• Intapp DealCloud

How to create a clear private equity investment thesis

For every dozen private equity deals, only one or two generate significant returns to their investors, according to Investopedia. The biggest reason why deals either fail to deliver or fall through altogether: Firms often neglect to deal with red flags early on in an agreement. To help determine whether a deal will be profitable, private equity firms must first establish a clear, concise investment thesis.

A private equity investment thesis is an evidence-based case built in favor of a particular investment opportunity. It opens with a two- to three-sentence argument showing how the potential deal supports a general partner’s fund investment strategy, then provides details that support that conclusion.

An investment thesis is required for all buy-side dealmakers. Beyond fulfilling a requirement, the detailed proposition serves to:

  • Crystallize the group’s tactical plan, putting strategy into action
  • Inform intermediaries, investors, and fellow partners what’s at stake if the firm does — or doesn’t — invest
  • Answer the variety of questions that arise throughout a typical transaction

Follow these next steps to create a winning private capital markets investment thesis and identify the best opportunities for your firm.

Detail macroeconomic factors

To create a successful investment thesis, firms must first answer global and niche-agnostic economic questions. This will help set the stage for the acquisition target to shine against a macro backdrop.

Start by listing any relevant current headlines, political and social developments, and even consumer trends that are affecting investments across the board. These news stories will remind investors what they and your potential portfolio companies (portcos) are facing today.

For example, you might list the U.S. Securities and Exchange Commission’s most recent proposals, e-commerce adoption, or European political volatility as factors that are affecting investments. Detail the way these factors are helping or hindering the private capital markets in general.

You should also list headlines that affect the acquisition target’s industry, sector, and subsector, and explain whether these developments favor growth for your private company. For example, if a general partner’s acquisition target was in the durable goods manufacturing space, the principal would include the U.S. freight transportation services index (TSI) as a macroeconomic factor in his investment thesis, and would describe how its recovery predicts smoother supply chains to ease investor worries. Similarly, you can explain in your investment thesis how your portco will be positioned competitively among its sector rivals.

Risks aren’t traditionally included in investment theses, but you can include them if they strengthen your macroeconomic analysis. You may want to include factors such as whether global or national conditions oppose the potential portco’s growth or the investment’s performance. You can also describe how your acquisition target would sidestep or weather those pitfalls.

Bain & Co. experts recently declared that macroeconomic instability is dealmaking’s number-one enemy. Position your investment thesis to shine by having a good handle on macroeconomic factors.

Detail microeconomic factors

The macroeconomic information you gather can help you drill down into more granular information about an investment opportunity. Narrow your proposed direction by including microeconomic details about company-level questions to your investment thesis. Try to answer questions such as:

  • Why do you believe the target’s founder or owner will lead the company to growth? Describe ways the current CEO demonstrates innovative, creative problem-solving and strong leadership.
  • What do the company’s financial statements reveal about the business’s record-keeping? Are the reports straightforward and easy to read? Before due diligence, investigate the business’s financials to uncover thesis-supporting insights.
  • What do the company’s financial statements reveal about the viability of the business? Are there clues as to how leadership has handled finances at key inflection points? How much variance does each metric — such as return on equity, profit, return on assets, and earnings per share — exhibit?
  • How has the company navigated cash flow surprises in the past? Surprises can include headwinds and windfalls, and an event like a spike in the company’s quick ratio must be handled with as much finesse as a cash shortage. What proof is there that the business keeps growing sustainably amid short-term volatility?
  • How has the company used seed money? James W. Frick, former Vice President of Public Relations at the University of Notre Dame, famously said, “Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are.” When you look at previous injections, don’t just analyze the company’s capital efficiency. Draw conclusions about what the team prioritizes, such as growth over client retention.
  • What opportunities are there for better cost management? Are there areas where the business is spinning its wheels and expending resources without gaining effective traction? Could certain actions — such as managing talent differently, renegotiating vendor agreement terms, or terminating a failed market expansion — efficiently address these areas?
  • What’s the company’s reputation like? Consider hiring a market research firm to perform an exploratory branding assessment. Take it to the next level by gathering observations from clients, employees, and vendors. If any quotes prove highly relevant, include them in your investment thesis.
  • In what ways are competitors excelling or lagging? The ideal investment is in a market where rivals are failing to innovate. Does your target acquisition have what it takes to exploit market conditions faster and better than competitors?
  • What could go wrong? The best investment theses don’t deny risks but instead address them at an early stage. As you list potential pitfalls, identify ways the private equity firm’s management team can dodge or defuse these hazards.

Consider the professionals at Morgan Stanley, who use three questions to formulate the microeconomic portions of their investment theses.

  • Agility and defensibility — Is the company a disruptor or is it insulated from disruptive change?
  • Financial viability of the business — Does the company demonstrate financial strength with high returns on invested capital, high margins, strong cash conversion, low capital intensity, and low leverage?
  • ESG (environmental, social, and governmental) and the responsibility to do no harm — Are there environmental or social externalities not borne by the company, or are there governance and accounting risks that may alter the investment thesis?

Once you’ve compiled a substantial body of information to use in your investment thesis, sort the details by order of importance. Each deal’s details should be arranged differently since each investment is unique.

Establish and describe the trade setup

The final component of a good investment thesis answers the question, “So what?” It offers bold implications of the micro- and macroanalysis you just performed, and reveals what your next steps should be.

