investment thesis for private equity

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How to create a clear private equity investment thesis

Ben Harrison

President, Industries

For every dozen private equity deals, only one or two generate significant returns to their investors, according to Investopedia. The biggest reason why deals either fail to deliver or fall through altogether : Firms often neglect to deal with red flags early on in an agreement. To help determine whether a deal will be profitable, private equity firms must first establish a clear, concise investment thesis.

A private equity investment thesis is an evidence-based case built in favor of a particular investment opportunity. It opens with a two- to three-sentence argument showing how the potential deal supports a general partner’s fund investment strategy, then provides details that support that conclusion.

An investment thesis is required for all buy-side dealmakers. Beyond fulfilling a requirement, the detailed proposition serves to:

• Crystallize the group’s tactical plan, putting strategy into action
• Inform intermediaries, investors, and fellow partners what’s at stake if the firm does — or doesn’t — invest
• Answer the variety of questions that arise throughout a typical transaction

Follow these next steps to create a winning private capital markets investment thesis and identify the best opportunities for your firm.

Detail macroeconomic factors

To create a successful investment thesis, firms must first answer global and niche-agnostic economic questions. This will help set the stage for the acquisition target to shine against a macro backdrop.

Start by listing any relevant current headlines , political and social developments, and even consumer trends that are affecting investments across the board. These news stories will remind investors what they and your potential portfolio companies (portcos) are facing today.

For example, you might list the U.S. Securities and Exchange Commission’s most recent proposals, e-commerce adoption, or European political volatility as factors that are affecting investments. Detail the way these factors are helping or hindering the private capital markets in general.

You should also list headlines that affect the acquisition target’s industry, sector, and subsector, and explain whether these developments favor growth for your private company. For example, if a general partner’s acquisition target was in the durable goods manufacturing space, the principal would include the U.S. freight transportation services index (TSI) as a macroeconomic factor in his investment thesis, and would describe how its recovery predicts smoother supply chains to ease investor worries. Similarly, you can explain in your investment thesis how your portco will be positioned competitively among its sector rivals.

Risks aren’t traditionally included in investment theses, but you can include them if they strengthen your macroeconomic analysis . You may want to include factors such as whether global or national conditions oppose the potential portco’s growth or the investment’s performance. You can also describe how your acquisition target would sidestep or weather those pitfalls.

Bain & Co. experts recently declared that macroeconomic instability is dealmaking’s number-one enemy . Position your investment thesis to shine by having a good handle on macroeconomic factors.

Detail microeconomic factors

The macroeconomic information you gather can help you drill down into more granular information about an investment opportunity . Narrow your proposed direction by including microeconomic details about company-level questions to your investment thesis. Try to answer questions such as:

• Why do you believe the target’s founder or owner will lead the company to growth? Describe ways the current CEO demonstrates innovative, creative problem-solving and strong leadership.
• What do the company’s financial statements reveal about the business’s record-keeping? Are the reports straightforward and easy to read? Before due diligence, investigate the business’s financials to uncover thesis-supporting insights.
• What do the company’s financial statements reveal about the viability of the business? Are there clues as to how leadership has handled finances at key inflection points? How much variance does each metric — such as return on equity, profit, return on assets, and earnings per share — exhibit?
• How has the company navigated cash flow surprises in the past? Surprises can include headwinds and windfalls, and an event like a spike in the company’s quick ratio must be handled with as much finesse as a cash shortage. What proof is there that the business keeps growing sustainably amid short-term volatility ?
• How has the company used seed money? James W. Frick, former Vice President of Public Relations at the University of Notre Dame, famously said, “Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are.” When you look at previous injections , don’t just analyze the company’s capital efficiency. Draw conclusions about what the team prioritizes, such as growth over client retention.
• What opportunities are there for better cost management? Are there areas where the business is spinning its wheels and expending resources without gaining effective traction? Could certain actions — such as managing talent differently, renegotiating vendor agreement terms, or terminating a failed market expansion — efficiently address these areas ?
• What’s the company’s reputation like? Consider hiring a market research firm to perform an exploratory branding assessment. Take it to the next level by gathering observations from clients, employees, and vendors. If any quotes prove highly relevant, include them in your investment thesis.
• In what ways are competitors excelling or lagging? The ideal investment is in a market where rivals are failing to innovate. Does your target acquisition have what it takes to exploit market conditions faster and better than competitors?
• What could go wrong? The best investment theses don’t deny risks but instead address them at an early stage. As you list potential pitfalls, identify ways the private equity firm’s management team can dodge or defuse these hazards .

Consider the professionals at Morgan Stanley , who use three questions to formulate the microeconomic portions of their investment theses.

• Agility and defensibility — Is the company a disruptor or is it insulated from disruptive change?
• Financial viability of the business — Does the company demonstrate financial strength with high returns on invested capital, high margins, strong cash conversion, low capital intensity, and low leverage?
• ESG (environmental, social, and governmental) and the responsibility to do no harm — Are there environmental or social externalities not borne by the company, or are there governance and accounting risks that may alter the investment thesis?

Once you’ve compiled a substantial body of information to use in your investment thesis, sort the details by order of importance. Each deal’s details should be arranged differently since each investment is unique.

Establish and describe the trade setup

The final component of a good investment thesis answers the question, “So what?” It offers bold implications of the micro- and macroanalysis you just performed, and reveals what your next steps should be .

To describe the proposed trade, explain how the micro and macro factors will work together to increase carry for partners and returns for limited partners. Propound an entry point or “ setup price ,” and describe how you arrived at your proposed acquisition’s target price. Industries — and different private equity firms within those spaces — vary in how they calculate reasonable prices.

Keep in mind that the industry standard expects your firm to find the product of estimated earnings and your expected multiple. For example:

• Estimated earnings × EV/EBITDA = target price
• Estimated earnings × FCF/market capital = target price
• Estimated earnings × Price-to-earnings (P/E) ratio = target price

In your investment thesis, explain why your firm uses a particular multiple and how it came to estimate future earnings . Be sure to include these details as a footnote or sidenote for more curious readers.

Once you’ve proposed a purchase price, describe why the buy side should value the business at that entry point. You may need to briefly repeat what you’ve stated in your micro- and macroeconomic research findings, but within the context of your financial investment.

You should also outline what will happen if you choose not to invest in a particular business. Will the current owners keep their stake, or will a rival scoop them up ? Will a competitor fumble the operational improvements or liquidate too early or late? Or will the competitor execute brilliantly, generate alpha, and solidify or even expand its limited partner pool?

Finally, you must weave in a capital plan to detail how your investors’ committed capital will improve company profits for either returns or reinvestments. The capital plan outlines some of the strategic moves and operational improvements you believe will generate short-term wins and future sustainable growth. It should include no more than three or four actions; for example, you could include initiatives like increasing dividends or paying down debt to put free cash flow to work.

To wrap up the investment thesis, discuss how the deal would work into and support the fund’s overall investment strategy. Detail ways your firm brings a competitive advantage to the deal. Have your partners demonstrated acumen with similar deals? List the reasons why you’re the company’s best bet for making above-market returns.

Summarize your investment thesis

Now that you’ve built a complete — but also quite complex — investment thesis, it’s time to develop a clear, effective presentation . General partners distill their investment theses into bite-size, portable overviews that are more memorable and digestible for their audiences. Concisely summarizing your thesis will:

• Help busy readers better understand your thesis. For skimmers and scanners who want to skip around your thesis, a synopsis gives them a starting and ending point.
• Steer future investments, further defining your role in your niche. If, for example, a particular investment thesis persuades limited partners and intermediaries to commit to an event-based investment, you may become a firm known for that type of strategy.
• Provide you with a successful deal that you can use as an example during events like employee training, marketing, and roadshows. Imagine one of your vice presidents attends a trade event and meets an esteemed limited partner who expresses interest in your firm’s most recent deal. A quick investment thesis summary is the perfect way to explain the deal and further the partner’s interest.
• Set up a memorial to look back on. As the investment’s time horizon approaches, your team should reflect on how the deal began and what twists and turns you and your portco navigated along the way. This exercise will help prepare your team for future scenarios and investment opportunities.

Examples of investment thesis summaries

Authors David Harding and Sam Rovit highlighted a summary of Clear Channel’s merger-specific investment thesis. The media company had decided to expand into outdoor advertising sales and needed to build its case and present it to stakeholders. Note the three concrete benefits the company describes in detail:

Clear Channel’s expansion into outdoor advertising leverages the company’s core competencies in two ways: First, the local market sales force that is already in place to sell radio ads can now sell outdoor ads to many of the same buyers, and Clear Channel is uniquely positioned to sell both local and national advertisements . Second, much like the radio industry 20 years ago, the outdoor advertising industry is fragmented and undercapitalized. Clear Channel has the capital needed to ‘roll up’ a significant fraction of this industry, as well as the cash flow and management systems needed to reduce operating expenses across a consolidated business.

This summary explains that the acquiring executives planned to generate returns by:

• Using existing talent and preventing costs usually associated with successful deals
• Applying skills and processes from one sector to improve the newly added operation
• Combining assets or “ rolling up ” to share costs and benefits through a newly formed industry rather than fragmented sectors

Best of all, the summary uses a single paragraph to get the job done.

Here are a few examples from dealmakers in other private capital markets:

• Private equity — Read the overviews of investment theses from Arcspring , Sun Capital Partners , WestView Capital Partners , and Safanad , a team that clearly communicates its commitment to private equity with real estate incorporated.
• Real estate private equity (REPE) — CrowdStreet articulately summarizes how and why the firm invests, and it states its intentions by asset class and sector. The synopsis covers hospitality, industrials, health care, multifamily, office space, retail, self-storage, senior care, student housing, and life sciences.
• Impact investing — The FSIG and Creatella investment thesis summaries are clear and give a high-level flyover of the model deal’s macro- and microeconomics.
• Venture capital — Wavemaker Partners , Chloe Capital , and La Poste Ventures substitute corporate language with simpler and more digestible terms.

What to do with your new investment thesis

An investment thesis is more than a report: It’s the developing narrative of a successful deal. You’ll likely need to update your thesis and presentation more than once, and in a variety of ways, throughout the lifecycle of the investment.

Publish the investment thesis in your team’s internal deal management system, and assign permissions to those who refer to the plan often. Set up notifications so that you receive alerts whenever someone comments or edits the investment thesis. If your current deal management system doesn’t support this level of effective collaboration, contact DealCloud to request a demo today.

Remember: Successful deals start with successful investment theses. Don’t let investors wade into a transaction before taking the steps above to identify red flags and create an evidence-based plan that everyone can buy into.

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How to Write an Investment Thesis in Private Equity

Get looped in.

Recent years have posed significant challenges for M&A activity, with private equity deal volume experiencing a stark 46% decline compared to the previous year in 2022. Similarly, venture capital deals globally saw a notable 42% decrease in the first 11 months. Moreover, the mounting dry powder, surpassing $1 trillion USD in the US alone, underscores the urgency for firms to adapt their business strategies to thrive in 2023 and beyond.

Amidst this landscape, transitioning to a direct sourcing model alongside intermediary deals is imperative. However, economic uncertainties compel firms to further refine their outbound strategies to capitalize on opportunities efficiently. Dealmakers face the crucial task of optimizing their time and focusing on strategic investments that align with their objectives. Crafting a compelling investment thesis becomes paramount, guiding direct deal sourcing efforts and enabling firms to differentiate themselves in a competitive market.

Read on to discover how a meticulously crafted investment thesis can drive success in direct deal sourcing strategies.

What Is an Investment Thesis in Private Equity?

An investment thesis is, quite literally, a thesis statement. It's succinct, yet comprehensive enough to serve as your firm's guiding principle to both source and secure ideal investments. 

Imagine you're back in school and writing a term paper. Remember how a thesis was treated as a single defining statement that guided the development of your entire paper? The same is true of an investment thesis for your private equity firm. Unlike your term paper, however, firms often have more than one thesis because they often focus on multiple types of deals at once. 

Dealmakers' theses can also be broken down into two specific types: top-down and bottom-up. A top-down investment thesis is something that helps your team understand and seek out ideal investment targets when sourcing.

Top-Down Investment Thesis for Venture Capital Example:

‍ "This $10MM seed fund focuses on US-based cannabis startups that are furthering the industry through technology and infrastructure research and development that can leverage our partners' vast experience in the logistics and supply chain sectors."

Once your firm has identified an ideal company that fits its top-down thesis, it's time to create a bottom-up version. Far more direct and specific in nature, a bottom-up investment thesis includes everything from particular information about the target company including financial statements and forecasting, future business plans, funding strategy reasoning, industry trends, etc. as well as why your firm is the best choice.

‍ Bottom-Up Investment Thesis for Private Equity Example:

‍ "Smith Partners is seeking to invest a $20MM Series A round in Asclepius, Inc. to aid in their rapid growth and contributions to the advancement of the healthcare industry. Their dedication to modernization combined with SP's vast network of cutting-edge automation manufacturers and forward-thinking healthcare providers make this partnership particularly exciting."

A bottom-up thesis would then continue into specifics about the company, detailing financial and employee records, proprietary knowledge or advantages such as patents, and more about what your firm brings to the transaction. A final bottom-up thesis can take many different forms: e.g., a comprehensive document, presentation, or video.

The key to both a top-down and bottom-up investment thesis is specificity. Every thesis your firm creates should be valid only for your firm . The combination of geographic location, sector or industry, company stage or type, fund size, reasons behind the investment or focus, and your firm's specific differentiators should make each of your theses unique.

Steps for Building an Investment Thesis Framework

Creating an investment thesis framework will help your firm draft theses more quickly and make sure all of the necessary information is included. Answering the following series of questions is a good place to start building a framework for both top-down and bottom-up theses:

• What is the goal of this thesis? This answer takes one of two forms: to find new target investment opportunities or to secure a potential deal. But before you can detail the rest of the thesis, you must know your end goal. ‍
• What are the basic parameters of your ideal deal? Once you have your overall goal, sort out the basics first: overall available capital, company demographics (e.g., location, size, industry), etc. ‍
• What are the influencing internal factors? What is your firm hoping to get from a deal that would fit this thesis? Do you need to bridge a valuation gap in your portfolio, for example? ‍
• What are the influencing external factors? If you've ever gone through a thematic sourcing exercise, this will feel similar. While your thesis should not be nearly as large in scope as a thematic investing strategy, socioeconomic or industry trends can be a driving factor for why your firm is looking at this type of investment and should be called out in your thesis. ‍
• Why your firm? While this is the simplest question, it's not only the most difficult to answer but also the most important. Your differentiator "what only your firm can offer to the industry or target company" and why you are particularly suited to this segment of the market (in a top-down thesis) or specific deal (in a bottom-up thesis) is the key to crafting a successful investment thesis in private equity. ‍
• Why this deal? For a bottom-up thesis, you must detail why this deal should be transacted: - Why this company? Is it the founder that instills confidence? Do they have intellectual property that makes the deal worthwhile? How are their financials impacting this decision? - Why now? - What does the future look like and what are your plans post-transaction? - What is the eventual exit strategy? When would you plan for that to happen? - How does this deal impact your portfolio?

The framework you build from answering these questions can then be refined into a single statement or document that serves as your thesis. But be prepared to make iterations. You must continually refine your theses as you gather more data, learn more about your ideal investment, and the world continues to evolve and change.

Putting Your Investment Thesis to Work

Once your firm establishes a thesis, it's time to leverage it effectively. Remember, a well-crafted thesis serves as a guide for qualifying opportunities and determining their potential value. Integrating your top-down criteria into a robust deal sourcing platform facilitates market mapping, identifies relevant conferences, enables direct sourcing, and offers comprehensive insights into target companies and their competitive landscape.

With over 190,000 sources and millions of data points, Sourcescrub's deal sourcing platform has consistently enhanced research productivity by 42.8% and expanded deal sourcing pipelines by 36%. Let's chat to explore how we can assist you in developing and executing your investment theses in any industry landscape.

Originally posted on “January 10, 2023”

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Investment Thesis Template

Create your own investment thesis slide with this free template

Prior to becoming a Founder for Curiocity, Hassan worked for Houlihan Lokey as an Investment Banking Analyst focusing on sellside and buyside  M&A , restructurings, financings and strategic advisory engagements across industry groups.

Hassan holds a  BS  from the University of Pennsylvania in Economics.

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The  Boston Consulting Group as  an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

This template allows you to create your own investment thesis slide detailing your overall strategy.

The template is plug-and-play , and you can enter your own text or numbers. The template also includes other slide pages for other elements of a financial model presentation.

According to the WSO Dictionary ,

"An investment thesis aims to take an abstract idea and turn it into a functional investment strategy. An investment thesis helps investors evaluate investment ideas, ideally guiding them in selecting the best ideas that can help meet their investment objectives."

A screenshot below gives you a sneak peek of the template.

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The Impact Investor | ESG Investing Blog

Investing for financial return is only part of the equation.

How to Create an Investment Thesis [Step-By-Step Guide]

Updated on June 13, 2023

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One of the worst mistakes an investor can make is to sink their money into an investment without knowing why. While this may seem like the world’s most obvious mistake to avoid, it happens every day. Look no further than the stock market for plenty of examples of misguided optimism gone terribly wrong.

