Financial Poise
How Private Equity Chooses Portfolio Companies

How Private Equity Chooses Portfolio Companies

How investment strategies are decided

As a threshold matter, keep in mind that private equity funds, by definition, invest in established companies with real revenue.  While some experts categorize venture capital as a subset of private equity, AIMkts does not.  For more on this, click here.

A PE firm’s investment strategy starts with its investment mandate.  An investment “mandate” is revealed in the marketing materials and/or legal disclosures that you, as an investor, need to review before ever investing in a fund.  Stated simply, many firms pledge to limit their investments in particular ways.

A fund’s strategy, in turn, is usually (and should be) a function of the expertise of the fund’s managers.

Varying ways to focus strategy

How, when, and in what fashion a PE firm chooses its portfolio companies can be categorized in several ways.  For example:

There are secondary factors that influence how private equity firms choose portfolio companies. PE firms are comprised of members with different areas of expertise. The expertise of a particular PE firm facilitates the selection of portfolio companies. Some determining factors are:

1) Lifecycle:

  • Growth capitalinvests in slightly more mature companies that are growing and profitable; however, these companies have financial limitations.  Such limitations inhibit further development and expansion. To generate capital, such companies sell equity but maintain majority ownership. Case studies concerning growth capital can be found at Private Equity Growth Capital Council’s website.
  • Leveraged buyouts (LBOs) concentrate on the acquisition of mature, stable companies. The transaction is financed by two sources: equity (selling the ownership of the company) and debt (borrowing money to use as leverage).  A “management buyout,” is a type of LBO in which the main buyer is the current management team, supported by a PE firm.  Perhaps the best known LBO was that of RJR Nabisco by KKR in 1988. Bryan Burrough and John Helyar wrote about this in Barbarians at the Gate: The Fall of RJR Nabisco.
  • Distressed investments and special situationspertain toinvestments in equity or debt securities of companies that are experiencing financial distress.  For more information on distressed investing, click here.

2) The size of the company measured by:

  • Revenue
  • Value of assets

3) Geography:

  • Regional
  • Multi-regional
  • Pan-continental

4) Industry

5) Investment size:

  • Small
  • Medium
  • Large

All these factors influence how a PE firm narrows down the pool of potential portfolio companies. Once the company has been selected, private equity firms begin negotiations and conduct due diligence. Finally, the PE firm decides whether or not to invest in a particular company.


Diversification is a risk mitigation technique that plays into investment decisions.  In simplified terms diversification prevents “putting all of one’s eggs in one basket.”

Josh Lerner, author of Venture Capital, Private Equity, and the Financing of Entrepreneurship, writes, that, “… different GPs treat diversification differently. For instance, Warburg Pincus, a top-tier private equity firm, raises a single fund and invests across a host of stages, geographies, and industries. Sequoia Capital [in contrast] initially raised a number of different funds, some for U.S. early stage, others for India, another for China.”

Successful portfolio management requires a balance between investment strategy and diversification policy; however, there is no standard approach concerning the selection of investment strategy and diversification policy. It is the choice of the PE firm.

As a result, when investing in a PE fund an investor must conduct her own due diligence to gather all the crucial information to make an informed investment decision. Information about individual PE firms’ investment strategies, and their diversification policy, can be usually found on their websites. Some examples can be found here and here. Even though in most cases the information is vague, what is offered can provide a partial view of a particular firm’s investment strategies.  The details of an investment strategy are described in greater detail in a fund’s Limited Partnership Agreement, often in a section commonly titled “Investment policy guidelines.”

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About Kaja Kwasniewska

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