To describe the proposed trade, explain how the micro and macro factors will work together to increase carry for partners and returns for limited partners. Propound an entry point or “setup price,” and describe how you arrived at your proposed acquisition’s target price. Industries — and different private equity firms within those spaces — vary in how they calculate reasonable prices.

Keep in mind that the industry standard expects your firm to find the product of estimated earnings and your expected multiple. For example:

  • Estimated earnings × EV/EBITDA = target price
  • Estimated earnings × FCF/market capital = target price
  • Estimated earnings × Price-to-earnings (P/E) ratio = target price

In your investment thesis, explain why your firm uses a particular multiple and how it came to estimate future earnings. Be sure to include these details as a footnote or sidenote for more curious readers.

Once you’ve proposed a purchase price, describe why the buy side should value the business at that entry point. You may need to briefly repeat what you’ve stated in your micro- and macroeconomic research findings, but within the context of your financial investment.

You should also outline what will happen if you choose not to invest in a particular business. Will the current owners keep their stake, or will a rival scoop them up? Will a competitor fumble the operational improvements or liquidate too early or late? Or will the competitor execute brilliantly, generate alpha, and solidify or even expand its limited partner pool?

Finally, you must weave in a capital plan to detail how your investors’ committed capital will improve company profits for either returns or reinvestments. The capital plan outlines some of the strategic moves and operational improvements you believe will generate short-term wins and future sustainable growth. It should include no more than three or four actions; for example, you could include initiatives like increasing dividends or paying down debt to put free cash flow to work.

To wrap up the investment thesis, discuss how the deal would work into and support the fund’s overall investment strategy. Detail ways your firm brings a competitive advantage to the deal. Have your partners demonstrated acumen with similar deals? List the reasons why you’re the company’s best bet for making above-market returns.

Summarize your investment thesis

Now that you’ve built a complete — but also quite complex — investment thesis, it’s time to develop a clear, effective presentation. General partners distill their investment theses into bite-size, portable overviews that are more memorable and digestible for their audiences. Concisely summarizing your thesis will:

  • Help busy readers better understand your thesis. For skimmers and scanners who want to skip around your thesis, a synopsis gives them a starting and ending point.
  • Steer future investments, further defining your role in your niche. If, for example, a particular investment thesis persuades limited partners and intermediaries to commit to an event-based investment, you may become a firm known for that type of strategy.
  • Provide you with a successful deal that you can use as an example during events like employee training, marketing, and roadshows. Imagine one of your vice presidents attends a trade event and meets an esteemed limited partner who expresses interest in your firm’s most recent deal. A quick investment thesis summary is the perfect way to explain the deal and further the partner’s interest.
  • Set up a memorial to look back on. As the investment’s time horizon approaches, your team should reflect on how the deal began and what twists and turns you and your portco navigated along the way. This exercise will help prepare your team for future scenarios and investment opportunities.

Examples of investment thesis summaries

Authors David Harding and Sam Rovit highlighted a summary of Clear Channel’s merger-specific investment thesis. The media company had decided to expand into outdoor advertising sales and needed to build its case and present it to stakeholders. Note the three concrete benefits the company describes in detail:

Clear Channel’s expansion into outdoor advertising leverages the company’s core competencies in two ways: First, the local market sales force that is already in place to sell radio ads can now sell outdoor ads to many of the same buyers, and Clear Channel is uniquely positioned to sell both local and national advertisements. Second, much like the radio industry 20 years ago, the outdoor advertising industry is fragmented and undercapitalized. Clear Channel has the capital needed to ‘roll up’ a significant fraction of this industry, as well as the cash flow and management systems needed to reduce operating expenses across a consolidated business.

This summary explains that the acquiring executives planned to generate returns by:

  • Using existing talent and preventing costs usually associated with successful deals
  • Applying skills and processes from one sector to improve the newly added operation
  • Combining assets or “rolling up” to share costs and benefits through a newly formed industry rather than fragmented sectors

Best of all, the summary uses a single paragraph to get the job done.

Here are a few examples from dealmakers in other private capital markets:

  • Private equity — Read the overviews of investment theses from Arcspring, Sun Capital Partners, WestView Capital Partners, and Safanad, a team that clearly communicates its commitment to private equity with real estate incorporated.
  • Real estate private equity (REPE) CrowdStreet articulately summarizes how and why the firm invests, and it states its intentions by asset class and sector. The synopsis covers hospitality, industrials, health care, multifamily, office space, retail, self-storage, senior care, student housing, and life sciences.
  • Impact investing — The FSIG and Creatella investment thesis summaries are clear and give a high-level flyover of the model deal’s macro- and microeconomics.
  • Venture capital Wavemaker Partners, Chloe Capital, and La Poste Ventures substitute corporate language with simpler and more digestible terms.

What to do with your new investment thesis

An investment thesis is more than a report: It’s the developing narrative of a successful deal. You’ll likely need to update your thesis and presentation more than once, and in a variety of ways, throughout the lifecycle of the investment.

Publish the investment thesis in your team’s internal deal management system, and assign permissions to those who refer to the plan often. Set up notifications so that you receive alerts whenever someone comments or edits the investment thesis. If your current deal management system doesn’t support this level of effective collaboration, contact DealCloud to request a demo today.

Remember: Successful deals start with successful investment theses. Don’t let investors wade into a transaction before taking the steps above to identify red flags and create an evidence-based plan that everyone can buy into.