What do you do if you need to apply problem-solving skills to reduce risks in Private Equity transactions?

Considering certain unique features, a risk management framework for private equity fund investments has to capture three primary sources of risk. (i) Market risk: the risk of losses in the market prices of the portfolio. (ii) Liquidity risk: the illiquidity of private equity partnership interests exposes investors to asset liquidity risk associated with selling positions in the secondary markets. (iii) Funding (or cashflow) risk: the unpredictable timing and magnitude of fund cashflows pose funding and cashflow risks to investors.

Begin by conducting a thorough risk assessment to identify potential risks associated with the transaction. This could include financial risks, such as market volatility or liquidity concerns, as well as operational risks, such as management turnover or regulatory compliance issues. Collaborate with the investment team, legal advisors, and other relevant stakeholders to ensure a comprehensive understanding of potential risks.

Once risks are identified, analyze the root causes behind each risk to gain insights into the underlying factors contributing to their occurrence. Understanding the root causes will enable you to develop targeted strategies to mitigate or eliminate these risks effectively.

Although common themes run through all due diligence processes, private equity due diligence processes tend to bring specific challenges: Industry due diligence Quality of Earnings (“Q of E”) assessment Legal due diligence Operational due diligence Developing an exit strategy The principles of due diligence for private equity are the same as those for any other company: Undertaking an extensive analysis of the target company and its environment to reduce risks for the buyer.

I have used all three (DCF, CCA and PTA) to triangulate a view. My advice is to then work scenarios; look at key market forces and points of frailty in that industry eg: supply chain, value chain (raw materials/sourcing, logistics). In addition, if your prospect has a large reliance on government contracts, seasonal trends or runs on tight margins; changes in geopolitics, domestic affairs and interest rates could introduce wide variability into your 3 primary valuation models. Lastly, consider the qualitatives such as competitive landscape, digital upgrades, disruptor potential and internal expertise (2 layers below management if you have visibility, LinkedIN is good for that!). A multi-faceted approach is always my go-to.

The ultimate aim of any private equity transaction is an attractive exit multiple. Undertaking the aforementioned steps is a step in the right direction to achieving this. Still, even a company that has streamlined its operations and improved its sales significantly is only as valuable as the available buyers' market. For this reason, the final step of private equity due diligence is establishing the universe of potential buyers for the target company. These buyers usually involve a combination of strategic buyers (e.g., other companies in the target company’s industry or parallel industries) or financial buyers (e.g., another private equity firm or similar type of fund). A final option—although usually far less common—is an IPO.

If you have done this enough, you will have in mind accurate scaling cost estimates which can reduce risk significantly. Working those into your deal structure, with earn-outs, your acquisition cost should come down. For young PE firms holding zero to two portfolio companies, synergies are a moot point. In that case, look to fundraise LPs with a suite of 3-5 targets in mind that demonstrate your fund's vision, network and strategy. An "n of 1" is less attractive to LPs no matter what the GPs lay down.