That’s where the idea of an investment thesis comes in. An investment thesis is a common tool used by venture capital investors and hedge funds as part of their investment strategy.

Most funds also use it on a regular basis to size up potential candidates during buy-side job interviews. But you don’t have to work at a venture capital fund or private equity firm to reap the benefits of creating an investment thesis of your own.

Table of Contents

What Is an Investment Thesis?

Materials needed to create a thesis for your investment strategy, a step-by-step guide to creating a solid investment thesis, step 1: start with the essentials, step 2: analyze the current market, step 3: analyze the company’s sector, step 4: analyze the company’s position within its sector, step 5: identify the catalyst, step 6: solidify your thesis with analysis, free tools to help strengthen your investment strategy.

An investment thesis is simply an argument for why you should make a specific investment. Whether it be a stock market investment or private equity, investment theses are all about creating a solid argument for why a certain acquisition is a good idea based on strategic planning and research.

While it takes a little more work upfront, a clear investment thesis can be a valuable tool for any investor. Not only does it ensure that you fully understand why you’re choosing to put your hard-earned money into certain stocks or other assets, but it can also help you develop a long-term plan.

Should an investment idea not go as planned, you can always go back to your investment thesis to see if it still holds the potential to work out. By considering all the information your thesis contains, you’ll have a much better idea of whether it’s best to cut your losses and sell, continue holding, or even add to your position.

An investment thesis includes everything you need to create a solid game plan, making it a foundational part of any stock pitch.

See Related : Best Socially Responsible Stocks To Invest In Today

One of the benefits of an investment thesis is that it can be as complex or as simple as you like. If you actually work at a venture capital firm , then you may want to develop a full-on venture capital investment thesis. But if you’re a retail investor just looking to solidify your investment strategy, then your thesis may be much more straightforward.

If you’re an individual investor, then all you really need to create an investment thesis is somewhere to write it out. Whether it be in a Google or Word doc or on a piece of paper, just make sure you have a place to record your thesis so that you can consult it down the line.

If you’re developing a venture capital investment thesis that you plan to present to an investment committee or potential employers, then there are plenty of great tools online that can help. Slideteam has thousands of templates that can help you create a killer investment thesis , as well as full-on stock pitch templates.

As mentioned earlier, an investment thesis holds the potential to help you plot out a strategy for pretty much any acquisition. But for the sake of simplicity, we’ll assume throughout the examples in the following steps that you’re an investor interested in going long on a stock that you plan to hold for at least a few months or years.

Venture capitalists looking to invest in companies or startups can also apply the same principles to other investment goals. Investors who are looking to short a certain stock should also be able to use these techniques to locate potential investments. The main difference, of course, is that you’ll be looking for bad news instead of good.

First things first. Before you get into doing the research that goes into an investment thesis or stock pitch, make sure you take the time to write out the basics. At the top of the page, include things like:

• The name of the company and its ticker symbol
• Today’s date
• How many shares of the company you already own, if any
• The current cost average for any shares you may already hold
• Whether the stock pays dividends and, if so, how often. You may also want to include the current ex-dividend and dividend payment dates.
• A brief summary of the company and what it does

See Related : How to Start Investing With Purpose

Now it’s time to take a look at the entire market and the direction it’s headed. Why? As Investors Business Daily points out,

“History shows 3 out of 4 stocks move in the same direction as the overall market, either up or down. So if you buy stocks when the market is trending higher, you have a 75% chance of being right. But if you buy when the market is trending lower, you have a 75% chance of being wrong.”

While the overall market direction is definitely an important factor to keep in mind, what you choose to do with this information will largely come down to your individual investing style. Investors Business Daily founder William O’Neil advised investors only to jump into the market when it was trending up.

Another approach, however, is known as contrarian investing, which revolves around going against market trends. Warren Buffett summed up the idea behind this strategy with his famous quote, “Be fearful when others are greedy, and greedy when others are fearful.” Or as Baron Rothschild more graphically put it, “Buy when there is blood in the streets, even if the blood is your own.”

Most investors who are looking for a faster return will likely be better off waiting to strike until the iron is hot. If you align more with the long-term contrarian philosophy, however, bleak macroeconomic outlooks may actually strike you as an ideal investment opportunity .

See Related: How to Invest in Private Equity: A Step-by-Step

Now that you’ve got a look at the overall market, it’s time to take a look at the sector your company fits into. The Global Industry Classification Standard (GICS) breaks down the entire market into 11 sectors. If you want to get even more specific, you can further break down companies into the GICS’s 24 industry groups, 69 industries, and 158 sub-industries.

Once you identify which group your company belongs to, you’ll then want to take a look at that sector’s performance. Fidelity provides a handy breakdown of the performance of various sectors over different time periods.

But why does it matter? Two reasons.

• Identifying which sectors various companies belong to can help you ensure that your portfolio is properly diversified
• The reason that sector ETFs tend to be so popular is that when a sector is trending, many of the stocks within that sector tend to move in unison. The reverse is also true. When a certain industry is lagging, the individual stock prices of the companies in that industry may be affected negatively. While this is not always the case, it’s a general rule of thumb to keep in mind.

The idea behind working sectors into your investment criteria is to give you an overview of what type of investment you’re about to make. If you’re a momentum trader, then you may want to shoot for companies within the strongest-performing sectors this year or even over the past few months.

If you’re a value investor, however, you may be more open to sectors that have historically experienced high growth, even if they are currently suffering due to the overall state of the economy. Some speculative investors may even be interested in an innovative industry with strong potential growth possibilities, even if its time has not yet come.

See Related : How to Invest in Community [Step-by-Step Guide]

If you want to up your odds of success even more, then you’ll want to compare the company you’re interested in against the performance of similar companies in the same industry.

These are the companies that tend to get the most attention from large, institutional investors who are in a position to significantly increase their market value. Institutional investors tend to have a huge amount of money in play and are far less likely to invest in a company without a proven track record.

When choosing an investment, they’ll almost always go with a global leader over a new business, regardless of its promise. However, they also consider intrinsic value, which considers how much a company’s stock is selling for now, as opposed to how much revenue the company stands to earn in the future. In other words, institutional investors are looking for companies that are stable enough to avoid surprises but that also stand to generate considerable capital in the future.

Why work this into your game plan? Because even if you don’t have millions of dollars to invest in a company, there may be hedge funds or venture capital firms out there that do. When these guys make an investment, it tends to be a big one that can actually move a company’s share price upward. Why not ride their coattails and enjoy a solid growth rate as they invest more money over time into proven winners?

That’s why it’s important to make sure that you see how a company stacks up against its closest competitors. If it’s an industry-leading business with a large market share, it’s likely to be a strong contender with solid fundamentals. If not, you may end up discovering competing companies that make sense to consider instead.

See Related : What is a Triple Bottom Line? Definition & Examples

At this point, hopefully, you’ve identified the best stock in the best sector based on your ideal investing style. Now it’s time to find out exactly why it deserves to become a part of your portfolio and for how long.

If a company has been experiencing impressive growth, then there’s bound to be a reason why.

• Is the company experiencing a major influx of business because it’s currently a leader in the hottest sector of the moment? Or is it a “good house in a bad neighborhood” that’s moving independently of the other stocks in its industry?
• How long has it been demonstrating growth?
• What appears to be the catalyst behind its movement? Does the stock owe its growth to strong management, recent world events, the approval of a new drug, the introduction of a hot new product, etc?

One mistake that far too many beginning investors make is assuming that short-term growth alone always indicates the potential for long-term profit. Unfortunately, this is not always the case. By figuring out exactly why a stock is moving, you’ll be far better positioned to decide how long to hold it before you sell.

A strong catalyst can cause the price of a stock to skyrocket overnight, even if it’s laid dormant for years. Even things like social media hype and rumors can cause a stock’s price to shoot up over the course of a given day. But woe to the investor that assumes these profits will last. Many are often left holding the bag when the price increase turns out to be part of a “ pump and dump .”

While many day traders can make a nice profit by capitalizing on these situations, such trades are best avoided altogether if you plan to hold a stock long-term. That’s why it’s so important to understand whether a stock is “in play” for the day or whether its growth can be attributed to more permanent factors that support the potential for a high return over time.

See Related : How to Become an Impact Investor [Step-By-Step Guide]

If you’re planning on investing a significant amount of capital in any stock, then a little research may be able to save you from a lot of heartache. Keep in mind that the focus of an investment thesis is to formulate a reasoned argument about why adding an asset to your portfolio is a good idea.

While all investments come with some level of risk, research can be an excellent risk mitigation strategy. There’s nothing worse than watching an investment fail due to an obvious factor you could have spotted with closer analysis. Don’t let it happen to you!

Fundamental analysis can help you ensure that your potential investments have the underlying traits that winning stocks are made of. While there’s a bit of a learning curve involved when you’re first starting out, here are some of the things you’ll want to focus on:

EPS stands for “earnings per share.” It’s a common financial indicator that basically tells you how much a company makes each time it sells a share of its stock. In this regard, a higher EPS is a good thing, but it’s important to look for solid EPS growth over time. Ideally, you’ll want to see consistent growth in a company’s EPS over the past three or more quarters.

Sales and Margins

Investing is all about putting your cash into successful companies, which is why sales and margins are key components to finding worthy investments. Sales indicate how much a business has made from (you guessed it) sales. Sales margin, also known as gross profit margin, is the amount of revenue a company actually gets to keep after you factor in overhead and other production costs. Ideally, a good investment will exhibit strong, consistent sales growth in recent years.

Return On Equity (ROE)

ROE is one of the more commonly used valuation metrics and is calculated by dividing the company’s net income/shareholders’ equity. ROE is basically a measure of how efficiently a company is using the capital it generates from equity fundraising to increase its own value. The higher the ROE, the more likely it is that a company operates with a focus on using its cash flow to increase its profits.

See Related : How to Do a Stakeholder Impact Analysis?

While these are just a few examples of various analysis methods to work into your investment thesis, they can go a long way toward locating solid companies worth investing in. Interested in learning more about technical and fundamental analysis? There are now plenty of great sites that can help you master the secrets of the training world.

In our opinion, Tradimo is one of the most underrated, as it provides tons of free classes for investors of all levels. Udemy also has some great classes that can help you learn how to beef up your investment thesis with as much quality information as possible.

But keep in mind that these are only suggestions. The most important part of any personal investment thesis is that it makes sense to you and can serve as a valuable tool to help you along your investing journey.

Related Resources

• Best Impact Investing Online Courses
• Best Green Apps for a More Sustainable Life
• Sustainable Investing vs Impact Investing: What’s the Difference?

Kyle Kroeger, esteemed Purdue University alum and accomplished finance professional, brings a decade of invaluable experience from diverse finance roles in both small and large firms. An astute investor himself, Kyle adeptly navigates the spheres of corporate and client-side finance, always guiding with a principal investor’s sharp acumen.

Hailing from a lineage of industrious Midwestern entrepreneurs and creatives, his business instincts are deeply ingrained. This background fuels his entrepreneurial spirit and underpins his commitment to responsible investment. As the Founder and Owner of The Impact Investor, Kyle fervently advocates for increased awareness of ethically invested funds, empowering individuals to make judicious investment decisions.

Striving to marry financial prudence with positive societal impact, Kyle imparts practical strategies for saving and investing, underlined by a robust ethos of conscientious capitalism. His ambition transcends personal gain, aiming instead to spark transformative global change through the power of responsible investment.

When not immersed in the world of finance, he’s continually captivated by the cultural richness of new cities, relishing the opportunity to learn from diverse societies. This passion for travel is eloquently documented on his site, ViaTravelers.com, where you can delve into his unique experiences via his author profile.

Writing a Credible Investment Thesis

by David Harding and Sam Rovit

Every deal your company proposes to do—big or small, strategic or tactical—should start with a clear statement how that particular deal would create value for your company. We call this the investment thesis . The investment thesis is no more or less than a definitive statement, based on a clear understanding of how money is made in your business, that outlines how adding this particular business to your portfolio will make your company more valuable. Many of the best acquirers write out their investment theses in black and white. Joe Trustey, managing partner of private equity and venture capital firm Summit Partners, describes the tool in one short sentence: "It tells me why I would want to own this business." 10

Perhaps you're rolling your eyes and saying to yourself, "Well, of course our company uses an investment thesis!" But unless you're in the private equity business—which in our experience is more disciplined in crafting investment theses than are corporate buyers—the odds aren't with you. For example, our survey of 250 senior executives across all industries revealed that only 29 percent of acquiring executives started out with an investment thesis (defined in that survey as a "sound reason for buying a company") that stood the test of time. More than 40 percent had no investment thesis whatsoever (!). Of those who did, fully half discovered within three years of closing the deal that their thesis was wrong.

Studies conducted by other firms support the conclusion that most companies are terrifyingly unclear about why they spend their shareholders' capital on acquisitions. A 2002 Accenture study, for example, found that 83 percent of executives surveyed admitted they were unable to distinguish between the value levers of M&A deals. 11 In Booz Allen Hamilton's 1999 review of thirty-four frequent acquirers, which focused chiefly on integration, unsuccessful acquirers admitted that they fished in uncharted waters. 12 They ranked "learning about new (and potentially related) business areas" as a top reason for making an acquisition. (Surely companies should know whether a business area is related to their core before they decide to buy into it!) Successful acquirers, by contrast, were more likely to cite "leading or responding to industry restructuring" as a reason for making an acquisition, suggesting that these companies had at least thought through the strategic implications of their moves.

Not that tipping one's hat to strategy is a cure-all. In our work with companies that are thinking about doing a deal, we often hear that the acquisition is intended for "strategic" reasons. That's simply not good enough. A credible investment thesis should describe a concrete benefit, rather than a vaguely stated strategic value.

This point needs underscoring. Justifying a deal as being "strategic" ex post facto is, in most cases, an invitation to inferior returns. Given how frequently we have heard weak "strategic" justifications after a deal has closed, it's worth passing along a warning from Craig Tall, vice chair of corporate development and strategic planning at Washington Mutual. In recent years, Tall's bank has made acquisitions a key part of a stunningly successful growth record. "When I see an expensive deal," Tall told us, "and they say it was a 'strategic' deal, it's a code for me that somebody paid too much." 13

And although sometimes the best offense is a good defense, this axiom does not really stand in for a valid investment thesis. On more than a few occasions, we have been witness to deals that were initiated because an investment banker uttered the Eight Magic Words: If you don't buy it, your competitors will.

Well, so be it. If a potential acquisition is not compelling to you on its own merits, let it go. Let your competitors put their good money down, and prove that their investment theses are strong.

Let's look at a case in point: [Clear Channel Communications' leaders Lowry, Mark, and Randall] Mayses' decision to move from radios into outdoor advertising (billboards, to most of us). Based on our conversations with Randall Mays, we summarize their investment thesis for buying into the billboard business as follows:

Clear Channel's expansion into outdoor advertising leverages the company's core competencies in two ways: First, the local market sales force that is already in place to sell radio ads can now sell outdoor ads to many of the same buyers, and Clear Channel is uniquely positioned to sell both local and national advertisements. Second, similar to the radio industry twenty years ago, the outdoor advertising industry is fragmented and undercapitalized. Clear Channel has the capital needed to "roll up" a significant fraction of this industry, as well as the cash flow and management systems needed to reduce operating expenses across a consolidated business.

Note that in Clear Channel's investment thesis (at least as we've stated it), the benefits would be derived from three sources:

• Leveraging an existing sales force more extensively
• Using the balance sheet to roll up and fund an undercapitalized business
• Applying operating skills learned in the radio trade

Note also the emphasis on tangible and quantifiable results, which can be easily communicated and tested. All stakeholders, including investors, employees, debtors, and vendors, should understand why a deal will make their company stronger. Does the investment thesis make sense only to those who know the company best? If so, that's probably a bad sign. Is senior management arguing that a deal's inherent genius is too complex to be understood by all stakeholders, or simply asserting that the deal is "strategic"? These, too, are probably bad signs.

Most of the best acquirers we've studied try to get the thesis down on paper as soon as possible. Getting it down in black and white—wrapping specific words around the ideas—allows them to circulate the thesis internally and to generate reactions early and often.

The perils of the "transformational" deal . Some readers may be wondering whether there isn't a less tangible, but equally credible, rationale for an investment thesis: the transformational deal. Such transactions, which became popular in the exuberant '90s, aim to turn companies (and sometimes even whole industries) on their head and "transform" them. In effect, they change a company's basis of competition through a dramatic redeployment of assets.

The roster of companies that have favored transformational deals includes Vivendi Universal, AOL Time Warner (which changed its name back to Time Warner in October 2003), Enron, Williams, and others. Perhaps that list alone is enough to turn our readers off the concept of the transformational deal. (We admit it: We keep wanting to put that word transformational in quotes.) But let's dig a little deeper.

