Private equity may seem easy to some observers. Buy a company, perhaps insert some debt, provide a bit of operational advice and execute a killer exit. Those of us who manage private equity investments for a living know there is a lot more to it than that. Along with the expertise and hard work that is required, we are faced with many tough decisions on the road to that successful — or not so successful — exit.
As I reflect on the investments I have made over 25 plus years, I have distilled the toughest of these decisions down to four: initial investment, management change, the “good money after bad” assessment and when is the right time to sell.
1) Initial investment: What to buy and at what price?
I believe the initial investment decision determines about two-thirds of the deal’s outcome. Why? If you’ve picked a tough industry, a weak company, designed an inappropriate capital structure and/or overpaid, it will be very difficult to recover from that initial decision. It is possible to improve upon a poor investment by making strategic acquisitions, pivoting the business plan or changing out management (see below), but all of these course-corrections will likely improve upon a mediocre outcome, not provide a great return.
2) Assessing management performance: Should they stay or should they go?
Management also has a huge effect on the result. Consider the portfolio company where the management is clearly faltering. I, their private equity backer, find it difficult to make a change. My reasoning? These are the people I initially funded. I have successfully worked with them before and I have supported the team through the objections and concerns of my partners. It would be sensible to give them another couple of quarters to get back on plan. After all, they did have some very good reasons for their lack of performance.
Sometimes it is acceptable to give management more time to figure things out. However, I have found, more often than not, more time actually hurts. It also seems incredibly difficult to imagine inserting a new person or team into what is probably a difficult situation. Yet, after making the change – assuming I find the right person – things usually get better.
3) The “Good Money After Bad” conundrum: Should I continue to fund?
Consider, once again, the portfolio company where things are not going well. Yet I, their private equity backer, am spending an inordinate amount of time on this investment. I have a plan but it is going to take just a little more capital and a little more time… or so I think. Circumstances have changed from when I made the initial decision to invest.
The correct (but tough) decision may be to not fund further and take my lumps now. It is easy for me to fall blind to this realization because I have been so close to the investment for so long (and likely the initiator of the investment). My judgment may be clouded by my inordinately rosy/optimistic focus on the original outcome I envisioned. [Note: There is a reason why banks have dedicated workout departments. It is a way for a fresh and unvarnished set of eyes to look at the situation.] The easier, but often wrong, decision is to continue to fund because it puts off the inevitable. The tougher call is to just let it go.
4) Timing the exit: When is the best time to sell?
Unlike my previous two decisions, the decision to sell is not just about getting out of a bad or difficult situation. I have seen too many great investments become poor ones by hanging on too long. Here again I can become complacent and try to expand on a modest gain even though the circumstances may have changed (or are at risk of changing). Sometimes the incentives for both private equity investors and management encourage holding on too long. I must remember that I need to examine our exit plan and timing frequently, maybe as often as on a quarterly basis.
None of these are easy decisions to make, particularly in the moment of a live deal. We at Catalyst think of private equity investing as an apprenticeship business. One thing is for sure – we are all going to make mistakes. We must make sure we share those experiences with each other to try to prevent or minimize similar mistakes in the future. Being rigorous around these four decisions helps maximize the value and risk-reward of the portfolio as a whole, which in the end is what matters.
Brian Rich is managing partner and a co-founder of Catalyst Investors, a growth equity firm. He started his career as an industrial engineer at Intel before attending Columbia Business School. Rich also founded and managed TD Capital (USA).
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