Once PE firms have raised money, they are often under considerable pressure to invest that money within a reasonable period of time. Otherwise, their investors will be frustrated that their capital is tied up (they can’t use it for other purposes, having legally committed to provide it when requested) yet not being deployed in pursuit of returns. With this in mind, we’ll now look at how PE firms make investment decisions.
PE firms follow a set of thorough processes when trying to identify suitable investment opportunities. This involves extensive due diligence and the evaluation of a broad variety of factors to assess the potential risks and returns for prospective investments. The steps set out below aren’t necessarily carried out in this precise order; the process can be very fluid, with steps being taken simultaneously at times. We just wanted to give a flavour of what the investment process can involve.
1. Sourcing opportunities
PE firms utilise multiple channels to help identify potential investment opportunities. This can include reaching out to investment banks, business brokers and M&A advisors for tips, as well as networking across relevant industries. PE firms also often leverage their relationships with management teams, industry experts, and other stakeholders to help source promising targets.
2. Screening and initial evaluation
Once potential opportunities are identified, a PE firm will conduct an initial review of each prospective target to check that the investment would align with its investment criteria. This may involve analysing financial metrics, market and industry dynamics, growth prospects, competitive positioning, and the potential for operational and/or financial improvement. Targets that meet the initial screening criteria then reach the more detailed due diligence stage. Often only a small percentage (perhaps 10%) of the targets initially assessed will proceed to detailed due diligence, and the PE firm might ultimately only invest in a handful (either because due diligence reveals potential issues, it can’t agree the valuation or terms, or another PE firm is chosen as the preferred bidder).
3. Portfolio fit and strategic alignment
The PE firm will also assess how the target company fits within its existing portfolio and aligns with its broader investment strategy and objectives. As part of this, it will evaluate potential synergies that could arise as a result of diversifying its portfolio, plus any strategic alignment with its sector focus.
4. Due diligence
In short, due diligence is an in-depth investigation carried out to help a party (in this case, the PE firm) gain a deeper understanding of another company's (i.e. a target investee company’s) operations, market positioning, competitive landscape, regulatory environment, and growth opportunities.
Given the large investments made by PE firms, and therefore the level of risk involved, the PE firm and its advisors will conduct comprehensive due diligence into prospective targets to validate assumptions, assess risks, and uncover potential issues that could impact the viability or price of the proposed investment. This includes financial, legal, operational, and commercial due diligence, often involving specialised teams and external advisors.
This can include tax specialists, accountants (to review the target’s financial information and assist with valuing the target), lawyers (to review contracts and other legal documents), management consultants, and - depending on the nature of the target company’s assets and industry - other specialist consultants (e.g. real estate advisors if the target company operates in the real estate industry). Each advisor/consultant will prepare its own due diligence report which will be provided to the PE firm.
For a deeper insight into the due diligence process, check out our due diligence-focused case study and our overview of what due diligence involves and key issues to look out for.
5. Investment thesis development
Based on the due diligence findings, PE firms develop an “investment thesis”, which documents the rationale for the investment, including potential value creation strategies, and projections of expected returns. The investment thesis then serves as a guiding framework for decision-making throughout the investment lifecycle.
6. Negotiation and deal structuring
Next, a PE firm will then negotiate high level deal terms with the seller (i.e. the owner of a target company’s shares). This may involve agreeing the valuation, capital structure, governance arrangements, and exit options, as well as other contractual rights, obligations and protections.
The deal will often be structured in a way that aligns the interests of the management team and other stakeholders with those of the PE firm, for example by allocating shares to key managers (and potentially require them to invest their own capital so that they have “skin in the game”). Check out this lesson for more information on management incentive structures.
7. Investment committee approval
Ultimately, investment decisions must be signed off by the firm's investment committee (or “IC”), which is typically comprised of the firm’s senior employees. The IC will review the due diligence report, the investment thesis, and the preliminary deal terms before deciding whether to grant approval to proceed with the investment.
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