Sometimes what looks like a successful transformational deal is really a case of mistaken identity. In search of effective transformations, people sometimes cite the examples of DuPont—which after World War I used M&A to transform itself from a maker of explosives into a broad-based leader in the chemicals industry—and General Motors, which, through the consolidation of several car companies, transformed the auto industry. But when you actually dissect the moves of such industry winners, you find that they worked their way down the same learning curve as the best-practice companies in our global study. GM never attempted the transformational deal; instead, it rolled up smaller car companies until it had the scale to take on a Ford—and win. DuPont was similarly patient; it broadened its product scope into a range of chemistry-based industries, acquisition by acquisition.

In a more recent example, Rexam PLC has transformed itself from a broad-based conglomerate into a global leader in packaging by actively managing its portfolio and growing its core business. Beginning in the late '90s, Rexam shed diverse businesses in cyclical industries and grew scale in cans. First it acquired Europe's largest beverage-can manufacturer, Sweden's PLM, in 1999. Then it bought U.S.–based packager American National Can in 2000, making itself the largest beverage-can maker in the world. In other words, Rexam acquired with a clear investment thesis in mind: to grow scale in can making or broaden geographic scope. The collective impact of these many small steps was transformation. 14

But what of the literal transformational deal? You saw the preceding list of companies. Our advice is unequivocal: Stay out of this high-stakes game. Recent efforts to transform companies via the megadeal have failed or faltered. The glamour is blinding, which only makes the route more treacherous and the destination less clear. If you go this route, you are very likely to destroy value for your shareholders.

By definition, the transformational deal can't have a clear investment thesis, and evidence from the movement of stock prices immediately following deal announcements suggests that the market prefers deals that have a clear investment thesis. In "Deals That Create Value," for example, McKinsey scrutinized stock price movements before and after 231 corporate transactions over a five-year period. 15 The study concluded that the market prefers "expansionist" deals, in which a company "seeks to boost its market share by consolidating, by moving into new geographic regions, or by adding new distribution channels for existing products and services."

On average, McKinsey reported, deals of the "expansionist" variety earned a stock market premium in the days following their announcement. By contrast, "transformative" deals—whereby companies threw themselves bodily into a new line of business—destroyed an average of 5.3 percent of market value immediately after the deal's announcement. Translating these findings into our own terminology:

• Expansionist deals are more likely to have a clear investment thesis, while "transformative" deals often have no credible rationale.
• The market is likely to reward the former and punish the latter.

The dilution/accretion debate . One more side discussion that comes to bear on the investment thesis: Deal making is often driven by what we'll call the dilution/accretion debate . We will argue that this debate must be taken into account as you develop your investment thesis, but your thesis making should not be driven by this debate.

Simply put, a deal is dilutive if it causes the acquiring company to have lower earnings per share (EPS) than it had before the transaction. As they teach in Finance 101, this happens when the asset return on the purchased business is less than the cost of the debt or equity (e.g., through the issuance of new shares) needed to pay for the deal. Dilution can also occur when an asset is sold, because the earnings power of the business being sold is greater than the return on the alternative use of the proceeds (e.g., paying down debt, redeeming shares, or buying something else). An accretive deal, of course, has the opposite outcomes.

But that's only the first of two shoes that may drop. The second shoe is, How will Wall Street respond? Will investors punish the company (or reward it) for its dilutive ways?

Aware of this two-shoes-dropping phenomenon, many CEOs and CFOs use the litmus test of earnings accretion/dilution as the first hurdle that should be put in front of every proposed deal. One of these skilled acquirers is Citigroup's [former] CFO Todd Thomson, who told us:

It's an incredibly powerful discipline to put in place a rule of thumb that deals have to be accretive within some [specific] period of time. At Citigroup, my rule of thumb is it has to be accretive within the first twelve months, in terms of EPS, and it has to reach our capital rate of return, which is over 20 percent return within three to four years. And it has to make sense both financially and strategically, which means it has to have at least as fast a growth rate as we expect from our businesses in general, which is 10 to 15 percent a year. Now, not all of our deals meet that hurdle. But if I set that up to begin with, then if [a deal is] not going to meet that hurdle, people know they better make a heck of a compelling argument about why it doesn't have to be accretive in year one, or why it may take year four or five or six to be able to hit that return level. 16

Unfortunately, dilution is a problem that has to be wrestled with on a regular basis. As Mike Bertasso, the head of H. J. Heinz's Asia-Pacific businesses, told us, "If a business is accretive, it is probably low-growth and cheap for a reason. If it is dilutive, it's probably high-growth and attractive, and we can't afford it." 17 Even if you can't afford them, steering clear of dilutive deals seems sensible enough, on the face of it. Why would a company's leaders ever knowingly take steps that would decrease their EPS?

The answer, of course, is to invest for the future. As part of the research leading up to this book, Bain looked at a hundred deals that involved EPS accretion and dilution. All the deals were large enough and public enough to have had an effect on the buyer's stock price. The result was surprising: First-year accretion and dilution did not matter to shareholders. In other words, there was no statistical correlation between future stock performance and whether the company did an accretive or dilutive deal. If anything, the dilutive deals slightly outperformed. Why? Because dilutive deals are almost always involved in buying higher-growth assets, and therefore by their nature pass Thomson's test of a "heck of a compelling argument."

Reprinted with permission of Harvard Business School Press. Mastering the Merger: Four Critical Decisions That Make or Break the Deal , by David Harding and Sam Rovit. Copyright 2004 Bain & Company; All Rights Reserved.

[ Buy this book ]

David Harding (HBS MBA '84) is a director in Bain & Company's Boston office and is an expert in corporate strategy and organizational effectiveness.

Sam Rovit (HBS MBA '89) is a director in the Chicago office and leader of Bain & Company's Global Mergers and Acquisitions Practice.

10. Joe Trustey, telephone interview by David Harding, Bain & Company. Boston: 13 May 2003. Subsequent comments by Trustey are also from this interview.

11. Accenture, "Accenture Survey Shows Executives Are Cautiously Optimistic Regarding Future Mergers and Acquisitions," Accenture Press Release, 30 May 2002.

12. John R. Harbison, Albert J. Viscio, and Amy T. Asin, "Making Acquisitions Work: Capturing Value After the Deal," Booz Allen & Hamilton Series of View-points on Alliances, 1999.

13. Craig Tall, telephone interview by Catherine Lemire, Bain & Company. Toronto: 1 October 2002.

14. Rolf Börjesson, interview by Tom Shannon, Bain & Company. London: 2001.

15. Hans Bieshaar, Jeremy Knight, and Alexander van Wassenaer, "Deals That Create Value," McKinsey Quarterly 1 (2001).

16. Todd Thomson, speaking on "Strategic M&A in an Opportunistic Environment." (Presentation at Bain & Company's Getting Back to Offense conference, New York City, 20 June 2002.)

17. Mike Bertasso, correspondence with David Harding, 15 December 2003.

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What Is an Investment Thesis?

• Understanding the Thesis

Special Considerations

• What's Included?

The Bottom Line

• Portfolio Management

Investment Thesis: An Argument in Support of Investing Decisions

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

The term investment thesis refers to a reasoned argument for a particular investment strategy, backed up by research and analysis. Investment theses are commonly prepared by (and for) individual investors and businesses. These formal written documents may be prepared by analysts or other financial professionals for presentation to their clients.

Key Takeaways

• An investment thesis is a written document that recommends a new investment, based on research and analysis of its potential for profit.
• Individual investors can use this technique to investigate and select investments that meet their goals.
• Financial professionals use the investment thesis to pitch their ideas.

Understanding the Investment Thesis

As noted above, an investment thesis is a written document that provides information about a potential investment. It is a research- and analysis-based proposal that is usually drafted by an investment or financial professional to provide insight into investments and to pitch investment ideas. In some cases, the investor will draft their own investment thesis, as is the case with venture capitalists and private equity firms.

This thesis can be used as a strategic decision-making tool. Investors and companies can use a thesis to decide whether or not to pursue a particular investment, such as a stock or acquiring another company. Or it can be used as a way to look back and analyze why a particular decision was made in the first place—and whether it was the right one. Putting things in writing can have a huge impact on the direction of a potential investment.

Let's say an investor purchases a stock based on the investment thesis that the stock is undervalued . The thesis states that the investor plans to hold the stock for three years, during which its price will rise to reflect its true worth. At that point, the stock will be sold at a profit. A year later, the stock market crashes, and the investor's pick crashes with it. The investor recalls the investment thesis, relies on the integrity of its conclusions, and continues to hold the stock.

That is a sound strategy unless some event that is totally unexpected and entirely absent from the investment thesis occurs. Examples of these might include the 2007-2008 financial crisis or the Brexit vote that forced the United Kingdom out of the European Union (EU) in 2016. These were highly unexpected events, and they might affect someone's investment thesis.

If you think your investment thesis holds up, stick with it through thick and thin.

An investment thesis is generally formally documented, but there are no universal standards for the contents. Some require fast action and are not elaborate compositions. When a thesis concerns a big trend, such as a global macro perspective, the investment thesis may be well documented and might even include a fair amount of promotional materials for presentation to potential investing partners.

Portfolio management is now a science-based discipline, not unlike engineering or medicine. As in those fields, breakthroughs in basic theory, technology, and market structures continuously translate into improvements in products and in professional practices. The investment thesis has been strengthened with qualitative and quantitative methods that are now widely accepted.

As with any thesis, an idea may surface but it is methodical research that takes it from an abstract concept to a recommendation for action. In the world of investments, the thesis serves as a game plan.

What's Included in an Investment Thesis?

Although there's no industry standard, there are usually some common components to this document. Remember, an investment thesis is generally a proposal that is based on research and analysis. As such, it is meant to be a guide about the viability of a particular investment.

Most investment theses include (but aren't limited to) the following information:

• The investment in question
• The investment goal(s)
• Viability of the investment, including any trends that support the investment
• Potential downsides and risks that may be associated with the investment
• Costs and potential returns as well as any losses that may result

Some theses also try to answer some key questions, including:

• Does the investment align with the intended goal(s)?
• What could go wrong?
• What do the financial statements say?
• What is the growth potential of this investment?

Putting everything in writing can help investors make more informed decisions. For instance, a company's management team can use a thesis to decide whether or not to pursue the acquisition of a rival. The thesis may highlight whether the target's vision aligns with the acquirer or it may identify opportunities for growth in the market.

Keep in mind that the complexity of an investment thesis depends on the type of investor involved and the nature of the investment. So the investment thesis for a corporation looking to acquire a rival may be more in-depth and complicated compared to that of an individual investor who wants to develop an investment portfolio.

Examples of an Investment Thesis

Portfolio managers and investment companies often post information about their investment theses on their websites. The following are just two examples.

Morgan Stanley

Morgan Stanley ( MS ) is one of the world's leading financial services firms. It offers investment management services, investment banking, securities, and wealth management services. According to the company, it has five steps that make up its investment process, including idea generation, quality assessment, valuation, risk management , and portfolio construction.

When it comes to developing its investment thesis, the company tries to answer three questions as part of its quality assessment step:

• "Is the company a disruptor or is it insulated from disruptive change? 
• Does the company demonstrate financial strength with high returns on invested capital, high margins, strong cash conversion, low capital intensity and low leverage? 
• Are there environmental or social externalities not borne by the company, or governance and accounting risks that may alter the investment thesis?"

Connetic Ventures

Connetic Adventures is a venture capital firm that invests in early-stage companies. The company uses data to develop its investment thesis, which is made up of three pillars. According to its blog, there were three pillars or principles that contributed to Connetic's venture capital investment strategy. These included diversification, value, and follow-on—each of which comes with a pro and con.

Why Is an Investment Thesis Important?

An investment thesis is a written proposal or research-based analysis of why investors or companies should pursue an investment. In some cases, it may also serve as a historical guide as to whether the investment was a good move or not. Whatever the reason, an investment thesis allows investors to make better, more informed decisions about whether to put their money into a specific investment. This written document provides insight into what the investment is, the goals of the investment, any associated costs, the potential for returns, as well as any possible risks and losses that may result.

Who Should Have an Investment Thesis?

An investment thesis is important for anyone who wants to invest their money. Individual investors can use a thesis to decide whether to purchase stock in a particular company and what strategy they should use, whether it's a buy-and-hold strategy or one where they only have the stock for a short period of time. A company can craft its own investment thesis to help weigh out whether an acquisition or growth strategy is worthwhile.

How Do You Create an Investment Thesis?

It's important to put your investment thesis in writing. Seeing your proposal in print can help you make a better decision. When you're writing your investment thesis, be sure to be clear and concise. Make sure you do your research and include any facts and figures that can help you make your decision. Be sure to include your goals, the potential for upside, and any risks that you may come across. Try to ask and answer some key questions, including whether the investment meets your investment goals and what could go wrong if you go ahead with the deal.

It's always important to have a plan, especially when it comes to investing. After all, you are putting your money at risk. Having an investment thesis can help you make more informed decisions about whether a potential investment is worth your while. Make sure you put your thesis in writing and answer some key questions about your goals, costs, and potential outcomes. Having a concrete proposal in place can spell the difference between earning returns and losing all your money. And that's if your thesis supports the investment in the first place.

Harvard Business School. " Writing a Credible Investment Thesis ."

Lanturn. " What is an Investment Thesis and 3 Tips to Make One ."

Morgan Stanley. " Global Opportunity ."

Medium. " The Data That Built Our Fund's Investment Thesis ."

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Investment Thesis: An Argument in Support of Investing Decisions

October 29, 2023 by Abi Tyas Tunggal

An investment thesis is a well-reasoned argument that supports a specific investment decision, playing a vital role in the strategic planning process for individual investors and businesses alike. It comprises detailed research and analysis to evaluate an investment's potential profitability. A good investment thesis serves multiple purposes, including helping in the decision-making process, providing a comprehensive framework for monitoring and assessment, and offering a structured approach to identifying potential opportunities.

There are different types of investment strategies, such as venture capital , private equity, and long-term value investments. The core of an investment thesis involves identifying key parameters for evaluating an investment, understanding the unique market dynamics and competitive landscape, and realizing how to create value through strategic planning. To ensure a comprehensive and detailed investment thesis, it is crucial to involve thorough research, considering emerging trends and opportunities, and incorporating industry case studies for better understanding. Ultimately, financial statements and valuation metrics play a significant role in determining a well-suited investment decision.

Key Takeaways

• An investment thesis is a well-reasoned, research-based argument supporting a specific investment decision
• There are several types of investment strategies, and a well-structured investment thesis addresses market dynamics and competition to create value
• Research, valuation metrics, and understanding emerging trends are crucial in crafting a compelling investment ideas

Defining an Investment Thesis

An investment thesis is a well-structured, logical argument that justifies a particular investment decision, based on thorough research and analysis. It is essential for investors, as well as financial professionals in the domains of investment banking, private equity, hedge funds, and venture capital funds . A confident and knowledgeable investor will build out clear investment criteria to successfully navigate the investment landscape.

The primary purpose of an investment thesis is to outline the reasons and expected outcomes of a proposed investment, often focusing on the potential for growth and profit. This document offers a roadmap for investors, guiding them through their decision-making process, and helping to ensure that they arrive at rational and informed conclusions. A comprehensive investment thesis should consider various aspects, such as market conditions, competitive landscape, and financial performance of the targeted asset or company.

A strong investment thesis is built on rigorous market research and analysis. This involves evaluating historical and current financial information, as well as scrutinizing industry trends and the overall economic environment. Skilled investors will also incorporate their expertise in the industry to better assess the merits of an investment opportunity. This level of thoroughness creates a confidently expressed thesis, allowing investors to remain steadfast in their investment decisions, even amid market volatility.

In summary, an investment thesis plays a pivotal role in the investing process. It presents a well-reasoned argument, grounded in extensive research and clear analysis, that supports an investment decision. Crafting a robust investment thesis is crucial for both individual and institutional investors as it provides a solid foundation for investment choices and ensures the alignment of investment strategies with long-term objectives.

Importance of Research in Crafting an Investment Thesis

Thorough research is a crucial aspect of creating a solid investment thesis. It allows investors to gather vital information and insights that will help guide their investment decisions. There are several elements to consider while conducting this research, with data analysis, understanding risks, and returns being essential components.

Data Analysis

Data analysis forms the backbone of any research conducted for crafting an investment thesis. It involves collecting, organizing, and interpreting various types of data, such as financial statements, market trends, and industry forecasts, to identify patterns and make informed predictions about a potential investment opportunity. A comprehensive data analysis can help investors make confident choices based on reliable information, which is essential for a successful investment strategy.

Some key data analysis techniques used in crafting an investment thesis include:

• Comparative analysis: Comparing the performance of different companies within the same industry to identify investment opportunities.
• Trend analysis: Monitoring historical data to determine patterns and potential future developments.
• Financial statement analysis: Examining the financial health of a company through its balance sheets, income statements, and cash flow statements.

Understanding Risks and Returns

One of the primary goals of research in developing an investment thesis is to assess the risk/reward profile of a potential investment. This involves evaluating the potential risks associated with the investment and weighing them against the expected returns. A sound investment thesis should demonstrate a clear understanding of these risks and offer a rationale for why the investment’s potential returns make it a worthwhile addition to a portfolio.

