successful private equity firm takes on several responsibilities to generate the highest return for its investors. A team of highly compensated portfolio managers must monitor the holdings, direct strategies, restructure poorly performing companies, and identify new investment opportunities. This process requires an intimate understanding of a company’s culture, experience, and qualities that only come with practice.

The following are important steps in establishing a successful private equity firm.

Identify Opportunities to Buy Companies

The first step in any private equity transaction is identifying opportunities to buy companies. Veterans like Peter Comisar suggest that the average company could be better operated. There are usually opportunities for operational improvements or redesigns, such as business combinations, divestitures, or sales of assets or divisions. Ideally, the company will have options for multiple solutions. Clearly understanding the differences between these solutions and the pros and cons of each is key to making a successful investment decision.

Understand the Business

Understanding a business reduces risk by driving investment decisions based on a firm’s analysis of real numbers rather than hearsay. The private equity firm will know why the business exists and how it fits into the greater context of its parent company or other companies in its industry and its sector. Numerous quantitative methods can be used to understand a business better, including financial modeling and industry analysis. The goal is to prepare an offering memorandum that can be used to prepare a target company’s financial data that makes sense for the private equity firm.

Understand the Seller

Understanding a business also means understanding its owner. Private equity firms will want to understand the motivations of their sellers and the benefits they are likely to receive from selling the company. Private equity firms ask hard questions about why sellers are putting their businesses up for sale, what is motivating them, and what they hope to gain from selling their firm if possible. Private equity firms try not to invest in companies being sold for public relations reasons. This often happens when a new CEO is brought in and wants to imprint the company by selling it off.

Understand the Competition

Understanding the competition is particularly important for a business that does not operate in a monopoly or oligopoly market. The private equity firm will want to know how sales are generated and the competition. They will want to know the barriers to entry for competitors and if those barriers are sustainable. Suppose there are technological innovations that give a certain company an advantage. In that case, it may be worth paying more money for that company even if it has risks associated with it because of its proprietary nature. The private equity firm will also want to know if there is any government regulation that benefits, or could potentially hurt, the business they are investing in.

Private equity is an industry filled with all sorts of cowboys. From time to time, the media will break a story about some private equity firm or an individual investor who, to hit home runs, makes reckless decisions that ultimately lead to failure. To be successful in private equity, you must follow a highly disciplined and predictable approach.

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