I am currently reading a book about the legendary private equity firm, KKR, titled The New Financial Capitalists. I highly recommend it for anyone interested in learning about the industry that got so much negative press during the 2012 presidential election. From my perspective one of the really interesting facets of PE is how a firm comes to the conclusion to invest in a specific company. As a history major in college, I’ve always enjoyed detailed research projects and thats what due diligence is to me. The four areas I understand to be important are:
- Market Attractiveness
- Market grown/profitability/size, substitutes, key market trends
- Company Attractiveness
- Relative market share, profitability, strength of key people, cost position
- Competitive Environment
- Market fragmentation, new entrants, barriers to entry, key market trends, threats
- Exit
- Exit barriers, multiples, and presences of strategic and financial buyers
While I expect the general public at large to remain skeptical of the private equity industry I can certainly being to see its positive effects and consequences. There seems to be a general misconception that LBO’s work best when a firm exploits its investments and focuses on short term gains rather than long term value creation, however the reality cannot be further from the truth. In general most of the companies that got into bed with KKR saw increased employment in the long run as well as increased aggregate capital and R&D spending. For the average person like myself they position what a private equity firm does in this way:
They juxtapose an LBO to the typical consumer buying a house in the US. The consumer puts 10%-20% down, paying a premium up front because it's a beautiful house, much like a private equity firm does for an attractive business. This means they are involved in a very levered transaction (like an LBO). To create long term value in their home the consumer makes improvements and upgrades throughout the life of their investment hoping that in doing so they will see a reasonable ROI when they choose to sell their house. That scenario is private equity in a nutshell.