When it comes to public market investing, diversification is one of the so-called tried and true techniques for reducing risk. Basically, it means not putting all of one’s eggs in one basket, and instead, spreading risk by allocating one’s assets among different categories of securities, such as stocks and bonds, among others, with further diversification within those categories. On the other hand, concentrated investing is the exact opposite — investors limit their exposure and focus their bets on only a handful of securities. Some mutual funds, for instance, are “concentrated,” in that they invest in only 20 or so securities.
In the private investing world, buying a single company is the ultimate concentrated investment because the buyer is investing in just one “security,” so to speak. Private Equity Groups that own multiple companies are more similar to the concentrated mutual funds in that most PEGs own a limited number of companies. To compare it to the mutual fund world, for example, buying a private company is like betting that a fund manager can perform well enough to rank in the top quartile or top decile forever. In other words, the buyer is essentially making a bet on a single company (or small group of companies) that they believe can remain a leader(s) in their market(s) or industry(ies) for the foreseeable future.
On the surface, such an investment strategy appears to be very risky.
And it is.
By their nature, all investments come with some modicum of risk.
But unlike in public market securities, where the old adage “past performance is not an indication of future results” is a standard disclaimer, when a buyer purchases a private company, the buyer wants to believe the seller’s investment thesis that the company’s past performance is an indicator of the company’s future performance. In fact, that is the buyer’s expectation that they can not only replicate the company’s past results, but exceed them in the future, leading to the private company purchase trifecta: increase sales, improve profitability, and realize a multiple arbitrage, i.e., sell the company at a higher multiple than the purchase multiple.
From the seller’s perspective, maximizing the attractiveness of the company to buyer candidates is a matter of managing or de-risking company characteristics that are otherwise perceived as risky. Such risks include customer/vendor concentration, key employee concerns, business cyclicality, etc. As we have written previously, buyers and sellers perceive risk differently, of course, and these varying perceptions impact the company’s valuation.
Transparency is another issue that differs with regard to purchasing a private versus a public company. Every quarter, public companies disclose their business performance (including quarterly and year-to-date results) for anyone who cares to review it. Sure, there are tricky ways to hide information, but the SEC heavily regulates earnings reports, thus, companies have a duty to be transparent about the good, the bad, and the ugly of their operating results.
In the case of a privately-held company, transparency is a significant and critical aspect of the transaction, with the perception of transparency playing an integral role in building trust between the buyer and seller – which ultimately impacts whether or not the transaction closes. It is like investor sentiment in the public markets, except the valuation is driven not by herd mentality, but by the perceptions and objectives of two parties — the buyer and the seller.
To that end, the buyer’s perception of the company’s tangible and intangible assets and the ability of those assets to generate cash flow (because after all, bills are paid with cash, not earnings) – drives valuation. How do those assets generate a product/service and attract customers? How do they entice employees to join the company and work hard to achieve positive bottom-line results? How much customer demand is there for the product or service that the company provides? How much competition is there? What is the business proposition for the company to get paid for providing that? These are all questions the seller must proactively address and present to buyer candidates in order to establish the long-term viability of the company, and its earnings and cash flow, under new ownership. Again, the buyer is banking on being able to replicate and build on the company’s past performance (sales, cash flow, retention of clients, etc.) to generate strong (or stronger) future results
In conclusion, ultimately the seller of a privately-held company is selling, and the buyer is purchasing, a concentrated investment in a single security and a single market sector. The expectation is that the purchased assets will continue to produce products/generate services that will remain broadly “in-favor” for the foreseeable future, and will ultimately generate positive and increasing cash flow. It is a risky proposition, but with that said, the risks can be well worth the rewards for both parties.
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