Part 2: The "Secret Sauce" of Private Equity

Thrive Resources Blog Series: Private Equity is Not a Black Box

We’ve established where the money comes from - the Limited Partners (LPs), but where is it going? And, how is money made on that money by the General Partners (GPs)? There are a number of different strategies firms use - to boil it down, private equity firms buy companies. Most of the time they buy majority control positions in those companies to control the board of directors, although there are also PE firms that will buy into minority positions. Each firm applies their own proprietary “strategy” in deciding which companies to buy, and once acquired, they then execute carefully developed plans for those companies to generate returns on their investment. This is a gross simplification. There is a LOT more to it, but that is the gist in the simplest of terms.  

Secret Sauce

Presumably, the PE GPs are paid the big bucks because they have a specialized differentiated approach to buying, growing and selling companies which ideally should generate strong returns for their LPs. While results can vary, the successful firms are good at this because they have honed their approach well. When I say approach, I’m referring to the combination of their choice of investment strategy (buy out, carve out, buy and build etc), chosen culture, where they fall on the financial versus the operational spectrum, any special skill set or value driver they bring, their methodology for choosing target acquisitions, their particular industry or functional specialization, knowledge of their markets, use of debt, their hold period, and arguably the most important of all, how they identify, hire, develop and retain top talent. The way they integrate and execute on all of this is their “secret sauce”. One top firm we have worked with extensively has a team of operating partners who bring tremendous value to their portfolio companies by working hand in hand with them to execute buy and build strategies in highly niche markets. As a result of their secret sauce, they have discovered a way to make magic. LPs clamor to invest and they have been able to raise fund after fund while also upgrading their investor mix over the years to currently include only exclusively A+ ranked LPs. 

Investment Theses

Once a PE firm has its proprietary strategy defined, it sets out to develop its “investment theses” in each of its industry targeted markets, and most often, in its sub-markets. A larger internal team typically participates in this process, generally led by whichever partner has the industry expertise in that sector. They look at trends, they study science, technology, population growth, trends on every front, they consult with all kinds of experts and advisors and they ultimately take a position on where the future opportunities lie in their targeted sectors. The more specific an investment thesis, in my humble opinion, the better chance they will find matching companies to buy. In my limited experience watching this process unfold over the last 20+ years, it seems that some think that by throwing a wider net, they leave open more opportunity, but in reality, generalist theses can lead to lots of wheel spinning spreading resources too thin across too broad a spectrum. The super focused theses that are well-researched and thought out often lead to faster and more effective execution - and since time is money in private equity, I can’t help but believe this is one of the characteristics that sets apart the great firms from the good. 

As an aside, investment theses in private equity are one of the things I love about my job. They keep it interesting by offering a constant influx of cutting edge, data-based information and providing a front row seat to some of the top thought leaders on coming changes in different industries, geographies and global markets.  As a perennial optimist, I love that they sell you on the hope for the future. If you don’t feel excited after reading one, either they didn’t do a good job pulling it together, or you aren’t as geeky as me!

In Part 3 we'll discuss how private equity firms target their acquisitions.