Some common risks to consider when crafting an investment thesis include:

• Market risk: The risk of an investment losing value due to fluctuations in the market.
• Credit risk: The risk that a company or issuer of a financial instrument may default on its obligations.
• Operational risk: The risk of losses arising from failed internal processes, systems, or personnel within a business.

Evaluating these risks requires investors to develop a deep understanding of the investment opportunity, its industry, and the factors that may impact its performance. A diligent and systematic approach to research can help investors identify potential risks and gains, leading to informed and confident decision-making in crafting a strong investment thesis.

Types of Investment Strategy

When it comes to crafting an investment thesis, selecting an appropriate investment strategy is crucial. In this section, we will discuss two popular strategies: Value Investing and Growth Investing.

Value Investing

Value investing is a strategy that focuses on identifying undervalued stocks or assets in the market. These investments typically have lower valuations, which are reflected in their price-to-earnings ratios or book values. The central idea behind value investing is that the market may sometimes undervalue a company or asset, presenting an opportunity for investors willing to do thorough research and analysis.

The process of value investing involves:

• Fundamental analysis : Evaluating a company's financial health, management, and competitive advantages
• Value metrics : Identifying various valuation metrics, such as price-to-earnings, price-to-book, and dividend yield
• Margin of safety : Discovering investment opportunities with a built-in cushion to reduce the risk of loss

Famous investors, such as Warren Buffett and Benjamin Graham, have implemented value investing strategies to achieve long-term success.

Growth Investing

On the other hand, growth investing centers on companies that are expected to grow at an above-average rate compared to their industry. Growth investors seek opportunities in businesses they believe will offer substantial capital appreciation through rapid expansion or market-share gains. They prioritize the potential for future profit over the stock's valuation.

Features of growth investing include:

• High expectations : Companies targeted by growth investors typically have a history of robust revenue and profit growth
• Momentum : Investors seek stocks with upward price momentum, as increasing demand for these stocks may drive prices even higher
• Risk tolerance : Growth stocks can be volatile, and investors must be prepared to weather price swings

Renowned growth investors like Peter Lynch and Phil Fisher have demonstrated the effectiveness of growth investing throughout their careers.

Both value and growth investing strategies have their unique advantages and require different levels of risk tolerance. Investors should carefully consider their investment thesis and select a strategy that aligns with their objectives and risk appetite.

Venture Capital and Private Equity Investment Theses

When considering investments in private companies, venture capital (VC) and private equity (PE) firms each have their own unique strategies encapsulated within their respective investment theses. These theses provide guidance on the focus of investments, the sectors or geographies of interest, and the stage of the target companies.

Learn more about the differences between private equity and venture capital .

Venture Capital Investment Thesis

A venture capital investment thesis outlines how a VC fund aims to make money for its investors, typically referred to as Limited Partners (LPs). This strategy identifies crucial factors such as the stage of companies the fund will invest in, commonly early-stage companies, the targeted geography, and specific sectors of focus.

The thesis may vary depending on a venture capitalist's unique specialization, with some firms concentrating on a specific vertical and stage, while others invest more broadly without a core thesis driving their decisions. The underlying objective of a VC investment thesis is to outline how the firm will achieve high returns on investment by supporting and nurturing the growth of portfolio companies.

Private Equity Investment Thesis

In contrast, a private equity investment thesis is an evidence-based case in support of a particular investment opportunity. It usually begins with a concise argument illustrating how the potential deal supports the fund's general investment strategy. The thesis then provides details that substantiate this preliminary conclusion.

Private equity firms often target more established companies compared to venture capital firms, focusing on businesses with a proven track record. The PE investment thesis may identify areas where operational improvements, strategic mergers, or better capital structures could enhance value, ultimately generating a good return for the firm and its investors.

Overall, both venture capital and private equity investment theses serve as critical frameworks guiding investment decisions. They not only help align these decisions with a firm's specialized strategy but also provide a basis for evaluating potential deals to ensure they contribute to the firm's goals and long-term value creation.

Key Parameters for Evaluating an Investment

When assessing the viability of an investment, it is essential to examine various key parameters to make informed decisions. By analyzing these factors, investors can gain a deeper understanding of a company's financial health and its potential for growth.

One vital metric to consider is earnings per share (EPS) , which represents the portion of a company's profit attributed to each outstanding share of its common stock. A higher EPS indicates higher earnings and suggests that the company may be a lucrative investment opportunity.

Another fundamental metric is the return on assets (ROA) , which measures the effectiveness of a company in using its assets to generate profit. The higher the ROA, the better the company is at utilizing its assets to generate earnings. Similarly, return on equity (ROE) is a measure of financial performance that calculates the proportion of net income generated by a company's equity. A higher ROE demonstrates the efficient usage of shareholders' investments.

Conducting a thorough analysis of the company's financial statements is crucial. This includes reviewing income statements, balance sheets, and cash flow statements. By doing so, investors can gain insights into the company's profitability, liquidity, and solvency.

Another important factor to consider is a company's cash position. Adequate cash reserves enable a company to meet its short-term obligations and invest in growth opportunities. On the other hand, a lack of cash can leave a company vulnerable to market fluctuations and financial stress.

It is also essential to evaluate a company's capital structure, which refers to the proportion of debt and equity financing it uses to fund its operations. A balanced capital structure ensures financial stability, while excessive debt may lead to financial distress.

Examining a company's debt level is crucial, as it can directly impact the company's financial flexibility and risk profile. A high level of debt can hinder a company's ability to grow and adapt to changes in the market, making it a less attractive investment option.

Assessing a company's assets and how they're managed plays a significant role in evaluating an investment opportunity. This includes tangible assets, such as property and equipment, and intangible assets, such as patents and trademarks. Effective asset management contributes to a company's ability to generate profit.

Finally, it is important to scrutinize a company's costs associated with its operations, such as production costs and overhead expenses. A company that efficiently manages its costs will likely generate higher profitability and provide better returns for investors.

Creating Value through Strategic Planning

Strategic planning plays a crucial role in creating value for investors and businesses. It serves as the foundation for effective decision-making and guides companies towards achieving their goals. Through strategic planning, management teams can identify and focus on core competencies that contribute to a company's competitive advantage.

One way to create value is to prioritize revenue growth. By identifying key growth drivers, such as product innovation or market expansion, companies can allocate resources accordingly to boost earnings. Such targeted investments in growth engines allow firms to capture a larger market share and drive long-term profitability.

Another aspect of strategic planning involves optimizing a company's holdings. By assessing the existing portfolio, management can decide whether to divest underperforming assets or make strategic acquisitions that align with their investment thesis. The right combinations and adjustments can significantly enhance a company's overall performance and shareholder value.

Risk management is also an essential aspect of strategic planning. Companies must assess potential risks and incorporate suitable mitigation measures in their plans. This ensures that organizations are prepared for unforeseen circumstances, which can safeguard profits and protect the company's assets.

Furthermore, creating value requires continuous improvement and adaptation to market trends. Companies should routinely reevaluate their strategies to identify both internal and external factors that may impact their current position. By setting clearly defined objectives and quantifiable financial targets, management teams can measure their progress effectively and adjust their strategic plans as needed.

In summary , creating value through strategic planning involves a combination of focusing on core competencies, prioritizing revenue growth, optimizing holdings, managing risk, and continuously reassessing the company's strategic direction. This holistic approach can help businesses enhance their profitability, strengthen their market position, and ultimately deliver strong value creation to investors.

Understanding the Market and Competition

Before developing an investment thesis, it is crucial to have a deep understanding of the market and its competition. The stock market is influenced by various factors such as economic supercycles, bear markets, and secular trends. Analyzing these elements will provide a solid foundation to recognize potential investment opportunities.

An economic supercycle is a long-term pattern that occurs over several decades, during which the economy undergoes periods of growth and contraction. Investors need to be aware of the current phase and how it may impact their investment decisions. For instance, during a growth period, certain industries tend to outperform, while others may underperform during a contraction phase.

In addition to analyzing these market conditions, investors must also pay heed to the competitive landscape of the sector in which they plan to invest. Examining the competitors within the industry enables one to identify companies with competitive advantages, which may lead to superior performance. These advantages can stem from factors such as lower costs, innovation, or a dominant market share.

A bear market occurs when the stock market experiences a prolonged decline, typically characterized by a decrease of 20% or more from recent highs. In such environments, it becomes even more crucial for investors to understand the competitive dynamics within an industry to identify resilient companies that can withstand market downturns.

A secular trend is a long-term movement in a particular direction that can last for several years or even decades. Identifying secular trends within industries is essential to spotting opportunities for long-term growth. For example, investors may capitalize on sectors benefiting from a shift towards clean energy usage or the increasing importance of artificial intelligence.

In summary, understanding the market and competition requires a deep analysis of the stock market, economic supercycles, bear markets, and secular trends. By researching industry trends, evaluating market opportunities, and assessing the strengths and weaknesses of competitors, investors can develop a robust investment thesis that increases the likelihood of achieving long-term returns.

Industry Case Studies

In the investment world, the importance of an investment thesis cannot be overstated. By examining various industry case studies, we can gain insight into how businesses make strategic investments to enhance their value. In this section, we'll discuss notable examples from companies such as DuPont, General Motors, Rexam PLC, and Clear Channel Communications.

DuPont is a leading science and innovation company with a focus on agriculture, advanced materials, and industrial biosciences. During its acquisition of Dow Chemical, DuPont developed a robust investment thesis to justify the merger. Their investment case relied on the belief that the combined entity would benefit from increased operational efficiencies, new market opportunities, and enhanced innovation capabilities. This approach provided a strong rationale for the deal, which has created a more competitive company in the global market.

General Motors (GM) , a multinational automobile manufacturer, crafted its investment thesis in response to evolving trends in the automotive industry, such as the increasing importance of emissions reduction, electrification, and autonomous technology. GM's investment case centered on embracing these trends, focusing on innovation, and expanding its product offerings through strategic M&A, investments, and partnerships. For example, GM has made significant investments in electric vehicles and autonomous driving technology, positioning the company for future growth in these areas.

Next, we have Rexam PLC , a former British packaging manufacturer that was a leading producer of beverage cans globally. When Ball Corporation sought to acquire Rexam, they developed an investment thesis based on the value derived from combining the two companies' strengths. This thesis outlined the strategic fit between both companies, synergies from combining production capabilities, and projected growth, particularly in developing markets. The successful acquisition helped Ball Corporation consolidate its position as a global leader in the packaging industry.

Lastly, Clear Channel Communications is a media company specializing in outdoor advertising. As the company sought to expand its presence in this sector, it created an investment thesis centered around leveraging its core competence in outdoor advertising and acquiring strategic assets. One example is Clear Channel's acquisition of crucial billboard locations to solidify its competitive edge in the outdoor advertising market. This targeted growth strategy has allowed Clear Channel to remain a dominant player in the industry.

In conclusion, these industry case studies demonstrate the value of a well-crafted investment thesis. Effective investment theses provide a roadmap for companies to pursue strategic acquisitions and investments that create long-term value, while also helping investors evaluate the viability of proposed deals. By understanding how companies like DuPont, General Motors, Rexam PLC, and Clear Channel Communications have strategically invested in the market, we can better appreciate the importance of a well-structured investment thesis.

Long-Term Investment Strategies

A long-term investment strategy refers to an approach where investors hold onto their investments for an extended period, typically more than one year. This type of strategy aims to achieve the investment goal by allowing assets to grow through market fluctuations and capitalizing on the power of compounding interest. Diversification and patience play pivotal roles in ensuring the success of a long-term investment strategy.

Portfolio managers often use various techniques and methods to craft long-term investment portfolios. Some of these techniques include targeting undervalued sectors or stocks, dividend reinvestment plans, dollar-cost averaging, and asset allocation. By employing these strategies, portfolio managers increase chances of achieving their clients' investment goals over time.

In order to develop long-term investment strategies, investors should first define their investment goal . This could include objectives such as saving for retirement, funding a child's college education, or purchasing a home. Clear investment goals help in designing an appropriate investment strategy, taking into account factors like the investor's risk tolerance, time horizon, and available capital.

One key aspect of a successful long-term strategy is diversification . Diversifying across asset classes and industries allows investors to spread risks and potentially achieve higher risk-adjusted returns. A well-diversified portfolio will typically consist of a mix of stocks, bonds, and other asset types, with variations in investment size, industry sector, and geographical location. This diversified approach minimizes the impact of underperforming investments on the overall portfolio.

Another crucial element in long-term investing is patience . Market fluctuations can be tempting for investors to react to their emotions and make impulsive decisions, which could derail a well-thought-out investment strategy. Maintaining a disciplined approach and sticking to one's investment plan, even during periods of market volatility, is paramount to achieving long-term success.

In conclusion, long-term investment strategies require investors to define clear goals, diversify their portfolio, and exercise patience in the face of market fluctuations. By adhering to these principles, investors and portfolio managers can steer a course towards achieving their investment objectives.

Emerging Trends and Opportunities

In recent years, various emerging trends have presented attractive opportunities for investors. Among these trends, renewable energy, megatrends, and the coffee shop market stand out as sectors with significant potential for growth.

Renewable energy has gained considerable attention and investment as a response to the global push for addressing climate change and reducing emissions. Solar, wind, and hydroelectric power are some of the most prominent technologies in this sector. With an increased interest in clean energy from both governments and consumers, companies in this space are poised to experience substantial growth.

Megatrends such as urbanization, aging populations, and technological advancements are also influencing investment opportunities. These large-scale shifts provide a backdrop for businesses to tap into new markets and adjust their strategies to capitalize on these changes. For instance, companies working in healthcare and biotechnology may benefit from catering to the needs of an aging population, while businesses focused on artificial intelligence (AI) and automation may find increased demand due to technological advancements.

The coffee shop market, too, presents investment opportunities. This industry has experienced robust growth in recent years as consumers increasingly seek out unique, high-quality coffee experiences. Independent and specialty coffee shops are at the forefront of this trend. Niche coffee shops that offer novel and authentic experiences have seen success by catering to the specialized preferences of today's consumers. As the demand for artisanal and premium beverages continues to rise, businesses operating in this space can expect to have ample opportunities for growth.

In conclusion, current emerging trends such as renewable energy, megatrends, and the coffee shop market offer a wealth of investment opportunities. As these sectors continue to develop and evolve, investors with well-informed investment theses stand to benefit from the potential rewards in these growing industries.

Role of Financial Statements and Valuation Metrics

Financial statements play a vital role in the investment thesis by providing crucial information about a company's financial health and performance. They consist of the balance sheet, income statement, and cash flow statement, which offer insights into the company's assets, liabilities, revenues, expenses, and cash flows. Investors use these statements to assess the company's past performance, current financial condition, and potential for future growth.

Valuation metrics, on the other hand, are vital yardsticks that investors use to compare different investment opportunities and make informed decisions. These metrics include price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, price-to-book (P/B) ratio, dividend yield, and return on equity (ROE), among others. By analyzing these ratios, investors can gauge a company's value relative to its peers and make better investment choices.

Analysts and investors scrutinize financial statements to identify growth trends, profitability, and financial stability. For instance, they may calculate the gross margin, operating margin, and net profit margin to determine the company's profitability across different stages of its operations. Additionally, they examine liquidity ratios, such as the current ratio and quick ratio, to assess the company's ability to meet its short-term obligations.

Valuation metrics provide a quantitative basis for comparing investment opportunities within the same industry or across different sectors. For example, a lower P/E ratio may indicate that a stock is undervalued, while a high P/E ratio might suggest overvaluation. Moreover, the P/B ratio can help investors determine if a stock is undervalued by comparing its market price to its book value.

Another key valuation metric is the dividend yield, which measures the annual dividend income per share relative to the stock's price. A higher dividend yield may attract income-oriented investors, while a lower yield might be more appealing to growth-focused investors. Furthermore, the ROE ratio, which measures a company's profitability in relation to its equity base, is an essential metric for evaluating the efficiency of management in creating shareholder value.

In conclusion, financial statements and valuation metrics are indispensable tools for investors to evaluate a company's financial health and investment attractiveness. By analyzing these data points, investors can make well-informed investment decisions that align with their risk tolerance and investment objectives.

Concluding Thoughts on Crafting a Compelling Investment Thesis

Crafting a compelling investment thesis is crucial for informed investing decisions, as it helps investors thoroughly analyze a potential opportunity. A well-researched investment thesis demonstrates the investor's conviction level and reinforces their confidence in the investment choice. This process involves a deep understanding of the business, its value drivers, and its potential growth trajectories.

A strong investment thesis should be definitive, clearly articulating the reasoning behind the opportunity and the expected returns. This allows investors to stay focused on their goals and maintain their conviction, even when the stock's price movement does not align with their expectations.

By adopting a confident, knowledgeable, and neutral tone, investors can effectively communicate their investment thesis to others. Clarity in presenting the investment case is essential for persuading potential partners or stakeholders to support the opportunity. Utilizing formatting tools such as tables and bullet points can aid in conveying essential information efficiently and ensuring the investment thesis is easy to understand.

In summary, crafting a compelling investment thesis enables investors to make well-informed decisions that align with their financial goals. By developing a thorough understanding of the investment opportunity and maintaining a strong conviction level, investors can better navigate the market and achieve long-term success.

Frequently Asked Questions

How do you develop a strong investment thesis.

