Does the Private Equity “Playbook” need an update for the Next Decade?

PE playbook

By Mike Ryan, BPN Co-Founder and CEO
The best private equity investors are careful enough to minimize mistakes which destroy capital, and bold enough to identify, vet and close two or three phenomenal investments which make their overall Fund returns. They have to work every day to source opportunities, diligence their pipeline, provide strategy/governance/oversight for their portfolio companies, raise capital and manage people and process, but their success (or failure) typically rests on a handful of major decisions they make during the life of each fund. Because the stakes are so high, and the competition for returns so fierce, PE firms devote thousands of hours and millions of dollars to research, analysis and monitoring of each investment.

While specific strategies, regions and sectors vary, private equity has a very good playbook – governance control enables PE firms to install a strong CEO,  implement the margin improvement program (cost cutting) and capital structure (leverage) they desire, and capture outsized returns as long as three conditions are met: 1) they don’t overpay on the entry price 2) the business performs reasonably on the revenue line and 3) they achieve an attractive exit multiple. While there have been multiple “vintages” and Fund cycles since the Global Financial Crisis, when future investment historians say “remember the good old days” they will almost certainly be referring the decade that has just ended  (by the way, public equities and credit have done pretty well too, and across all asset classes we have literally never seen “sharpe ratios” this good for this long).

Sure, multiples paid have risen considerably, but leverage has been cheap and readily available and the exit prices realized have justified the upward creep. In fact, it’s likely that truth serum would elicit more regrets over passing on deals because of valuation worry than pulling the trigger on deals gone bad. Such is the FOMO factor in 10-year bull markets.  Given the “dry powder” PE funds have amassed with record-breaking fund raises, sourcing deals is a major task, but the best PE firms are great at generating deal flow, courting sellers, filtering through opportunities and applying the playbook outlined above.

The knowledge pile that PE firms build around a prospective or current portfolio company is huge. The companies themselves provide a pitch deck or offering memorandum plus a well-stocked data room. Private equity firms hire smart associates from the best business schools and banks, inform themselves with extensive industry reports provided by consultants (who also hire the same top tier MBAs), pay for sector research and data sets, conduct background checks and customer reference calls, and of course employ accountants and lawyers to conduct formal diligence. Once they really understand the company (but usually after their key leaders have already decided they are going to buy it), they prepare a very comprehensive investment memo (with lots of appendices) and have a formal investment committee meeting to approve the purchase. When the salaries of their teams are properly allocated, it’s not uncommon for a typical private equity firm to spend millions of dollars (excluding the legal and audit fees) on research to support a single transaction. They do an awful lot of work, but does most of it really factor into the final decision making?

Will this approach work in the next decade? Well, buying good businesses, installing strong CEOs and improving margins and capital structures is a winning formula, but history teaches that entry price matters an awful lot, anticipating and calling the odds on a wider range of scenarios seems critical,  and simulating the exit multiple you may receive in 5 years may be more important than producing a 3 inch investment memo with a simplified spread sheet covering a few “cases” and a data table of IRRs. To avoid passing on deals which turn out to be big winners or closing deals which eventually destroy capital, more of the rich insight and deep research living in their knowledge pile must factor directly into scenarios for how the actual cash flow may change, and how expectations about the long term outlook for growth and profitability (which will determine the exit multiple they get) may change. 

There are two great ways to make money:

  1. Invest in a powerful trend with a great operator (but don’t overpay!)
  2. Express a contrarian view about the future outlook (and be right!)

Both require the marriage of words and numbers, which we call Quantifying Stories in Scenarios. Visit to learn more.