Written by Kenneth Fick

In my previous article Private Equity Finance Reporting (Actual, Proforma and Adjusted), I touched on the topics of

• investment thesis

• the investment mindset

• the operating model.

In this piece, I will be focusing on

• the investment thesis

• what is the investment thesis

• why it is important if you work in Finance at a Private Equity (“PE”) owned company.

An investment thesis can be used for all investment(s) including public equity, debt, private equity, currency, real estate and anything else in which one entity (or person) invests money in another entity or vehicle.

There are typically at least two filtering layers that a Private Equity (“PE”) PE Fund applies to each investment. To understand the investment thesis, you need to understand the PE Fund’s investment strategy. The PE Fund’s investment strategy acts as an initial filmust is used to pitch investors and other external parties and defines how the PE Fund intends to generate returns. An investment thesis considers the PE Fund’s investment strategy and layers in investment specific characteristics, potential actions, and the reason why it believes that this specific investment will provide an attractive return within its broader investment strategy.

PE Fund Investment Strategy

It can be argued that great investing starts with great filtering. The world is filled with investment opportunities and they continue to multiply every day, so which ones may be best for you, your client or the company you work for? That is where the investment strategy comes in. A PE Fund’s investment strategy is typically a written document that details the opportunities that an investor is choosing to invest in, why they are choosing to invest in them and the risk and reward profile of doing so. Investors typically take a great deal of time, research, and effort in creating their investment strategy as it is the lens by which they will be viewing potential investment opportunities.. 

The investment strategy also sets forth certain criteria that investors apply to potential investments to determine if a particular investment is right for them. For example, when PE firms are starting out or launching a new fund, they will solicit Limited Partners (“LP”s) who are qualified investors looking to deploy large amounts of capital. To convince the LPs to invest in their PE Fund, they will pitch them using their investment strategy as the basis. Investment strategies come in all shapes and sizes, but generally include the following components:

• An observation of macroeconomic trends, industry, specific markets, or whatever impetus that will be driving investment decisions. 

• What particular trait(s) an investment(s) will have by which they believe there is attractive upside potential. 

• The expected return from the investment(s), the level of conviction that they have in being able to achieve it and why. 

An investment strategy is typically held steady for the life of the fund, but that does not mean that can’t change. When the world changes, the investment strategy may no longer make sense and should be revisited. Examples of times when reevaluation of the investment strategy may be required include:

• South American Sovereign Debt Crisis in the early 1980s

• 2007-2008 global financial crisis

• Brexit in the UK/Europe

• COVID and its affects

• The war in Ukraine

• High inflation rates

When any highly unexpected event occurs that may have a significant impact on an investment strategy a review to make sure the underlying assumptions previously identified still hold or if a pivot to a new strategy is warranted. A strong investment strategy is the first layer of filtering. For example, a PE Fund whose investment strategy is to invest in middle-market companies primarily in the services industry with TTM EBITDAs of $2MM - $5MM, can quickly filter out all opportunities related to real estate, manufacturing, distressed or private investments in public equity (also called PIPEs). That still leaves a lot of deals to look at, where its analysis and deeper knowledge base can add value. 

Investment Thesis

PE Funds get pitched many different types of investment ideas all the time. If an investment meets the PE Fund’s investment strategy and it decides to move forward, then more in-depth analysis is performed and a bespoke investment thesis is created for that particular investment. For example, a PE Fund may have an investment strategy which states it believes attractive returns can be garnered through the investment in rental properties in college towns. When presented a proposal to invest in the development of a college student apartment complex near a major university, they know it would fit within their investment strategy and may decide to evaluate for potential investment. At that point additional research and analysis is done to ascertain why this specific investment will have the return required at the acceptable risk level to make it worth investing the PE Fund’s capital.

An investment thesis contains the same three components as the PE Fund’s investment strategy but at the next level of granularity. For example, using the same example above of an apartment complex targeting college students located in a college town, the following may be considered:

• Macro/local/regional market trends. Is the college(s) growing enrollment? Is the town growing in population? What is the demographic profile of the students enrolled and the town itself? What are crime statistics for the area? What type of competition is there currently in the market? Are rents going up or down or staying the same?

• Investment specific traits. How much will the apartment complex cost to develop? How far away from campus will the apartment complex be located? Is it within walking distance of the campus? Will parking need to be taken into consideration? What types of amenities will the apartment complex need to woo tenants? How will the semester cadence effect occupancy? What marketing will be needed to bring in new tenants? What level of security will the facility need to be safe?

• Investment conviction. Given the above, what is a fair price and why? What is the most likely case, best and worst case and what are the possible events that would cause each? What are the anticipated returns given each scenario? What can the PE fund do to amplify returns or mitigate risks? What is the anticipated holding period? What is the expected sales price when it is sold at the end of the holding period? How much debt will be involved? Given all the risks and opportunities, what is the level of conviction the PE fund investor has in being able to make the return desired, in the time frame laid out and at the specific risk level?

A draft investment thesis is typically created at the beginning stages of the process, followed by a Letter of Intent. Due diligence will then progress and validate or reject different parts of the thesis or uncover new risks and opportunities that need to be considered. This meticulous process is often why so few investment opportunities eventually get funded. 

A recent example of well thought out and structured investment thesis can be found on Coherent Corp‘s  (NYSE: COHR) investor website where Bain Capital invested $2.15B in preferred equity in 2021 to support the II-VI/COHR merger. 

Why Do PE Funds Do All This Work?

Believe it or not, the point is not to torture the Finance team of the target investment , although for those that have been through a transaction it may feel this way, but rather to do the following:

• Put strategy into action. This is done to cement the reason for the investment and track its performance through time. In essence, a measuring stick.

• Inform internal and external parties to derive consensus. Such as the investment committee, investors, partners, deal team and acquired company management.

• Address all the questions that arise throughout the deal process and provide evidence of the known risks and opportunities.

The investment thesis, outlines the thinking at the time of the investment as to how they will make the business more valuable over the holding period. This helps to prevent irrational behavior due to short to medium-term disruptions with the markets. For example, what if 2-years post construction a water main breaks in front of the newly built apartment complex that prevents all traffic from entering and exiting the facility but will only take 2-weeks before it is resolved? This event may cause a revision of occupancy rates for the next year if it occurred at a crucial time when students are signing leases or moving in but will most likely not require a re-evaluation of the underlying investment thesis requiring a sale, default, liquidation or some other event.   

How A PE Fund’s Investment Thesis Affects The Acquired Company

As Finance professional in a PE owned company you need to know what the PE-Fund’s investment strategy and investment thesis is to provide the right financial reporting for them. A PE Fund’s investment strategy can typically be found on its website or by Googling its name.

An investment thesis can include many things such as financial models, business plan, and presentation(s). The best way for a Finance professional in a PE owned company to get this is to simply ask. If you have access to the PE-deal team, specifically ask them, if not ask the CFO, if not him/her, keep trying until you find someone. Although this document may not be shared with the company at large, for anyone that is responsible for financial reporting to the PE Fund, it should not be an issue to acquire. 

Knowing The Investment Thesis Is Job One

Frequently, PE Fund investors have never worked in a company like the they invest in. So, they may have no experience in identifying the difference between regular fluctuations due to changing seasonality and strategic shifts that require action. As a Finance professional in a PE owned company, you need to provide credible, transparent reporting that will allow the PE firm to effectively manage its investment. To do that effectively, you need to understand its investment thesis.