A strong investment thesis begins with thorough research on the company or asset in question. This may include looking at the financials, competitive position, management team, industry trends, and future prospects. It's essential to critically analyze the available information, identify potential risks and rewards, and establish a clear rationale for the investment based on this analysis. Staying focused on the long-term outlook and maintaining a disciplined approach to the investment process can also contribute to developing a robust investment thesis.

What are the key elements to include in an investment thesis?

An investment thesis should include the following key elements:

• Overview of the company or asset: Provide a brief background of the company or asset, including its market, size, and competitive positioning.
• Investment rationale: Detail the reasons for investing, such as attractive valuation, strong revenue growth, or a unique business model.
• Risk assessment: Identify potential risks and how they could impact the investment returns.
• Expected return: Estimate the potential financial return based on the identified growth drivers or catalysts.
• Time horizon: Indicate the investment period, typically long-term, during which the thesis is expected to play out.
• Fund size: Specify the amount of invested capital that will be allocated to this particular investment, considering its impact on portfolio construction, liquidity, and potential returns within the overall portfolio strategy

How can one evaluate the success of an investment thesis?

Evaluating the success of an investment thesis involves tracking the progress of the company or asset against its initial expectations and underlying assumptions. This may involve measuring financial performance, analyzing key developments in the industry and the company's position within it, and monitoring potential changes in overall market conditions. It is helpful to revisit the investment thesis regularly to assess its validity and make adjustments as necessary.

What's the difference between an investment thesis for startups and publicly traded companies?

An investment thesis for a startup often focuses on the growth potential of a new or emerging market, considering the innovative products or services the startup offers in that market. Here, the focus may be more on the potential for long-term value creation, the management team's ability to execute on their vision, and market fit.

For publicly traded companies, the investment thesis may include analysis of current financial performance, valuation multiples, and overall market trends. Publicly traded companies have more historical data and financial performance information available, allowing investors to make more informed decisions based on these factors.

How does an investment thesis guide decision-making in private equity?

In private equity, the investment thesis helps guide the selection of companies to invest in, as well as the structuring of deals to acquire those companies. It provides a blueprint for how the private equity firm aims to create value, including plans for operational improvements, financial engineering, or growth strategies. This thesis serves as a basis for monitoring the progress of an investment and helps make decisions on the timing of potential exits.

How can real estate investment theses differ from other sectors?

Real estate investment theses may focus on factors such as location, property type, market dynamics, and demographic trends to identify attractive investment opportunities. The analysis may also take into account macroeconomic factors, such as interest rates and economic growth, which can influence real estate markets. Additionally, real estate investments may be structured as either direct property investments or through financial instruments like Real Estate Investment Trusts (REITs), affecting the underlying investment thesis.

What considerations should a first-time fund manager have when developing a fund's investment thesis?

For a first-time fund manager, crafting a compelling and robust fund's investment thesis is paramount for attracting investors. Given their lack of a track record, these managers need to lean heavily on the research, clarity, and vision articulated in their investment thesis. The thesis should detail how the fund aims to identify ideal investments, especially those in industries with high margins. It should also benchmark the strategies against industry standards to highlight the manager's acumen and awareness of market norms.

How is a stock pitch related to an investment thesis and what role does a target price play in it?

A stock pitch is essentially a condensed, persuasive form of an investment thesis, often presented to stakeholders to advocate for investing in a particular publicly-traded company. A key element of any stock pitch is the target price, which is an estimation of what the stock is worth based on projections and valuation models. This target price serves as a quantitative anchor for the investment thesis, giving stakeholders a specific metric against which to measure potential returns and risks.

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Lessons from Private-Equity Masters

• Paul Rogers,
• Tom Holland,

Private-equity firms routinely achieve eye-popping returns on the businesses they operate. Their secret? A relentless focus on four management disciplines.

Going private was the making of auto parts manufacturer Accuride. For years, the enterprise had struggled as a unit within the giant Firestone Tire and Rubber Company (now Bridgestone/Firestone). Because Accuride’s business—making truck wheels and rims—was peripheral to Firestone’s core business, it found itself starved for resources and managerial attention.

• PR Paul Rogers ( [email protected] ) is a partner who leads Bain’s London office; he formerly led Bain’s Global Organization Practice. They are coauthors of the forthcoming book Decide and Deliver: Five Steps to Breakthrough Performance in Your Organization (Harvard Business Press, 2010). Portions of this article are adapted from the book.
• TH Tom Holland, a director in San Francisco, helps lead Bain’s Private Equity Group.
• DH Dan Haas ( [email protected] ) is a partner in Bain & Company’s Retail practice.

Partner Center

S T R E E T OF W A L L S

Building an investment thesis.

Now that you understand what characteristics make up attractive long and short ideas, it is time to explain how to formulate an investment thesis. Being able to construct a real and actionable investment idea is in the heart and soul of an analyst’s work in the hedge fund industry. Building a successful thesis begins with (1) rigorous due diligence at the Micro level, (2) aligning that view with the Macro environment, and (3) understanding the overall trade setup.

Good Company Qualities

• High return on capital
• Barriers to entry
• Growing industry
• High margins relative to competition

Good Management

• High insider ownership
• Well respected
• Clean accounting
• Infrequent restating of earnings
• Not overly promotional
• Good allocators of capital

All of these qualities are obvious and won’t differentiate your pitch, but they are qualities you will have to talk about, so make sure you understand them well.

Target Price = Your Earnings Estimate × Multiple

Company Earnings

• Will the company beat earnings expectiations in the next quarter or in the next year?
• If so, what are the catalysts that will cause the Company to beat earnings (e.g., higher revenue, higher margins, lower interest expense, share buybacks, etc.)? Paint the picture of how, when, and why there will be a catalyst that supports your view. Providing an opinion without fully understanding and explaining the relevant value drivers will be a recipe for failure.
• What’s your confidence the company will beat earnings? What’s the probability?
• What’s your margin of safety? What can go wrong?
• Does your pitch rely on multiple expansion? Why? Where is the company trading relative to its historical multiple? Should the multiple trade at a premium or discount given how the company has changed over the years, and where we are now in the business cycle?
• Where is the company trading relative to its peer group? If the entire market has seen multiple expansion, then is it fair that this company should too? In other words, is it expensive or cheap relative to itself historically and/or its peers, and can you explain why this might be wrong?
• What catalyst is going to cause this multiple to start expanding? Again, paint the picture of how, when, and why there will be a catalyst that supports your view.
• What is your confidence in multiple expansion? What’s the probability?

Target Price:

Your target price is the product of a forecasted earnings metric multiplied by the expected multiple. This multiple can be P/E, EV/EBITDA, EV/Sales, FCF/Market Cap, or any other reasonable metric. Some metrics are industry-specific and more valuable for those industries than the aforementioned general ones.

Regardless, if you provide a target price, you need to explain how you arrived at this target, and the stages of your thought process to get there. for example, if you claim that a stock is going to have +50% upside, but feel they won’t beat consensus earnings, then you are calling for +50% multiple expansion, pure and simple.

Although not ideal, stocks in industries with bleak macroeconomic outlooks can still be good investments. It is important to understand what is taking place at the company level, sub-sector level, industry level, and national level. This approach will help you determine whether you are investing in a “good house in a bad neighborhood.”

• How has the stock performed heading into the catalyst, i.e, before you put the trade on? If it has already gone up 10% recently, for instance, it will be much harder to outperform on the catalyst.
• How crowded is the trade? Are a lot of hedge funds already invested in the name? One easy way to determine this is to speak to a sell-side research analyst and ask whether they are getting a lot of calls from other funds regarding the company.
• Is the general public bullish or bearish? If you are researching a short pitch, it is key to check for existing short interest (SI function on Bloomberg). If it is a long, you should review the list of major holders of the stock (HDS function on Bloomberg). If the top holders are several hedge funds, then the stock pitch is likely overcrowded and may not be actionable. One of the biggest mistakes in a hedge fund interview is to pitch a stock that every hedge fund has already heard of and evaluated.

Crowded names can still work, but investors must tread lightly. When the market sells off or there is a change in sentiment, crowded names typically perform the worst. To check this, there is an index on Bloomberg of high hedge fund ownership stocks; you can use it to see whether your idea is on that list to make sure it isn’t already an overcrowded trade idea.

Other technical tools that can help evaluate the setup for a stock include RSI (relative strength index) and moving averages. The RSI is a momentum indicator—below 30 is considered oversold and above 70 is considered overbought.

Ideally, you want a stock that has recently underperformed its peers, is lightly owned by hedge funds, and is heading into a catalyst that you think will have a positive surprise . By contrast, a crowded name that has already outperformed based on the expectation of a positive catalyst will likely get a limited reaction if and when the catalyst does occur. For example, it is very common for companies to beat earnings expectations but not to experience an increase in their stock prices, because the general public or hedge funds are already expecting the earnings surprise. In today’s hyper-competitive market, one needs a truly different variant perception in order to outperform the market.

Other Investing Thoughts

• What constitutes a good investment idea? What does that phrase even mean? The answer is that it means something different to every person–that is what provides opportunities in a market. That is why some investors own a stock and others short it. If everyone agreed on what makes a good investment then everyone would own the same stocks.
• How much should you make per idea? Investors do not even agree on this principle. Developing frameworks for investing will help you follow a set of guidelines that you can refine over the years through experience, and as part of that, you will learn to determine what the expected profit and acceptable risk for a particular investment are.

Value Investing Framework

• Benjamin Graham defined the first basic tenant of value investing as follows: when the price of a security diverges from its intrinsic value (its corresponding cash flows), a value investor should work to exploit that divergence.
• The second basic tenant of value investing is the margin of safety: a security should preferably be purchased at a deep discount to its intrinsic value, to help limit the amount of downside risk the investment has.

Street of Walls Investing Framework

• It is very easy to get ideas from other investment professionals, but it will be very obvious in your pitch whether you have done the analytic work yourself or not.
• This is typically discovered when you are questioned on your assumptions in the model. If you built the model yourself, you can likely defend the assumptions much more intelligently.

Industry Analysis

Market size and growth.

Study the market size and growth of the company’s core industry. Even though you may be studying the beverage industry, the manufacturing companies and distribution companies have very different dynamics. The beverage manufacturers may not be growing much faster than CPI, but the distributors may be going through a massive consolidation period and therefore have earnings that are growing at a much faster pace.

Historical Industry Returns

A security may be cheap and look attractive, but that may be because the returns of the company and the industry are not attractive. For example, the stock Owens Corning (OC) traded at 8x earnings for a long time. This sounds inexpensive, but it was ultimately justified because operating margins were in the single digits. Eventually, however, industry did consolidate and operating margins expanded to 20%. Thereafter, the company’s earnings multiple expanded into the low teens.

Unit Economics

Most bottom-up, fundamental analysis is used to study the unit economics of a company. For example, what does it cost to make and sell one unit of output, and what is the profit on that unit? What are the pricing and volume trends? It is important to understand the value drivers clearly in order to build a detailed operating model for your pitch.

Competitive Positioning

• Do certain companies control industry pricing?
• How sustainable is the company’s competitive advantage?
• Are there high or low switching costs?
• Does branding matter
• Are there regulatory protections, such as tariffs?
• What important considerations are there with respect to the company’s customers and suppliers?

Cyclical / Seasonal

An industry may be in a strong growth period and look very attractive, but it may also be at the peak of a cycle that is possibly about to turn substantially negative. For example, the housing industry looked extremely attractive in the early 2000s, but crashed and was extremely unattractive into the late 2000s and beyond. This is due to both an economic downturn and a systematic overbuilding of homes that collapsed in the middle of the decade. In addition to the economic/business cycle, certain industries have drivers of cyclicality that are very specific. One example of this is the Oil & Gas industry—the price of oil alone can have a huge impact on a Oil & Gas company’s earnings potential.

It is also important to understand the seasonality of the business. Retailers tend to sell more product during the fourth quarter of the year, because of the holiday shopping season. Therefore, it may be wrong to extrapolate a trend in March and April if the majority of the company’s sales take place in the later months.

Investment Considerations

When you start working for a hedge fund you will quickly learn that each fund has their own unique investment style. Some hedge funds simply will not invest in companies that have weak management teams. It does not matter how attractive the opportunity or valuation is—the fund simply won’t invest. This principle often results from an investor getting burned from a bad management decision, such as a bad acquisition, or a focus on short-term earnings at the expense of long-term objectives. After gaining experience analyzing companies, you will eventually develop your own philosophy. Still, bear in mind that other investors may have an opinion on this topic that differs from yours, and you need to consider the philosophies of your teammates when evaluating an investment idea.

In studying management teams, you should look at the management team’s track record and understand both the buy-side and sell-side opinion on the management team. Study the company’s internal philosophy: how do they allocate capital? Is the current management team following what the company has always done? Another key to understanding how a management team will probably act is to study how the members are compensated. Is their compensation tied to revenue or earnings, return on capital, or some other metric? How much stock does the management team currently own? How much risk are they taking? Are they buying or selling stock? How many options do they have outstanding?

Study both relative and absolute valuation. A stock may appear cheap when compared to a stock in another sector, but very expensive against its peers. Thus, different investment situations call for different valuation metrics to be used.

One example of this principle is that it is completely unhelpful to use P/E if the company has no earnings (or negative earnings). You should also study the rate of growth of the earnings metric you chose. A company may look expensive at 30x earnings, but if it is doubling revenue every year and tripling earnings, it may not be so expensive after all. In fact, if you believe that this trend can continue, it may be an excellent long investment idea.

• Is there a difference between your earnings estimates and those of the street?
• If not, is your thesis really interesting, or is it just a “consensus trade”?
• What are the key events that the street will care about? Is it an earnings release, a new product release, or something more unusual?
• Does the street care about what happens next quarter or are they more focused on the potential signing of a big contract that could take place at any time?

Donald Rumsfeld once said there are “Known unknowns and unknown unknowns.” Some risks are riskier than others. How does the company control for this? How do you as the investor assess the downside risk from this?

• What has to happen for the downside case to play out?
• What has to happen in order to lose some benchmark amount, say 20% or more?
• If that event plays out, what will happen to the multiple? Will it go down or actually expand?
• All in all, what is the probability of a downside event and what is the maximum potential loss you might face in such a scenario?

Catalysts are extremely important in identifying when you are going to “get paid.” This is a crucial factor in sizing positions. If a catalyst is expected to take place in the near future, you probably want to have your position fully sized immediately. If not, it may make sense to taper into a position.

Framework for Investing: Large Market Movements

Rising Markets: The typical reaction to a rising stock price is to “chase” the returns. That means when a stock continuously goes up, day after day, the investor feels like he or she is missing an opportunity, and will be inclined to buy the stock. This pile-on mentality causes more investors to become a part of the action. This is a classic, human reaction to a strongly outperforming stock, and it can often lead to poor returns due to an undisciplined approach and the fickle nature of the market.

The same thing can happen when a stock continues to drop in price. Investors tend to panic and sell at exactly the worst time. During the heat of the battle, people tend to get emotional and sell their best stocks out of fear.

• Tell yourself it is normal to react this way when you are losing a lot of money. Fear is normal: both the fear of missing an opportunity and the fear of continuing to lose more money.
• Ask yourself, “Has my investment thesis changed?” If it has, then sell, but if it has not, then ignore your fears and hold the position.
• Have strict target prices in place. This will help you exit a position once your target has been achieved, and thereby avoid the trap of trying to “ride a winner.”

Here is a related excerpt written by Benjamin Graham, from The Intelligent Investor:

• “Imagine that in some private business you own a small share that costs you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects, as you know them. Often, on the other hand, the value he proposes seems to you a little short of silly.
• If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.”

Trading Considerations

The liquidity of a single stock is not a reason for a fundamental investor to buy a stock, but it can definitely be a reason for an investor not to buy a stock. The less liquid a stock is, the riskier the position becomes, as it is difficult to exit an illiquid position—especially during turbulent market conditions, when liquidity is often demanded.

In order to determine how liquid a stock is, you need to see how many shares trade on a regular basis. For example, if the average daily volume of a $10 stock is 1 million shares, then the stock trades $10 million per day. If you have a $1 million hedge fund, and you want to take a 10% position, you will need to buy $100,000 worth of stock, or 10,000 shares. If you wanted to buy all of that stock in 1 day you could, as you would only account for 1% of the daily volume ($100,000 in stock to be purchased ÷ $10,000,000 daily volume = 1%). A reasonable rule of thumb is that you do not want to account for more than 10-15% of a stock’s daily trading volume if you do not want to influence its price. So in this example, you could buy up to $1,500,000 worth of stock per day without moving the share price. If you were to buy $2,000,000 of stock in 1 day, or 20% of the daily volume, you would likely cause the stock price to increase (at least temporarily). If your desired position is much larger, then it could take many days to accumulate the desired position – and similarly, it could take a long time to unwind the position when you want to exit. This makes the investment much more risky.

Therefore, a stock may have fantastic management, excellent earnings growth, and an attractive price, but if there is no liquidity you probably simply cannot buy it.

