Key Factors that influence investments


Private Equity professionals are often asked what makes or breaks an investment decision. In other words, when evaluating prospective portfolio companies, what are they looking for which will convince them to either invest in the company or walk away?

A guiding principle for many investors is Warren Buffett’s 20-slot rule. When evaluating prospective investments, Buffett recommends asking the question,”If I had a punch card with only 20 slots for my entire career, and every investment represented one slot, would I punch my card on this investment?”

The 20-slot rule forces investors to think carefully, and make a very conscious and deliberate choice. If you’re punching your card on this deal, you have one less slot for the future. Each punch counts.

In order to make a decision on whether or not to punch the card, a PE firm needs to be convinced on the merits of the deal and to complete a thorough due diligence process.

The purpose of due diligence

Due diligence requires considerable time and effort on the part of both the company and the PE firm and hence entering this stage is not taken lightly by anyone. Entering due diligence signals that the PE firm has a high level of interest. The company is in an industry sector which is appealing and shows growth potential, the product(s) or service(s) address a market need and are sufficiently differentiated, the management team seems capable, and the business model is attractive enough to warrant a deeper dive.

Prior to due diligence, the PE firm will have constructed an investment thesis on how a proposed transaction will make financial sense. During diligence, the PE firm is looking for evidence to either prove or disprove its hypothesis by focusing on issues that will determine the ultimate success of the investment.

Simply put, the PE firm is looking for reasons to either punch the card with full conviction or else to put it away for another time.

What causes the card to be punched?

While each company and situation is unique, there are a few factors that have been common behind virtually every successful investment in our track record.

Strong free cash flow generation characteristics

We’ve heard Adi Godrej, Chairman of the Godrej Group say, “Sales is vanity, profit is sanity and cash is reality.” We wholeheartedly agree with his assessment.

Sales can be bought, profit can be managed, but it’s very hard to hide behind a free cash flow statement. To know how strong and viable the underlying economics of the business are, it is important to focus on the free cash flow generation of the business – how much capital expenditure is going to be required to sustain growth, what is the working capital requirement, how dependent is the business on future financing, how much cash will the business generate to re-invest and support its growth? These are all critical questions, which will play a large role in the ultimate success of the investment.

Fragmented market in a growing industry

The underlying attractiveness of the industry segment and the fundamental factors that influence growth within it are key areas that investors will probe during due diligence. Diligence work will focus on ascertaining whether the industry segment has the right structures for sustained and profitable growth.

Fragmented markets in growth industries are particularly attractive, because there is usually room for well-managed players to establish themselves and with the help of a strong strategic and operational approach, create a sustainable competitive advantage and capture a larger share of the growing market. One caveat however, is the presence of large, well-funded competitors who may have the pockets to engage in price wars and quickly turn it into a race towards the bottom.

Management’s ability to execute

When a PE firm is investing in a company, it is also making an inherent bet on management’s ability to execute. The best-laid strategic plans can be just plans, if not executed well. Due diligence will include many interactions with the management team of the organization in order to establish confidence in their ability and track record to execute on the strategy and to lead the business.

Are they a team that is action oriented? Are they a team that can deal with uncertainty and course correction? Do they have a finger on the pulse of the ongoing market dynamics? Can they inspire their teams to deliver on the goals? These will be questions that most PE firms will ask as part of their due diligence and a “No” to any one of them will be cause for concern.

Openness to a Partnership based approach

Despite the popular myth, a private equity investment in a company is not a zero-sum game. One side does not have to lose something for the other to gain. Rather, it should be seen as a collaborative and mutually beneficial partnership wherein besides providing the financial capital, the investor works closely with the business to accelerate its growth and create long -term value by leveraging global best practices.

Reputation and Transparency of Promoter and Management team

The importance of transparency and integrity of the promoter and the management team cannot be overstated. In order for the investment to be successful, there has to be mutual transparency, honesty, professionalism and integrity in the partnership.

It is important to note here that these attributes are important for both sides of the partnership – the company as well as the PE investor. In an environment where strong, well-managed companies can often have a choice of PE firms to partner with, they should also be evaluating the openness, candor, reputation and professionalism of the investment firm.

What causes the card to not be punched?

In addition to the absence of any of the key factors required for investment as mentioned above, there are other scenarios that could cause a deal to fall through. These include:

Valuation gap

A gap in valuation expectations between the promoter and the PE investor is a common reason for deal failures. While structuring of investments can sometimes help bridge the gap, there are occasions when the two sides are so far off, that the possibility of reaching an agreement is extremely low.

In most instances,a range of valuation expectations is communicated in advance of due diligence in order to avoid spending an inordinate amount of time when finding common ground is unrealistic. Sometimes though, valuation expectations from the investor are reduced based on findings during the due diligence process leading to a gap between the parties.

Misalignment of incentives

For a successful investment, it is imperative that the incentives of the promoter, key management and investor are aligned. For instance, private equity firms are going to be focused on a plan for exit from day one. It is important that there are discussions andclear alignmenton the investor’s exit strategy with the promoter to avoid difficult situations later.

Misalignment of incentives can also happen if the promoter and key management personnel don’t continue to have enough “skin in the game”, in the form of their ownership or future value creation opportunity.

Lack of Open Communication

Surprises are almost never a good thing in due diligence. Discovering something of critical, material business nature during diligence implies that it was either deliberately withheld or overlooked. Neither is a favorable implication and both place a good deal of doubt in the minds of the investor.

Punching the card also represents a commitment from the investor

Punching the card is an important step of the investment process, but only the beginning. The responsibility for a successful partnership rests with both parties – the company as well as the investor and the ultimate success will depend largely on how both continue to work together in an open, fair, transparent and mutually beneficial manner.

We have had the privilege of working with high quality entrepreneurs and management teams across industries in India. Based on learnings from those experiences, we are firm believers of making each punch count through a strong partnership-based investment approach.