What does PE Firm Looks in a Business
What does a Private Equity Firm sees for Deal to a Great Businesses ?
1. Large and Ideally Growing Target Addressable Markets (TAMs):
Even a great business can be a bad investment if its TAM is rapidly shrinking.
Conversely, a growing TAM allows a great company to grow exponentially, like an electric battery company benefiting from the expanding electric vehicle market.
Investors also assess how well a company can serve this market, considering product distribution abilities and go-to-market strategies.
2. Strong Competitive Moat:
A competitive moat is a non-negotiable feature for PE investments.
It refers to a company's unique advantages, such as brand strength, proprietary technology, or cost efficiency, that protect it from competitors and ensure long-term profitability.
Without a strong moat, a business risks being overtaken, as exemplified by Blackberry's decline despite initial market share, due to its inability to protect itself from iPhone and Android competitors.
3. Strong Financial Profile:
PE firms operate within narrow financial criteria because they use significant leverage (debt) to purchase companies.
They look for three specific financial traits:
Stable Cash Flows: Predictable and consistent cash inflows are essential to ensure the business can reliably cover operating expenses and increased debt obligations post-acquisition.
High Free Cash Flow Conversion: This indicates the efficiency with which a company turns revenue into cash, with higher conversion being preferable.
Low Capital Intensity: A business model that requires minimal investment in capital expenditures to generate revenue, leading to higher profitability and scalability.
4. Strong Unit Economics:
Unit economics refer to the direct revenue and costs associated with a single unit of a product or service.
They help PE investors evaluate a business model's profitability and scalability.
For example, Shopify has excellent unit economics because revenue per merchant can grow through fees and additional services, while adding a new merchant incurs hardly any additional costs, and retention rates are high.
Conversely, WeWork is cited as having terrible unit economics due to fixed, competitive rent prices, high costs for acquiring and renovating buildings, and low customer stickiness.
Investors assess a company's unique value proposition, product stickiness and churn rates, opportunities for upsell, fixed versus variable costs per unit, and how margins evolve with scale.
5. Great Management Team:
A strong management team is crucial, as a weak team can lead to business failure.
PE investors don't just look at credentials; they meet teams in person, interact throughout the diligence process, and constantly evaluate them.
They ask about the business's competitive advantages, opportunities, and threats; the industry's growth potential; the team's strengths and weaknesses; and their vision for operations, growth, and strategy.
The ultimate question is whether the management team is "credible and backable". If not, the entire team, including the CEO, may be replaced after acquisition.
Viable Exit Plans (Bonus Factor):
This is a crucial bonus factor because even a great business yields no returns if it cannot ultimately be sold.
PE firms need to have a clear strategy for exiting their investment, typically through M&A (Mergers and Acquisitions) or an IPO (Initial Public Offering). Without a viable exit, all the hard work may not result in financial gains
