Investor Education

Private Equity (“PE”) firms invest in companies, aiming to generate returns for their investors by proactively making improvements and growing the companies before selling them at a higher value. This article, part of our Private Equity Primer Series, explores the PE investment lifecycle, highlighting the key stages and strategies for successful investments. 
 

 

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1. Forming the fund and fundraising

The initial phase of PE lifecycle involves the formation and fundraising of the fund. During the formation phase, the fund manager develops a strategic investment focus, establishes fund terms and prepares key offering materials like the Private Placement Memorandum (“PPM”) and Limited Partner Agreement (“LPA”). Following the formation, the fund enters the fundraising phase, where the manager approaches potential investors to secure capital commitments. The initial closing marks the start of the fund's investment activities, but fundraising often continues to meet the overall fundraising target. 

 

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2. Identifying Potential Investment Opportunities

To generate returns for investors, fund managers will begin by scouting for investment opportunities that align with their strategy. They utilize a mix of methods including market research, professional networks, investment bankers, and direct outreach to potential targets. Advanced data analytics and AI tools are increasingly used to identify trends and promising sectors. Here are some of the traits that PE firms look for when identifying targets: 

• Historically Profitable with Cash Generation Potential

  Fund managers favour companies with a history of profitability and cash flow generation, even if they're currently underperforming. A strong financial past suggests potential for future success. 

• Low Failure Risk with Strong Asset Base

  Considering the leverage involved in PE deals, fund managers prefer companies with low failure risks and a substantial tangible asset base. These assets act as collateral for loans and ensure steady cash flow for debt repayment.

• Opportunities for Productivity Enhancement

  Fund managers often target companies with room for significant performance enhancements. Fund managers use their resources to drive productivity improvements through various levers such as operational enhancements, technology upgrades, and market expansion.

   

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3. Performing Due Diligence and Acquisition

Once a fund manager identifies a potential target company, a comprehensive due diligence process is undertaken. This multifaceted approach involves examining various aspects of the target company to ensure a well-informed investment decision. Some of the factors considered are:

• Financial Performance, e.g. EBITDA and net profit margins, etc.
• Market Position and Competitive Landscape, e.g. market share, growth potential, etc. 
• Legal Review, e.g. compliance, intellectual property concerns, etc. 
• Operational Assessment, e.g. production efficiency, supply chain, management effectiveness, and cost structures, etc. 
• ESG Evaluation, e.g. carbon footprint, adherence to reporting requirements, etc. 

Based on the due diligence findings, the fund manager moves on to the acquisition process that involves finalising the acquisition structure, negotiating the final terms of the deal, including the purchase price, financing structure, securing necessary financing from banks or other financial institutions, and finally closing the deal. 

 

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4. Adding Value and Managing Portfolio Companies

Post-acquisition, fund managers engage actively in the management of their portfolio companies. They might implement strategic changes, improve operational efficiencies, or streamline management practices. The goal is to increase profitability and growth prospects. Fund managers often leverage their network and expertise to provide strategic guidance, access to new markets, and additional capital for growth initiatives.

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Case Study Snapshot:

One notable example of how a PE firm employ a mix of value creation strategies is the acquisition of a US-based discount retailer, Dollar General, by Kohlberg Kravis Roberts (KKR):

Dollar General Corporation is a discount retailer. The Company offers merchandise, including consumable items, seasonal items, home products and apparel. Its merchandise includes brands from manufacturers, as well as its own private brand selections with prices at discounts to brands¹.

1.    Management Changes: KKR brought in a new CEO, Rick Dreiling², who previously ran drugstore chain Duane Reade Inc. He and his new management team was instrumental in boosting sales and implementing operational improvements. The leadership change ensured effective execution of new strategies.
2.    Operational and Product Optimisation: The new team and KKR streamlined Dollar General’s operations by improving supply chain management and reducing operational costs. Concurrently, they optimised their product mix, focusing on high-margin products like private-label goods, and streamlined their assortment by eliminating lower-performing items³.
3.     Growth and Expansion: Dollar General's market expansion involved the addition of new stores and the remodelling of existing ones⁴, at a time when market conditions were favourable due to falling lease rates.
4.    Debt Restructuring and Cost Management: Despite a substantial debt load, KKR effectively managed Dollar General’s financial leverage, improving its Debt-to-EBITA ratio⁵. Additionally, they significantly reduced shrinkage, which includes losses due to factors like shoplifting and mispricing, thereby saving considerable costs and contributing to the overall financial health of the company.

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