Lessons learned from Private Equity
Private equity firms are filled with some of the smartest minds in the broader business industry. As a part of our daily work with these firms, we have the opportunity to gain insight into their thinking. We hear them talk through their deal sourcing, investment hypotheses, and areas of concern. Over time, we can draw the connections among the successful deals, but more importantly, the process by which successful deals are reached. Each company is unique, but a successful deal process can be repeated across engagements.
With that in mind, I’ve pulled together a few of the lessons I’ve learned from the projects I’ve been involved in and that I believe are most applicable to our personal and professional lives:
- The value of understanding the economic principles of opportunity cost and sunk cost
- An independent perspective mitigates internal confirmation bias
- Dedicate time to what you do best
Opportunity cost and sunk cost: A common fallacy is continuing an action because we’ve done it in the past, despite there potentially being little incremental value relative to the additional effort. We feel committed because we’ve spent too much time, energy, or resources to just walk away, and broadly speaking this is the sunk cost fallacy. It’s the idea that the more you invest in something (emotionally, with your time, money), the harder it is to walk away.
Following that, the opportunity cost represents what we could be doing with that time, money, or resources instead of what is actually being done. Every dollar or hour spent on one project is a dollar or hour not being spent on another.
Private equity firms have a firm grasp on knowing when something is working and when it isn’t during the deal process. They understand that committing additional time and resources to a deal with little potential of closing, just because they’ve already been pursuing it, isn’t always the highest value-add of their time.
From time to time, we’ll be cut off mid-project for this reason specifically. If a new threat comes up in our research, the PE firm is too far off on valuation, or another deal-related roadblock comes up, firms are quick to move on to the next deal. There are too many additional opportunities to spend unnecessary time and effort on a failing deal, no matter if that means walking away from weeks of the team’s effort and money spent over the course of reviewing the deal.
The importance of an independent perspective: It’s too easy to get into an echo chamber when you have your eyes set on the prize – a completed deal. Likewise, we have a natural bias to look for details that validate our point of view while dismissing others that are contradictory, otherwise known as confirmation bias.
Partly in order to offset this tendency, private equity firms contract with external firms for diligence efforts for a better understanding of the market, company financials, legal, and other areas of importance. There’s considerable value in an independent set of eyes assessing the opportunity with no alternative motivations except for getting at the truth of the situation.
Whether a deal closes or not, we get paid. We have no financial incentive for a deal to be reached, beyond it being an attractive opportunity for our client. It’s in our best interest, for the sake of repeatable business, to be right, not to be confirmatory. Bringing in people that can deliver the difficult news, or who can validate an investment hypotheses through their own independent work, can give the added level of confidence needed to walk away from a bad deal or double down on a good one.
Dedicate time to what you do best: There can be a desire to be a master of all and control the full workflow. If you can do something, why pay someone else to do it? Following this line of thinking results in long days, with too much of it being dedicated to low-value work. Just because you can doesn’t mean you should.
In addition to the value of an independent perspective mentioned above, contracting work to external firms – work that PE firms could likely do themselves if they really wanted – allows them to focus their time and efforts in the areas where they bring the most value-add, while having the external firms focus on their highest value-add contributions. While we work on a market diligence, the partners and associates can be working with the management on growth avenues, identifying areas of cost savings post-close, lining up financing, or finding the right valuation that will win the deal while maximizing investor value, among other ventures.
This ties back to the idea of opportunity cost. Three weeks of two internal team members conducting a market diligence is three weeks they could have spent on other parts of the deal, while still arriving at the same conclusions. Running these work streams concurrently in the background also increases the speed with which a decision can be reached, which is crucial in a market that nowadays values fast-moving firms.
Delegating to others with more expertise, while recognizing the areas in which you can provide the highest value-add as an individual or firm, maximizes the value of all involved. Ultimately, working with specialized firms across different parts of a diligence, while dedicating internal time to more macro deal factors, means that each step of the process results in excellence versus simply completion.
Conclusion
There’s much to be learned from surrounding yourself with smarter people, or those that bring a different perspective to a discussion. The most benefit comes from recognizing the best practices from those people, and working to implement them in our own processes or work streams.
The above is just a sampling of what I’ve learned so far from my indirect exposure to the PE industry, and I’ll continue to keep look for other best practices from our clients, my colleagues, and other trusted advisors.