Shareholder Base

You may think that you have found a gem: a rare and precious investment opportunity that no other hedge fund is talking about. Fortunately, that notion is relatively easy to confirm or disprove. To check and see whether other sophisticated investors are involved in the company you’re researching, you can pull up the company’s quarterly holdings report on Bloomberg and see who the largest shareholders are.

For example, suppose that W.R. Grace (GRA) offers an exciting investment opportunity, according to your analysis. However, looking at the holders list, you determine that other hedge funds are well aware of this opportunity, as the top shareholders include large hedge funds such as Lone Pine, York Capital, TPG Axon, and Hound Partners.

It may not be a bad thing that other hedge funds are involved. You will probably be invested in a good company in this case, as large hedge funds rarely get involved in unsound investment ideas. That being said, crowded trades can, again, be very risky. First, if the market is already anticipating good news, it may be that the good news is already baked into the stock price. Second, if bad news comes out, then everyone will likely be forced to run for the exits at the same time. This will lead to adverse price movement that could destroy your holding.

Hedge funds in general tend to be short-term focused, so it could turn into a situation where one investor exits swiftly and triggers a domino-effect panic, crushing other investors in the wake.

Looking at charts can be very deceiving and can create misleading signals. For example, the stock chart below shows a quickly rising stock price, but that does not mean it is expensive. It may be cheap relative to its own history, the rest of the sector, or the market as a whole. The entire stock market might have been going up rapidly, or the sector as a whole might have had a big rally, and relative to the sector the stock underperformed, so it may actually be cheap on a relative basis.

You may also want to compare several valuation metrics simultaneously. For example, a company may look expensive on a Price/Earnings basis but cheap on an EV/EBITDA basis.

In the graph below, you can see that Factset Research Systems (FDS) is trading at 20x P/E. Relative to the market that is high, but relative to its own history, that is a normal trading ratio.

Business Model Questions

It is just as important to understand the industry in which a company operates as it is to understand the company itself. For example, if you are studying a homebuilder, it is important to understand the companies the homebuilders buy supplies from. If the building products companies are raising their prices and the homebuilder cannot raise prices, the builders are going to see their margins compress. Therefore, it is important to scan what is happening with related companies across the industry and sector to get a sense of the overall dynamic affecting the company’s earnings potential.

Homebuilding Industry: Related Participants

• Building Materials – USG, EXP, VMC, SHW
• Home Builders – LEN, DHI, KBH
• Building Products – WHR, MAS
• Furniture – TPX, LZB, ETH
• Extensions – Lawn care – SMG
• Mortgage Originator – BAC, C
• Insurance Provider – PRU, MET

A change by the mortgage originator will likely have an impact on the entire industry. If Bank of America (BAC) tightens its origination standards, then people will buy fewer homes; homebuilders will buy less carpet to go inside the homes; fewer beds will be sold; etc. Therefore, before considering an investment in a homebuilder or related entity, it would behoove you to perform checks to see what else is occurring in related industries and sectors across the value chain.

Business Model Advantages

Barriers to entry.

Companies with barriers to entry have a huge advantage relative to companies that do not. These barriers can occur for a variety of reasons, but some of the most common include economies of scale, substantial investment requirements, technological innovation, favorable government regulation, and networking effects. eBay, for example, is an extremely difficult company to compete against, because the company has established a formidable position as the largest Internet-based auction site available. Both buyers and sellers are unlikely to go to other sites, because both realize that eBay offers more individuals on the other side of the aisle to transact with. This makes it hard for new auction companies to compete with eBay effectively.

Companies in most industries will claim that they have high barriers to entry, but time will often show that a company earning significantly higher than its cost of capital will attract competitors. Put simply, if the company is earning outsized returns on the capital it invests, then it will attract competitor investment seeking to earn comparable returns. This competitive investment will result in increased production and sales competition, and diminished profit-earning potential will surely follow in the future.

Cost Advantages

The low-cost producer can have a huge advantage over its competition. In industries with large legacy assets, such as cement or coal production, the players with the newest assets are typically the lowest cost providers, and that allows for lower pricing often results in greater market share.

Alternatively, there is also a learning curve that can create the reverse effect, wherein the older industry participants have lower costs as the newer players are still “figuring it out.”

Customer Habits

Repeat purchase items, such as paper or office supplies, can create a strong advantage for the producer. The more entrenched companies become within their customer bases, the higher the switching costs for those customers. For example, a large technology roll-out may effectively lock a customer in to the provider’s products, as it costs too much to execute a complete technology overhaul to switch to a different vendor.

Economies of Scale

Companies with large fixed costs need scale in order to make a profit. The larger the fixed costs, the larger the scale needs to be. Incremental margins can be very high once a company crosses a certain threshold and is able to sufficiently leverage its cost base. This can make a company highly attractive and cause a company to trade at a high multiple, once the threshold production level has been achieved. This phenomenon is sometimes referred to as “operating leverage.”

Oligopolies, or Monopolistic Competition

Functioning oligopolies can act similar to monopolies, in terms of locking in outsized profit margins from its business. These situations should not take place for long according to basic economic theory, but they can and quite often do. For example, the roofing industry has greatly consolidated in recent years, so that four players currently control 80% of the roofing shingle manufacturing market. When one of the four manufacturers raises its prices, the other three can easily follow. For the past five years, none of the players has broken from the pack and tried to steal market share from the other three by offering a lower price. As a result, the industry has seen its operating margins grow from 8% to 20% in recent years. Whether this increase in margin is sustainable over the long term remains to be seen.

Expected Return

What is a “good” return for a portfolio? How do you know? What is a good return for an individual investment?

The Academic Approach

Expected Rate of Return = Risk-free return + Beta × (Expected Market Return – Risk-free return)

This is the equation from the Capital Asset Pricing Model (CAPM), which you will learn in school—but try pitching this to a portfolio manager at a hedge fund. He or she will likely tell you to get lost!

Theoretically this makes perfect sense, but most hedge funds don’t use this as a hurdle rate. Most funds target a 20% return—though very few are capable of actually achieving that return consistently.

The Practical Hedge Fund Approach

A more practical approach is to study what percentage of the time you will make money and lose money on your investments. From there, you need to understand how much you make when you are right and how much you lose when you are wrong. Here is an example of this framework:

As you can see:

Average Return per Idea = (% Right × Avg. Return When Right) + (% Wrong × Avg. Loss When Wrong)

% Right is often referred to as your “Hit Rate,” and Average Return When Right is often referred to as your “Slugging Rate.” The magnitude of your wins relative to that of your losses is referred to as your “Win/Loss Ratio.”

The best analysts are right about 60% of the time. Most people think they will be right closer to 75%, but the sad truth is that most investors will not do much better than 50%. You can still make money being right only 50% of the time, but you have to be very disciplined about cutting your losses. That is why maintaining a 2-to-1 Win/Loss ratio is so important.

Here is what is so troubling about the example given above: a fantastic analyst who is right 60% of the time, makes a 30% return when right, and maintains a 2-to-1 Win/Loss ratio, will only earn an average return of 12% per idea. However, as we noted, most hedge funds try to earn 20%, so how can they do this?

One possible solution is to employ leverage, but from an analyst’s perspective, he/she typically does not have control over this. So how can an analyst generate a higher return per idea?

A higher Hit Rate is very difficult to achieve. Also, achieving greater than a 2-to-1 Win/Loss ratio is also not realistic, as it would require tighter stop-loss controls that may result in the premature exit of lucrative investments simply because they took an initial “hit” before panning out.

Therefore the only real area to control is the Slugging Rate. If this is the lever, then the analyst cannot afford to invest in stocks that will only earn 10%, 20%, or even 30%. It is just not a high enough annualized return. At a 40% Slugging Rate, the analyst can get closer to the elusive 20% total return hurdle.

40% thus tends to be a “sweet spot” for many hedge fund analysts, as a minimum hurdle rate of return for putting on a position. If the investment only has a 6-month duration, then the return only needs to be 20%, which is roughly 40% on an annualized basis.

Searching for 40% Returns

What needs to happen in order for a stock price to increase? Either earnings need to expand, or the multiple needs to expand, or a combination of the two. The first step is to look at where the sell-side estimates are for the current year and two years into the future. If AAPL is trading at $611 today and is expected to earn $54 in 2013 and $63 in 2014, it is trading at 11x P/E and 10x P/E in 2013 and 2014. In order for the stock to reach $855, or 40% higher, you might project earnings to be 20% higher than the street in 2013 at ~$65, and for the multiple to expand by 20% to ~13x. Or, you might predict stronger earnings growth and less multiple expansion, or vice versa.

As you can see, it pays to think through different scenarios needed to achieve your target return.

A common mistake analysts make is to say that they believe a stock will appreciate by an amount but have earnings expectations that equal or are very similar to those of sell-side earnings estimates. That means that for the investment thesis to prove correct, the stock must increase entirely due to multiple expansion. That is generally viewed as a “low-quality” thesis, as expansion in a valuation multiple is more difficult to predict and gain confidence in than is growth in earnings.

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Private equity governance: Driving value and returns

How private equity firms approach governance and what boards and management teams can expect., key takeaways.

Maintaining total control over governance is critical for PE firms, with one exception.

Maximizing value requires ownership and governance at PE-owned companies to be well-aligned. 

Building strong governance boards and management teams may mean having to bring in outside talent.

It is well understood that private equity firms seek to take as much control of a company as necessary to execute their investment thesis, giving equal importance to value extraction and value creation.

Why is maintaining control over governance so important? Because it gives private equity the leverage to drive value and returns. Below, we examine key governance approaches that private equity firms adopt in pursuit of this quest, and what boards and management teams at companies controlled by private equity firms can expect.

An ownership strategy to maximize value

Boards of directors are entrusted as fiduciaries for stockholders in private and public settings; however, public company stockholders must rely on the board and executive officers to act in their best interests to maximize shareholder value.

The private equity leveraged buyout strategy typically involves the acquisition of a majority ownership stake in a portfolio company, which generally allows the sponsor to appoint the board of directors and fill key executive management positions.

Conversely, public company ownership can be widely dispersed among various stockholders who individually would not be able to influence the board’s composition. Thus, ownership of large public companies can often be separated from the stewardship of the company by one of the classic principal-agent dynamics of the business world.

Ownership and governance of a private organization are typically well aligned if not one and the same. This structure empowers sponsors to implement turnaround plans, discharge growth, and expansion strategies, and optimize the capital structures of the busi­nesses they acquire to maximize value to the private equity firm.

Reorganizing after an acquisition

Following a buyout, the private equity firm’s partners or deal makers will make up most of the company’s governing board. Alternatively, the firm may appoint its allies with specific industry knowledge or who have experience with similar business models.

Next come management changes, including in the chief executive officer position. As part of the investment thesis, private equity firms must consider how to build a leadership team that can grow the business. Even before acquiring the portfolio company, the private equity sponsor will identify top talent for key roles and move quickly once the deal closes to install them into position to begin the work of unlocking value.

Founders may be retained at the helm in some scenarios if their vision and that of the private equity firm are aligned. They and the management team may also continue in their positions if their lead­ership, skills, and talent are what the private equity group believes are necessary to take the private company to the next level. However, this will be under the watchful eye of a board controlled by the private equity sponsor.

It is common for private equity firms to have operating partners on retainer. These private equity professionals specialize in executing and operationalizing the private equity group’s strategy. Operating partners are more immersed in the company’s day-to-day operations, working closely to introduce operational efficiencies and sound internal controls, uncover synergies, and eliminate excess costs.

When giving others a voice is the answer

The exception to private equity’s total control is when the private equity sponsor follows a growth equity strategy, which is becoming more common as private equity and venture capital dry powder continues to increase. A proliferation of late-stage start-ups and other large, established private businesses are seeking financing in the form of growth equity to expand further and solidify their market penetration before determining their exit strategies.

Unlike buyout firms, growth equity funds usually will not take on a controlling ownership interest in the private business. Depending on the size of the investment, board seats or board observer positions may be granted to afford the private equity firm significant influence but not complete control. While this gives the sponsor some power to influence decisions, it is typically more of an advisory role.

There is ample evidence that sponsors improve the performance and profitability of private businesses through effective governance, regardless of their level of involvement. The stellar returns that private equity has generated over the past few decades leave a track record of creating and extracting value that speaks for itself.

Article was originally published in  NACD Directorship Magazine  Fall 2022 edition.

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Do Private Equity Fund Managers Opportunistically Smooth Fund Performance?

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• Affiliation: Kenan-Flagler Business School
• Private equity is a substantial and growing component of institutional investors’ portfolios. Investors rely on manager-reported fund performance when making capital allocation decisions, yet reported performance is subject to significant manager discretion. I examine whether private equity fund managers opportunistically smooth fund performance. Using Burgiss’ proprietary private equity dataset, I find that, after controlling for cumulative fund performance, fund managers report smoother fund growth before raising capital for new funds and when fund managers are publicly traded firms. The effect of fundraising on smoothness is greater for less established fund managers and for lower performing funds. The findings support the hypothesis that fund managers opportunistically smooth performance, an inference that is robust to the inclusion of fund and fund manager controls such as age, size and performance. My findings are relevant to fund investors making allocation decisions and regulators as they consider increasing private equity regulation.
• private investments
• institutional investors
• private equity
• earnings management
• https://doi.org/10.17615/m9vg-v598
• Dissertation
• In Copyright - Educational Use Permitted
• Landsman, Wayne
• Bushman, Robert
• Glaeser, Stephen
• Jenkinson, Tim
• Maydew, Edward
• Doctor of Philosophy
• University of North Carolina at Chapel Hill Graduate School

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Private Equity Interviews: The Official Guide

Private equity interviews: the official guide, private equity lbo modeling tests: the interview presentation, how to practice, and how the test is evaluated.

Let’s continue our conversation (from the last post) about the  private equity LBO modeling test . The LBO modeling test is used by many, perhaps most, PE firms both large and small as part of the interview process to test 3 things:

• Finance  knowledge
• Excel  modeling skills
• Executive  presentation / communication  skills

This is a short series that covers the  “who” and “what”  of the LBO modeling test, the specific  components  of the LBO modeling slide presentation, delivering the  oral presentation  to your interview committee,  how to practice  for the LBO modeling test, and how the modeling test is  evaluated  in the context of other recruiting considerations.

This post is about how to deliver the oral presentation of your investment thesis to the interview committee, how to practice for the LBO modeling test, and how the modeling test is evaluated in the context of other recruiting considerations. You can see other posts in this series here:

• Who  gets the private equity LBO modeling test and  what  is it ?
• Key components  of the LBO modeling test presentation

In the last post, I covered the  specific components  of the LBO modeling slide presentation. Next comes the oral presentation to the investment / recruiting committee.

Oral presentation 

When you deliver your oral presentation, your audience might be to just 1 investment professional or it might be all the partners of the firm. Whatever the size of the interview committee, the firm is not concerned with your actual recommendation as it is with your ability to reason and defend your conclusions thoughtfully.

In this regard, your communication skills are extremely important — more so than perfecting your model or understanding technical finance minutiae. You need to be able to state your recommendation clearly and unequivocally , as well as explain your supporting points simply, concisely, and compellingly .

So you should focus relentlessly on your investment recommendation , and only the most important supporting points (while addressing key risk factors). Do not get bogged down in details; do not say to your interviewers “if you look on page 132 of the investment memorandum….” No – you should be able to tick the key points off in your head for the various deal trade-offs without needing to reference anything more than your short slide deck.

To be sure, much of your presentation quality relates to your public speaking skills . Here are some tips that have always served me well.

• Speak twice as slowly as you normally would (this may feel unnatural to you, but it will NOT feel strange to your audience), make sure you pause at natural moments to allow your audience to absorb the points you just made, and make eye contact with your interviewers (if there are multiple audience members, be sure to make eye contact with each person every few seconds to keep them engaged)
• Write memory-jogging bullet points on your slides to remind you what your key points are, but do not write down your presentation verbatim
• Do a practice dry-run no matter what before you present, even if you only have 5 minutes to practice. Five minutes to collect your thoughts and rehearse your key points is infinitely better than inventing your presentation live and on-the-fly.

How to practice 

The LBO modeling test is certainly not for the faint of heart. There are a lot of moving pieces, and a lot of skills tested through the exercise: technical finance and accounting knowledge, Excel modeling skills, consulting-style macro / market analysis skills, slide presentation skills, and oral communication skills. Candidates who do well on the LBO modeling test tend to have practiced beforehand — plain and simple.

You should spend some time doing at least a couple practice iterations of the entire exercise end-to-end — yes, that means reading through an investment memorandum, actually going through the exercise of building a model, creating presentation slides, and then presenting orally (to friends and colleagues if possible, otherwise in front of the mirror).

Try to get a sample investment memorandum (ask a friend in banking if you don’t have direct access to one) and go through the exercise steps detailed above. (Alternatively, you could also just download the 10-K for a public company you don’t know well, and use that as the raw material for your practice test.)

Try to work through the key parts of the LBO model, referencing online resources or asking banking friends for help if you get stuck. See how fast you can get your modeling time down to, and try to systematically decrease the time it takes for you to build a model from scratch.

