How do PE Funds Evaluate Deals

How do PE firms evaluate deal opportunities?

• In PE, a deal will typically be sourced through the networks of a VP / Principal / MD post which an analyst / associate will be staffed on it
• Initial work will include going through the deal collaterals (IM / Model) and trying to understand the following (note the list of items below are illustrative and not exhaustive and could vary across deals basis the sector / company lifecycle):

• Industry Landscape:
  • Industry structure, fragmentation, segments, whitespaces / opportunities, historical growth drivers, etc. (Porters 5 forces on some level)
  • What are growth drivers going forward?
  • How is the target positioned in the industry?

• Company Business model:
  • What does the target do; what customer segments does it cater to?
  • Understanding the value chain of the industry and where the target fit into this value chain 
  • Historically where has growth come (new products / geographies / customer segments / etc.) from and what have been the drivers of margins / return metrics (RoE / RoCE, etc.)?
    • Going forward where will growth come from and how will this impact margins?
  • What is the moat of the business?
  • Is there concentration risk? (products, customers, geographies, etc.)
  • Working capital and fixed capital intensity of the business
  • Who are its competitors?
    • Key qualitative differences between the target and competitors
    • How does the target benchmark against competitors on key metrics such as revenue growth, margins, RoE / RoCE, NWC / Capex intensity, etc.

• Valuation and Returns:
  • Typically try to triangulate valuation (quick and dirty) using a combination of DCF, trading / transaction comps, etc.
  • Quite often the initial valuation ask is communicated to the deal lead by the banker
  • Will also try to run calculations on returns (quick and dirty) and split them into various components (revenue growth, margin expansion, multiple expansion, cash accretion, etc.)

• Key Issues to Evaluate through Due Diligence and Risks:
  • If the business seems attractive from the initial outside in work (i.e. decent historical revenue growth, stable margins, decent RoCE, strong apparent moat) then the following issues will need to be evaluated (illustrative and not comprehensive):
    • Potential drivers / nature of Industry growth going forward
    • Ability of the target to capture a larger market share of the industry
    • Clean accounting of the target
    • Ability of Management Team to scale the business as per projections at similar / higher margins and RoCE
    • Exit-ability of the asset after a ~5 year horizon (through IPO / strategic sale / etc.)

• After doing preliminary work on the above, the analyst will discuss the same with the BP / Principal and MD on the deal and then will typically refine their thoughts on the business after discussion with various other parties such as the banker, industry – experts, promoter of the company, etc. 
• The MD will then take a call whether or not to present this opportunity to the Investment Committee (through a presentation detailing all of the above built by the analyst / associate)
• Post discussion with the Investment committee, the deal tea will either pass the deal or commence due diligence on the target by appointing advisors (commercial, financial, legal, etc.)