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UNDERSTANDING THE SKILLS NEEDED FOR CAREERS IN PRIVATE EQUITY

INVESTING: IMPLICATIONS FOR CURRICULUM DEVELOPMENT

William A. Andrews, Stetson University


Campus Box 8398 Deland Florida, 32723, 386-822-7437, wandrews@stetson.edu

ABSTRACT

Using the same framework for evaluating an investment in a publicly-traded company versus a
privately held company can be a recipe for disaster. While there is some overlap in the
evaluation process, there are significant additional considerations for investing in a privately-
held company that require a broader set of skills. The article identifies 5 skill-sets that are critical
to successful private-equity investing that are not generally taught as part of the
finance/investment curriculum in universities. Curricular implications for universities and
corporate training programs are discussed.

EXECUTIVE SUMMARY

The skills involved in being a successful private equity investor are much broader than those
required to be a successful public equity investor. A general partner of a large Atlanta venture
capital (VC) firm, summed it up this way, “There is a saying in the industry that it costs $40
million to educate a venture capitalist”, referring to the high cost of learn-by-doing in this
industry. Clearly, in his mind there is a significant gap between those sufficiently schooled in
investing to begin a career in private equity and those who are good at it.

The author identifies 5 skills that are essential to successful private equity investing, but not
generally required in public equity investing. They include (1) valuing businesses in an illiquid
start-up context, (2) contractually structuring the investment, (3) maintaining an effective
personal network to (a) ensure adequate deal flow, and (b) assist portfolio companies in securing
critical resources, (4) negotiating skills associated with both purchasing and selling an
investment, and (5) skills in coordinating thorough due diligence.

Resources for developing these skills are suggested. In the academic context, the following
recommendations are offered to better assist students in entrepreneurship or investments
programs acquire these skills:

(1) Do not rely on the “general business requirements” to meet these skills.
(2) Some of these skills are process skills, meaning that they are developed by practice – not
merely through understanding the process.
(3) Due diligence is on virtually no one’s curriculum.
(4) A course in private equity investing can be demonstrated to accomplish the purposes of the
business capstone class, and might be offered in lieu of Strategic Management, for example.
INTRODUCTION

Private equity investments are the financial umbilical cords of small businesses. Using the same
framework for evaluating an investment in a publicly-traded company (PTC) versus a privately
held company (PHC), however, is a recipe for disaster. While there is some overlap in the
evaluation process, there are significant additional considerations for investing in a privately-
held company. The purpose of this article is to identify the distinctive skill sets required by
private equity investors that are not as important to investors in publicly traded stocks. By
identifying different requisite skills, we hope to improve curriculum development for both
company training programs as well as academic institutions.

A fair question might be whether the differences between the skill sets of a good public-equity
investor are really much different from those of a good private-equity investor. Alan Taetle,
managing partner of Noro-Moseley, a large Atlanta venture capital (VC) firm, summed it up this
way, “There is a saying in the industry that it costs $40 million to educate a venture capitalist”,
referring to the high cost of learn-by-doing in this industry! Clearly, in his mind there is a
significant gap between those sufficiently schooled in investing to begin a career in private
equity and those who are good at it. While this author doesn’t contend that this brief manuscript
will reduce the cost to six figures, it is hoped that it will be worth at least a few million dollars in
savings to those learning the craft, while pointing those charged with curriculum development in
the right direction.

A second question concerning the relevance of this manuscript might be whether private equity
investing is occurring on a scale large enough to justify the presentation of such a framework to
the small business community. Between 1990 and 2000, total venture capital (a subset of private
equity) under management grew from $32 billion to $210 billion (Timmons, p.476-7). Since the
dotcom bubble burst, venture firms have continued to invest $35 billion, $21 billion, and $17
billion respectively in 2001, 2002 and 2003 (Fong, 2005, p5). Although numbers are not in for
2005, capital commitments are up strongly from previous years. The point is that private equity
investing is both large and rapidly growing.