Do the same exercise with the market / industry analysis portion (which should be easier because little modeling is needed here), as well as rapidly creating your slides, formulating your investment thesis, and collecting your thoughts for your oral presentation.

Then practice delivering your oral presentation to get a feel for the pacing and flow , and where you need to be mindful about how much time you are spending getting through your points, etc.

How the LBO modeling test is evaluated 

The modeling test definitely counts for a lot in the evaluation of your candidacy, but you should always keep in mind that it is not the only thing determining whether you get an offer . PE firms tend to have many interview rounds, and since they are generally quite small and can afford to be selective, personal fit is as important (arguably even more important) than your modeling test performance.

To be sure, everyone needs to clear a certain bar for the modeling test, but between a good “tester” with great personal fit vs. an awesome “tester” with poor personal fit, I can’t tell you if one WILL ultimately get an offer, but I can tell you which one will NOT be getting an offer.

So keep in mind that PE interview prep must be balanced between your facility in going through the rigorous LBO modeling test and your personal fit / story for why you want to work in PE and why this firm feels like the next logical step for your career.

Be sure not to neglect the personal fit portions or nailing down the “why” behind your story. Most candidates have poorly thought-out stories for why they made certain career choices and where their careers are going, because they simply haven’t spent quality time thinking about what they actually want to do with their careers, and instead have been chasing the crowd into investment banking, management consulting, private equity and other jobs simply because those things sound prestigious and cool .

But the last thing PE firms need is yet another candidate trying to get into PE because it sounds prestigious and cool — those candidates tend to flame out once the novelty wears off and there is just hard work and long hours remaining, and they are consequently unlikely to perform well at a PE  firm.

So make sure you get your story down cold , you are personable in your interviews, and you perform reasonably well on your LBO modeling test . With those things in place, you will stand a good chance of getting an elite PE offer no matter how many other candidates you are competing against!

Found this series useful?

Check out our step-by-step  PE modeling training videos  for walk-through tutorials on how to build an LBO model, navigate Excel with ruthless efficiency, and rapidly create an LBO PowerPoint deck to present to your PE interviewers.

Also check out our PDF guide “ How to Nail Your Private Equity Interview (whether you have finance training or not) ” for much more in-depth tips and strategies on how to successfully interview for top private equity jobs!

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Bridging private equity’s value creation gap

For the past 40 years or so, private equity (PE) buyout managers largely invested capital in an environment of declining interest rates and escalating asset prices. During that period, they were able to rely on financial leverage, enhanced tax and debt structures, and increasing valuations on high-quality assets to generate outsize returns for investors and create value.

Times have changed , however. Since 2020, the cost of debt has increased and liquidity in debt markets is harder to access given current interest rates, asset valuations, and typical bank borrowing standards. Fund performance has suffered as a result: PE buyout entry multiples declined from 11.9 to 11.0 times EBITDA through the first nine months of 2023. 1 2024 Global Private Markets Review , McKinsey, March 2024.

Even as debt markets begin to bounce back, a new macroeconomic reality is setting in—one that requires more than just financial acumen to drive returns. Buyout managers now need to focus on operational value creation strategies for revenue growth, as well as margin expansion to offset compression of multiples and to deliver desired returns to investors.

Based on our years of research and experience working with a range of private-capital firms across the globe, we have identified two key principles to maximize operational value creation.

First, buyout managers should invest with operational value creation at the forefront . This means that in addition to strategic diligence, they should conduct operational diligence for new assets. Their focus should be on developing a rigorous, bespoke, and integrated approach to assessing top-line and operational efficiency. During the underwriting process, managers can also identify actions that could expand and improve EBITDA margins and growth rates during the holding period, identify the costs involved in this transformation, and create rough timelines to track the assets’ performance. And if they acquire the asset, the manager should: 1) clearly establish the value creation objectives before deal signing, 2) emphasize operational and top-line improvements after closing, and 3) pursue continual improvements in ways of working with portfolio companies. Meanwhile, for existing assets, the manager should ensure that the level of oversight and monitoring is closely aligned with the health of each asset.

Second, everyone should understand and have a hand in improving operations . Within the PE firm, the operating group and deal teams should work together to enable and hold portfolio companies accountable for the execution of the value creation plan. This begins with an explicit focus on “linking talent to value”—ensuring leaders with the right combination of skills and experience are in place and empowered to deliver the plan, improve internal processes, and build organizational capabilities.

In our experience, getting these two principles right can significantly improve PE fund performance. Our initial analysis of more than 100 PE funds with vintages after 2020 indicates that general partners that focus on creating value through asset operations achieve a higher internal rate of return—up to two to three percentage points higher, on average—compared with peers.

The case for operational efficiency

The ongoing macroeconomic uncertainty has made it difficult for buyout managers to achieve historical levels of returns in the PE buyout industry using old ways of value creation. 2 Overall, roughly two-thirds of the total return for buyout deals that were entered in 2010 or later, and exited 2021 or before, can be attributed to market multiple expansion and leverage. See 2024 Global Private Markets Review .   And it’s not going to get any easier anytime soon, for two reasons.

Higher-for-longer rates will trigger financing issues

The US Federal Reserve projects that the federal funds rate will remain around 4.5 percent through 2024, then potentially drop to about 3.0 percent by the end of 2026. 3 “Summary of economic projections,” Federal Reserve Board, December 13, 2023.   Yet, even if rates decline by 200 basis points over the next two years, they will still be higher than they were over the past four years when PE buyout deals were underwritten.

This could create issues with recapitalization or floating interest rate resets for a portfolio company’s standing debt. Consider that the average borrower takes a leveraged loan at an interest coverage ratio of about three times EBIDTA (or 3x). 4 The interest coverage ratio is an indicator of a borrower’s ability to service debt, or potential default risk.   With rising interest expenses and additional profitability headwinds, these coverage ratios could quickly fall below 2x and get close to or trip covenant triggers around 1x. In 2023, for example, the average leveraged loan in the healthcare and software industries was already at less than a 2x interest coverage ratio. 5 James Gelfer and Stephanie Rader, “What’s the worst that could happen? Default and recovery rates in private credit,” Goldman Sachs, April 20, 2023.   To avoid a covenant breach, or (if needed) increasing recapitalization capital available without equity paydown, managers will need to rely on operational efficiency to increase EBITDA.

Valuations are mismatched

If interest rates remain high, the most recent vintage of PE assets is likely to face valuation mismatches at exit, or extended hold periods until value can be realized. Moreover, valuation of PE assets has remained high relative to their public-market equivalents, partly a result of the natural lag in how these assets are marked to market. As the CEO of Harvard University’s endowment explained in Harvard’s 2023 annual report, it will likely take more time for private valuations to fully reflect market conditions due to the continued slowdown in exits and financing rounds. 6 Message from the CEO of Harvard Management Company, September 2023.

Adapting PE’s value creation approach

Operational efficiency isn’t a new concept in the PE world. We’ve previously written  about the strategic shift among firms, increasingly notable since 2018, moving from the historical “buy smart and hold” approach to one of “acquire, align on strategy, and improve operating performance.”

However, the role of operations in creating more value is no longer just a source of competitive advantage but a competitive necessity for managers. Let’s take a closer look at the two principles that can create operational efficiency.

Invest with operational value creation at the forefront

PE fund managers can improve the profitability and exit valuations of assets by having operations-related conversations up front.

Assessing new assets. Prior to acquiring an asset, PE managers typically conduct financial and strategic diligence to refine their understanding of a given market and the asset’s position in that market. They should also undertake operational diligence—if they are not already doing so—to develop a holistic view of the asset to inform their value creation agenda.

Operational diligence involves the detailed assessment of an asset’s operations, including identification of opportunities to improve margins or accelerate organic growth. A well-executed operational-diligence process can reveal or confirm which types of initiatives could generate top-line and efficiency-driven value, the estimated cash flow improvements these initiatives could generate, the approximate timing of any cash flow improvements, and the potential costs of such initiatives.

The results of an operational-diligence process can be advantageous in other ways, too. Managers can use the findings to create a compelling value creation plan, or a detailed memo summarizing the near-term improvement opportunities available in the current profit-and-loss statement, as well as potential opportunities for expansion into adjacencies or new markets. After this step is done, they should determine, in collaboration with their operating-group colleagues, whether they have the appropriate leaders in place to successfully implement the value creation plan.

These results can also help managers resolve any potential issues up front, prior to deal signing, which in turn could increase the likelihood of receiving investment committee approval for the acquisition. Managers also can share the diligence findings with co-investors and financiers to help boost their confidence in the investment and the associated value creation thesis.

It is crucial that managers have in-depth familiarity with company operations, since operational diligence is not just an analytical-sizing exercise. If they perform operational diligence well, they can ensure that the full value creation strategy and performance improvement opportunities are embedded in the annual operating plan and the longer-term three- to five-year plan of the portfolio company’s management team.

Assessing existing assets. When it comes to existing assets, a fundamental question for PE managers is how to continue to improve performance throughout the deal life cycle. Particularly in the current macroeconomic and geopolitical environment, where uncertainty reigns, managers should focus more—and more often—on directly monitoring assets and intervening when required. They can complement this monitoring with routine touchpoints with the CEO, CFO, and chief transformation officer (CTO) of individual assets to get updates on critical initiatives driving the value creation plan, along with ensuring their operating group has full access to each portfolio company’s financials. Few PE managers currently provide this level of transparency into their assets’ performance.

To effectively monitor existing assets, managers can use key performance indicators (KPIs) directly linked to the fund’s investment thesis. For instance, if the fund’s investment thesis is centered on the availability of inventory, they may rigorously track forecasts of supply and demand and order volumes. This way, they can identify and address issues with inventory early on. Some managers pull information directly from the enterprise resource planning systems in their portfolio companies to get full visibility into operations. Others have set up specific “transformation management offices” to support performance improvements in key assets and improve transparency on key initiatives.

We’ve seen managers adopt various approaches with assets that are on track to meet return hurdles. They have frequent discussions with the portfolio company’s management team, perform quarterly credit checks on key suppliers and customers to ensure stability of their extended operations, and do a detailed review of the portfolio company’s operations and financial performance two to three years into the hold period. Managers can therefore confirm whether the management team is delivering on their value creation plans and also identify any new opportunities associated with the well-performing assets.

If existing assets are underperforming or distressed, managers’ prompt interventions to improve operations in the near term, and improve revenue over the medium term, can determine whether they should continue to own the asset or reduce their equity position through a bankruptcy proceeding. One manager implemented a cash management program to monitor and improve the cash flow for an underperforming retail asset of a portfolio company. The approach helped the portfolio company overcome a peak cash flow crisis period, avoid tripping liquidity covenants in an asset-backed loan, and get the time needed for the asset’s long-term performance to improve.

Reassess internal operations and governance

In addition to operational improvements, managers should also assess their own operations and consider shifting to an operating model that encourages increased engagement between their team and the portfolio companies. They should cultivate a stable of trusted, experienced executives within the operating group. They should empower these executives to be equal collaborators with the deal team in determining the value available in the asset to be underwritten, developing an appropriate value creation strategy, and overseeing performance of the portfolio company’s management.

Shift to a ‘just right’ operating model for operating partners. The operating model through which buyout managers engage with portfolio companies should be “just right”—that is, aligned with the fund’s overall strategy, how the fund is structured, and who sets the strategic vision for each individual portfolio company.

There are two types of engagement operating models—consultative and directive. When choosing an operating model, firms should align their hiring and internal capabilities to support their operating norms, how they add value to their portfolio companies, and the desired relationship with the management team (exhibit).

Take the example of a traditional buyout manager that acquires good companies with good management teams. In such a case, the portfolio company’s management team is likely to already have a strategic vision for the asset. These managers may therefore choose a more consultative engagement approach (for instance, providing advice and support to the portfolio company for any board-related issues or other challenges).

For value- or operations-focused funds, the manager may have higher ownership in the strategic vision for the asset, so their initial goal should be to develop a management team that can deliver on a specific investment thesis. In this case, the support required by the portfolio company could be less specialized (for example, the manager helps in hiring the right talent for key functional areas), and more integrative, to ensure a successful end-to-end transformation for the asset. As such, a more directive or oversight-focused engagement operating model may be preferred.

Successful execution of these engagement models requires the operating group to have the right talent mix and experience levels. If the manager implements a “generalist” coverage model, for example, where the focus is on monitoring and overseeing portfolio companies, the operating group will need people with the ability (and experience) to support the management in end-to-end transformations. However, a different type of skill set is required if the manager chooses a “specialist” coverage model, where the focus is on providing functional guidance and expertise (leaving transformations to the portfolio company’s management teams). Larger and more mature operating groups frequently use a mix of both talent pools.

Empower the operating group. In the past, many buyout managers did not have operating teams, so they relied on the management teams in the portfolio companies to fully identify and implement the value creation plan while running the asset’s day-to-day operations. Over time, many top PE funds began to establish internal operating groups  to provide strategic direction, coaching, and support to their portfolio companies. The operating groups, however, tended to take a back seat to deal teams, largely because legacy mindsets and governance structures placed responsibility for the performance of an asset on the deal team. In our view, while the deal team needs to remain responsible and accountable for the deal, certain tasks can be delegated to the operating group.

Some managers give their operating group members seats on portfolio company boards, hiring authority for key executives, and even decision-making rights on certain value creation strategies within the portfolio. For optimal performance, these operating groups should have leaders with prior C-suite responsibility or commensurate accountability within the PE fund and experience executing cross-functional mandates and company transformations. Certain funds with a core commitment to portfolio value creation include the leader of the operating group on the investment committee. Less-experienced members of the operating group can have consultative arrangements or peer-to-peer relationships with key portfolio company leaders.

Since the main KPIs for operating teams are financial, it is critical that their leaders understand a buyout asset’s business model, financing, and general market dynamics. The operating group should also be involved in the deal during the diligence phase, and participate in the development of the value creation thesis as well as the underwriting process. Upon deal close, the operating team should be as empowered as the deal team to serve as stewards of the asset and resolve issues concerning company operations.

Some funds also are hiring CTOs  for their portfolio companies to steer them through large transformations. Similar to the CTO in any organization , they help the organization align on a common vision, translate strategy into concrete initiatives for better performance, and create a system of continuous improvement and growth for the employees. However, when deployed by the PE fund, the CTO also often serves as a bridge between the PE fund and the portfolio company and can serve as a plug-and-play executive to fill short-term gaps in the portfolio company management team. In many instances, the CTO is given signatory, and occasionally broader, functional responsibilities. In addition, their personal incentives can be aligned with the fund’s desired outcomes. For example, funds may tie an element of the CTO’s overall compensation to EBITDA improvement or the success of the transformation.

Bring best-of-breed capabilities to portfolio companies. Buyout managers can bring a range of compelling capabilities to their portfolio companies, especially to smaller and midmarket companies and their internal operating teams. Our conversations with industry stakeholders revealed that buyout managers’ skills can be particularly useful in the following three areas:

• Procurement. Portfolio companies can draw on a buyout manager’s long-established procurement processes, team, and negotiating support. For instance, managers often have prenegotiated rates with suppliers or group purchasing arrangements that portfolio companies can leverage to minimize their own procurement costs and reduce third-party spending.
• Executive talent. They can also capitalize on the diverse and robust network of top talent that buyout managers have likely cultivated over time, including homegrown leaders and ones found through executive search firms (both within and outside the PE industry).
• Partners. Similarly, they can work with the buyout manager’s roster of external experts, business partners, suppliers, and advisers to find the best solutions to their emerging business challenges (for instance, gaining access to offshore resources during a carve-out transaction).

Ongoing macroeconomic uncertainty is creating unprecedented times in the PE buyout industry. Managers should use this as an opportunity to redouble their efforts on creating operational improvements in their existing portfolio, as well as new assets. It won’t be easy to adapt and evolve value creation processes and practices, but managers that succeed have an opportunity to close the gap between the current state of value creation and historical returns and outperform their peers.

Jose Luis Blanco is a senior partner in McKinsey’s New York office, where Matthew Maloney is a partner; William Bundy is a partner in the Washington, DC, office; and Jason Phillips is a senior partner in the London office.

The authors wish to thank Louis Dufau and Bill Leigh for their contributions to this article.

This article was edited by Arshiya Khullar, an editor in McKinsey’s Gurugram office.

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How private equity operating partner roles are changing

• May 13, 2024

Operating teams and partners are transforming to help meet the demands of today’s market

An emerging position in private equity (PE) firms, the operating partner or operating team is designed to help counsel the portfolio company (portco) through the value creation plan — from pre-diligence through exit — that is integral to the original deal thesis. This role traditionally has helped serve multiple purposes from providing strategic insight and advice, to supporting board initiatives or even being on the board itself and, when necessary, stepping in to help portcos execute the value creation plan.

