PE 101: The Investment Process - and why it matters to LPs

As a potential Limited Partner (LP), it's important to understand how the private equity investment process actually works. How a fund makes investment decision has perhaps the largest impact on that fund’s returns. How these decisions are made can be a black box, however, so let's break it down.



A PE fund may “source”, in other words, look at, thousands of private companies before deciding to invest in one. This can be a laborious task but is important for a fund looking to make sure they get into only the best deals. To satisfy this need to examine thousands of companies, many larger firms have entire teams dedicated to identifying potential investment opportunities. The quality of this deal-sourcing team and their industry expertise can have a significant impact on the quality of investment opportunities available to the firm. As an LP, it's important to evaluate the deal-sourcing capabilities of the firm you are considering investing with not just for the size of the team, but also for the quality of the current pipeline and ability to source future deals.


Due diligence

After a company has been sourced and the team believes it has potential, due diligence will commence. This is a very intense process and involves analyzing the financial statements, operations, management team, market position, growth prospects of the company being considered for investment, and more. Often a PE firm will bring in outside advisors such as accountants, consultants, and lawyers to help analyze a company and cover any blind spots they may have. The quality of the due diligence process can impact the accuracy of the valuation of the company and in the end, the returns that LPs will receive on the investment.



If the company is deemed to be high quality during diligence, the PE firm will then try to determine the right valuation at which to invest in the company. PE firms typically use a combination of methods to determine the right value of the company, such as discounted cash flow, comparable company analysis, or asset-based valuation. The price a fund chooses to bid for a company can be impacted by many factors such as if the process is competitive or not (other PE funds are also bidding to make an investment), if there is a formal process, if a bank is involved, etc. Accuracy in underwriting and modeling is a crucial determinant of returns to the fund's investors.


Investment Committee

Before making the investment, the team working on the deal will present the opportunity to the fund's Investment Committee (IC). The IC is typically responsible for reviewing and approving all potential investments and usually is the most senior and prestigious role at any PE or VC fund. The committee will assess the investment thesis, review the due diligence findings, and evaluate the potential risks and rewards of the investment. The IC plays a critical role in ensuring that all potential investments are thoroughly reviewed and approved before the firm moves forward with the deal. Understanding the experience of the investment committee and who they are should be top of mind for any LP considering investing in a PE or VC fund.


Once an investment is approved and made, that company officially becomes a part of the PE fund’s portfolio and the limited partners in the fund will receive a capital call to fund the investment. Over time, if the PE fund did its job well during the investment process, that company will yield significant returns for investors down the road.

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