline to turn to.

The importance of due diligence

Due diligence is the key moment to carefully evaluate the investment opportunity. Not having a well defined process is a recipe for failure. It causes investors to simply go through the motions of a due diligence process, without diving in and asking the key questions where necessary.

Having a clear, well-defined process allows investors to take a risk-based approach to due diligence, prioritizing the most crucial aspects of the investment thesis. Being aware of your non-negotiables beforehand is essential for ensuring that risk is properly evaluated.

In conclusion, investors seldom fail because they pass on a deal that might turn out to be good, but rather because of the bad deals they fail to avoid.

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 a pipeline, and run an efficient, but comprehensive due diligence process.