We are seeing an industry shift that is moving the operating partner role to more prominence by relying on their experience to work closely with portco management. The operating partner role now spans the deal life cycle, from diligence through exit and provides support across the value creation levers — growth, cost, and risk. Since 2010, 47% of value creation has come from operations, up from 18% in the 1980s. Meanwhile, financial engineering’s contribution to value creation has fallen to 25% from 51% in the same period. 1 A few causes for this trend are worth highlighting:

• With valuations maintaining record highs, traditional financial or management team improvements (i.e., company restructuring/reorganizing) are having less impact on the value of the company as changes in how the company operates.
• Many industry leaders in dealmaking know that there may be no winding back of the clock to a time when inflation wasn’t a major factor and interest rates were low. They can adapt to the new macro conditions that favor operations.
• With valuations at current levels, fewer deals are taking place, giving a new focus on more substantial transformation of the portcos currently held by the PE firms.
• With high interest rates here to stay, limited partners (LPs), the parties investing in PE firms, aren’t looking for firms to do deals based around traditional financial engineering. Many LPs have increased demand for sophisticated operating teams and are looking for specific capabilities in operations. LPs are demanding both industry and functional knowledge to support current portfolio and future investment.

It is our opinion that these market realities can cause PE firms to rethink how their teams are structured and the way the firms go about creating value at their portcos.

Some firms have met the challenge posed in the market, but many others continue to struggle to develop the kind of operating teams that can create value for their current investors. Based on our discussions in the PE industry, we have identified a few areas where we have seen firms struggle, and how industry leading firms have met those challenges to help thrive in this environment. The new economics of value creation are forcing firms to rethink their operating team strategy — our belief is that you can’t wait and still get ahead.

What are the execution difficulties operating partners and teams face?

In the past, operating teams based their support on the investment thesis and associated playbooks that they could apply generally to portcos after they are acquired. Sometimes these still work, but many firms are finding that the business transformation required to unlock value needs nuance and a level of domain knowledge that traditional managers typically did not have. As such, firms are looking for operating partners with specialist knowledge, be that sector experience or transformational experience (technology, operations structure, etc). For example, many firms are looking for operating team members who can quickly work with a portco, have the experience and knowledge to understand what the issues are, and are able to help deploy targeted responses to each of those problems. Some firms may only need certain specialists’ part of the time, as opposed to bringing on additional headcount in the operation team, which may be limited by their investment prospectus.

Further, some operating personnel have come up in the environment of the last 10 years, with low interest rates and without significant inflation. A different skillset is needed to find success in the current market. Regardless of the source of the talent gap, finding the personnel who have the right experience (or have done the work) can remain a perennial struggle. Industry leaders who manage to find success despite these issues succeed by tying their operating team capabilities directly to the overall deal themes and required capabilities of their firm.

While this can differ from firm to firm, the deals team at times tends to be one of the leading voices on how a value creation plan needs to be executed, but the operating team may find issues with the company on the ground that may not seem as serious to the deal team, causing conflict. As such, it can happen where deals teams and operating teams may not see eye-to-eye on how appropriately one can realize the PE firm’s investment thesis. These types of issues can come about for a variety of reasons, such as a lack of defined role for each team across the investment cycle, a lack of trust among teams, difficulties in determining how much of the portco change came from the operating team’s involvement, or unclear accountability for a portco not reaching its goals. Whatever the cause of the conflicts, industry leading firms succeed by making their culture an open topic in internal discussions and making the changes needed to thrive.

Market conditions are leading even larger PE firms to acquire middle-market companies that may have less experience and sophistication than the larger targets we have previously seen many firms focus on. This can bring its own set of issues. For example, management at the portco level may be less experienced than needed to both see how the business will need to change in the future and to help scale the business following the value creation plan. They may also be focused on the wrong metrics. With interest rates being at their current height, earnings before interest, taxes, depreciation and amortization (EBITDA) is no longer the only data point that matters, with some firms looking beyond EBITDA to cash flow conversion in this market. These types of issues and slowdowns can force the private equity owner to replace the management team, causing additional delays across for the value creation plan. Industry leaders are assessing how appropriately one can work with management early (sometimes even at diligence) to understand how to make management true partners in value creation.

PE funds often have a ceiling built into the origination agreement that limits the total spend on operating functions and value creation plans. This makes right-sizing the PE operating team much more critical and difficult. Further, a focus of the operating team is not to go outside of the deal plan on what needs to be done to the portfolio company. If the changes needed go outside of the plan, then a cost discussion can occur around both what the firm absorbs versus the portco and what kind of value improvement the portco can expect to see as a result. There is no one-size-fits-all answer to any of these questions, but firms can often get bogged down in cost management and miss the bigger-picture opportunities. Industry leaders have a detailed understanding of the personnel and structure that helps make the most sense for their firm and are developing a network of advisors to help fill any remaining gaps.

How are leading PE firms finding success in improving their operating teams?

Focusing on your niche for growth and enhancing it.

It’s almost impossible to be the best at everything. How you build out your team can be directly connected to how you want to generate value. Do you have a sector specialization focus? What about  digital transformation ?  Sustainability ?  Emerging technology ? Investing in your operating team’s niche and being top class in that field can lead to success.

Managing costs at a granular level

Industry leading firms target their spend to produce the highest value. Operating teams will always have a limit built into the fund origination agreement, so every dollar of spend needs to bring return on investment. A complete assessment at the top of the portco, including understanding management’s capabilities, can help avoid costly pitfalls and find the path forward with only the necessary capital outlay. Also, leaders in this space supplement their in-firm skill set by maintaining a pool of external advisors with a breadth of experience in various sectors and technical capabilities that can help assist in keeping costs down.

Building a culture of trust across the firm and into the portco level

Open communications  and alignment between the deals team and the operating team are essential. Additionally, many firms are enhancing their communications by using industry leading technology to build real-time communication among the deal team, operating team and management. Further, bringing the teams together as one from pre-diligence to pre-exit can help both sides get a more complete picture of the potential of any portfolio company.

Collaborate with portco management on value creation opportunities

Management is an invaluable resource for perspectives on operations and opportunities for improvement. Many industry firms see the operating team role as a counselor, guiding management and  the board of directors  toward the end goal and receiving feedback in the process. A functioning collaboration between the firm and portco is essential to unlocking value.

Highlight your operating team’s strengths in the broader market

Whether it's fundraising with prospective LPs or demonstrating your firm’s strengths to future portcos, leading PE firms include the operating team’s capabilities as part of their marketing materials. Both LPs and portcos are looking to collaborate with firms that can help bring their returns to the next level, and you can use the investments you have made in building a world-class operating team to your advantage.

Build a strategy around combining the latest technologies with a subsector focus

Portcos that have found transformative growth use  a combination of the right technologies for their needs and a focus on subsector strategy  that allows them to quickly find opportunities in the market. Further, they plan out a leverage model to help determine where it makes sense to reach out to third parties for assistance.

Where do operating teams go next?

Ten years ago, a sophisticated operating team with knowledge on how technology can transform a portco’s operations was a niche capability. Now, it is table stakes. LPs are looking for teams that can help transform their underlying portcos for the better. They want the teams to produce the kind of high-value businesses that can generate the returns they come to private equity for in the first place. Firms that have built out the kinds of operating teams that can make these changes are already ahead of the game and will likely have a much easier time fundraising than their competitors.

Beyond fundraising, we are seeing more PE firms create individual deal thesis with a greater focus on operating improvements. Some firms have even included as part of their value creation plan an operations transformation built around a combination of strategy, tech and analytics to create value opportunities that may not have been available previously. This shows that industry leading firms have recognized the realities of this market and are treating their operating teams as a strategic differentiator to help enable the returns that their investors expect. Delaying investments in your operating team can put you behind other firms that can see the signs and move quickly. Now is the time to build the capabilities that will help your firm create value into the future.

1: Ted Bililies, “Private Equity Needs A New Talent Strategy,” Mondaq Business Review, October 26, 2023, accessed via Factiva, January 16, 2024.

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All the Rage in Private Equity: Mortgaging the Fund

A little-known financial tool was the talk of the Milken Institute’s Global Conference.

By Lauren Hirsch ,  Michael J. de la Merced ,  Bernhard Warner and Ephrat Livni

At the Milken Institute’s Global Conference this week, a little-known risky financial tool became the subject of a hot debate among Wall Street titans.

Many private equity firms have quietly begun mortgaging their investment funds, piling leverage upon leverage. In other words, they’re taking out loans against the businesses they’ve already taken out loans to buy.

At a time when dealmakers are desperate to raise new cash after the boom of the pandemic era, this mechanism — known as a net asset value loan — is allowing them to do it overnight.

More P.E. firms are using the tool as they set out to raise their next funds, especially those confronting a hurdle during a slow period for dealmaking: They have yet to return cash to the limited partners they tapped for their last round.

“We’re having unprecedented pressure from our L.P.s to send them cash,” Jonathan Sokoloff, a managing partner at the private equity firm Leonard Green, said onstage at the Milken conference. “We’ll send you cash any way we can.”

A spokeswoman for Leonard Green said the firm has never used any form of N.A.V. loan.

The big debate at Milken was whether private equity firms that are solving this problem with N.A.V.s are risking their future to buy some time with investors.

How N.A.V. loans work. Offered by banks and some smaller private credit-focused lenders, they are backed by the net asset value of select P.E. firms’ investments. They have a higher interest rate than other forms of private equity lending, which appeals to lenders.

There is about $150 billion in N.A.V. facilities on the market today, according to the ratings agency S&P Global. It expects that figure to double in the next two years. Investor liquidity is only one use of the loans, which are often invested back into portfolio companies.

Lenders say they offer the loans cautiously. “When we come and lend to the portfolio, the fund will be in Year 4 or 5,” Pierre-Antoine de Selancy, a co-founder of the private equity financing firm 17Capital, told DealBook. “We have a very good source of information.”

Lenders and advisers who work on N.A.V. loans say they are generally structured to minimize risk, with short durations of two or three years and a low loan-to-value ratio, a measure that compares an asset’s estimated value with the size of the loan. Loans against diversified assets can be safer than ones against an individual company because the risk is spread. That can also mean better loan terms.

But the danger is leveraging an illiquid asset. The private equity business model relies on taking out debt against each of a fund’s businesses. But N.A.V. loans are most often borrowing against a group of businesses. That diversifies the risk, but it could effectively mean using a good business to help prop up a bad one, while also adding increasingly expensive leverage to an already leveraged fund .

“It introduces a greater degree of risk,” Patricia Lynch, who leads the securitization practice at the law firm Ropes & Gray, told DealBook.

The quality of these loans depends in part on a private equity firm’s ability to accurately calculate the value of its businesses (often with the stamp of a third-party appraiser). If the loans sour, it is not fast or easy to sell those assets.

Limited partners have limited recourse. Many of their agreements with private equity firms were written before N.A.V. loans were in vogue, which means these loans may be technically allowed, if not explicitly. But executives at several large pension funds who spoke to DealBook on the condition of anonymity, because they were not authorized to comment on behalf of their firms, said they had told P.E. firms that they had concerns about using N.A.V. loans for distributions. Others, like Neuberger Berman, take a measured approach.

“The general sentiment is: Why are you using them?” Liz Traxler, a managing director at Neuberger Berman, said. “If you have transparency on the usage, and that aligns with the L.P.s, things are probably going to be very positive.”

The worst-case scenario — that P.E. firms default on their N.A.V. loans — may be unlikely, but it is an untested risk that could hurt the very investors whom private equity firms are trying to appease in the first place. As Anne-Marie Fink, the chief investment officer of the State of Wisconsin Investment Board, put it onstage at Milken: “If I get a little bit back now, but you’ve levered the whole fund and I’m cross-collateralized all through a N.A.V. loan, and I eventually lose my money, that’s not a good way for me to get my money back.” — Lauren Hirsch

IN CASE YOU MISSED IT

TikTok sued to block a law that could force its sale. The company argues that the recently passed law — which requires the app to split from ByteDance, its Chinese owner, or face a ban — violates the First Amendment by effectively killing in the United States an app that millions of Americans use to share their views. The heart of the case is lawmakers’ intent to defend the nation from what they and some experts say is a security threat.

FTX said it planned to repay all its customers. It will base their reimbursement on what they were owed as of November 2022 , when the cryptocurrency exchange filed for bankruptcy, plus interest. The customers won’t benefit from the huge jump in crypto prices since then.

More drama unfolded around a Paramount deal. If Sony Pictures Entertainment and Apollo Global Management succeed in the $26 billion acquisition they’ve expressed interest in, they plan to break up the media empire, DealBook’s Lauren Hirsch and The New York Times’s Ben Mullin reported . In other potential breakup news, T-Mobile and Verizon are said to be in talks that would divvy up U.S. Cellular, according to The Wall Street Journal .

U.S. authorities are reportedly examining Tesla’s claims about its Autopilot feature. The inquiry by federal prosecutors centers on whether Elon Musk’s electric carmaker committed securities or wire fraud by suggesting its cars can drive themselves, when its systems require human supervision, according to Reuters. It may again raise the question: Is it fraud, or is it puffery?

‘Fun-flation,’ Taylor’s version

Europe has finally gotten in on Taylor Swift’s record-breaking Eras Tour — and the economic bonanza that seems to come with it.

The billion-dollar tour began in Europe on Thursday in Paris’s 40,000-seat La Défense arena, before moving on to Stockholm, London, Amsterdam and other major cities through August.

Swift’s shows appear to have inspired tourists to hit Europe. Americans who missed out last summer at home are taking advantage of a strong dollar, with tickets costing less on the other side of the Atlantic.

Airbnb rentals are up in the cities hosting concerts. Airbtics, which tracks data on Airbnb rentals, found a sharp uptick in bookings for several European stops on the Eras Tour. In Paris, rental occupancy jumped to nearly 100 percent on Thursday, up from 73 percent a week earlier. Milan, Munich, Vienna and Warsaw saw similar patterns, according to Airbtics. When European tickets went on sale in July, searches for Airbnb rentals in London, Edinburgh, Cardiff and Liverpool during concert dates increased an average 337 percent for show nights, compared with searches for those dates the previous month, according to Airbnb.

Some economists expect the Eras Tour to be the first boost for a busy European summer of events. Holger Schmieding, the Berenberg economist who coined the term “fun-flation” to describe how consumers were splashing out despite high inflation last year, predicts the trend will continue in Europe in 2024. Swift’s tour is one of several big events on the continent, including the UEFA European soccer championship, which starts in Germany next month, and the Summer Olympics, which open in Paris in July.

Households in Europe may have even more spending firepower than last year. Food and fuel inflation is moderating more rapidly than in the United States, and interest rates could start coming down as soon as next month. “This summer, we will in Europe have significant further gains in the purchasing power of consumers,” Schmieding told DealBook.

What the NFT boom (and bust) says about the dark side of the art market

Remember NFTs? Briefly during the pandemic, the nonfungible tokens generated countless headlines and billions in sales. Now, while other crypto assets are soaring, that market is down to mere millions, and former President Donald Trump is using NFTs to raise campaign funds . But the boom illuminated dark corners of the art market and economy, the Times reporter Zachary Small writes in “Token Supremacy: The Art of Finance, the Finance of Art, and the Great Crypto Crash of 2022.” DealBook spoke with Small about the upcoming book.

What did the emergence of NFTs reveal about the art market?

They shed light onto the speculation and laundering that happen in the art market all the time. Sales of NFTs are recorded through the blockchain, so we could see prices in real time as they were changing and deduce what was happening. There was a lot of wash trading, where someone had set up two wallets under different signatures and was trading back and forth to elevate the price of a work until some unsuspecting rube bought into it because they thought it was doing well. Some experts and analysts say that ended up being a significant portion of the market.

So should the art market be regulated more like the stock market?

The art market is often referred to as the largest unregulated market in the world. You have paintings trading for hundreds of millions of dollars. But the Bank Secrecy Act does not apply, so it’s very easy to use shell companies. Buyers don’t know sellers. Oligarchs have been very successful in using art advisers as patsies and in moving money. But federal regulators have a fundamental difficulty with the art market because it doesn’t seem serious. How do you put a price on art, and who cares? It’s a champagne problem for billionaires.

NFTs adopted a very similar approach. It’s a genius approach to create things that look ridiculous so regulators feel they don’t really need to step in. From my reporting, that’s a very deliberate strategy on the part of companies and investors to avoid regulation, and it’s worked.

What does the NFT boom tell us about the future?

What’s most urgent to me is that if you want to know how the 20- and 30-year-olds think about the economy, you need to know what they were doing in the NFT and crypto world. I think this acceptance of volatility and speculation as we’ve all lived through the interest rates changing and inflation and all the other economic red flags, it creates a system where speculation and volatility are more accepted. It makes it harder for regulators to safeguard the system.

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An earlier version of this article misstated Jonathan Sokoloff’s position at the private equity firm Leonard Green. He is a managing partner, not the founder.

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Lauren Hirsch joined The Times from CNBC in 2020, covering deals and the biggest stories on Wall Street. More about Lauren Hirsch

Michael de la Merced joined The Times as a reporter in 2006, covering Wall Street and finance. Among his main coverage areas are mergers and acquisitions, bankruptcies and the private equity industry. More about Michael J. de la Merced

Bernhard Warner is a senior editor for DealBook, a newsletter from The Times, covering business trends, the economy and the markets. More about Bernhard Warner

Ephrat Livni reports from Washington on the intersection of business and policy for DealBook. Previously, she was a senior reporter at Quartz, covering law and politics, and has practiced law in the public and private sectors.   More about Ephrat Livni

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