ESSENTIAL DIFFERENCES

Ten essential differences between public and private investing can be identified. From these 10
differences, a set of 5 skills will be deduced.

• Information on private firms is not readily available to the investing public.


This has two implications: (1) A system of generating “deal flow” is required to
ensure that the company has an adequate selection of investment alternatives.
There are no computerized screening tools for finding prospective investments as
exists for publicly traded stocks. An investor must devise a method for ensuring
that they see a lot of prospective deals. Usually, this involves working through an
effective professional network. (2) Once a prospective company is identified,
investors have access only to what information the owner wishes to disclose. In
practice, it becomes something of a courtship ritual. The company will not likely
disclose all that the investor wishes to know upon the investor’s initial expression
of interest. Moreover, the company will (should) be scrutinizing the legitimacy of
the investor. As mutual interest continues, disclosure increases. Managing this
courtship process requires considerable social and negotiation skills. There are
mistakes to be made by being too aggressive and by being nonchalant. Such skills
are not required for successful public investing, are rarely taught in finance
curricula.

• The deal is contractually determined. When making a private equity


investment, the contract to invest must define the financial instrument to be used
and include a number of clauses to protect the investor in case of certain
exigencies (Wilmerding 2005):
o Usually private equity investors will try to invest using cumulative
preferred stock or convertible debt (Gladstone 2004). Such instruments
are preferable to common stock in that they secure a current yield for the
investor and thereby increase the total return. Moreover, such instruments
have priority in bankruptcy.
o The investor will want some anti-dilution protection in the event the
company raises money at a later date at a valuation lower than the current
valuation. A typical provision might allow the investor to convert his or
her preferred stock or convertible bond to common stock at a set price or a
price equal to the lowest price at which the company subsequently sells
stock.
o To make sure the investor is not locked into a minority position which it
cannot liquidate, most investors will require the company to agree to a put
option. Here, the company agrees to buy back the investor’s position after
a certain date with significant profit for the investor.
o The investor may have the conversion rate of his or her shares increase
dramatically is the company misses its sales projections by a wide margin.
o Early-stage investors may require their approval on subsequent financing
deals, capital expenditures or executive compensation.
o The investors may attempt to secure preference to sell their shares first in
the event of an IPO.
o The investor may require board representation.
A good understanding of the contractual tools of private equity finance is critical
to successful investing, especially since the projections on which valuation is
based are exceedingly tentative.

• Valuation must be determined. While investors in public stocks must determine


if the valuation of the market makes the investment attractive, investors in private
equity do not even have a starting point. As one business broker put it, 80% of
buyers and sellers have unrealistic expectations of what the company is worth
(Rosen 2005). Good investors in such an environment need a combination of
compelling analytical skills for valuation, and strong persuasive skills to move
entrepreneurs toward their assessment of valuation. However, since the investor is
buying the future of a company that has very little past in an industry that may be
emerging, valuation cannot be viewed apart from the contractual terms that would
change the terms of the investment in the event that someone’s crystal ball turns
out to be poorly calibrated concerning future projections. Moreover, the private
equity investor does not have the benefit of technical analysis to guide his timing
or determination of value. Again, negotiation skills become prominent.

• The shares won’t always go to the highest bidder. In contrast to public


investing, companies seeking venture capital are also typically seeking managerial
guidance, industry connections, market in-roads and access to broader financial
markets. Such value add-ons are expected to come from the venture capital team
and are more important to the smart entrepreneur that a higher valuation. It is
quite common for firms to take a deal that offers them a lower valuation of their
company if they believe a particular VC team can make the pie considerably
bigger. The good investor must have skills and connections that can enhance the
firm's prospects. In public investing, shares go to the highest bidder.

• Private equity investments are illiquid and cannot be easily reversed when the
industry or company prognosis deteriorates. Instead, the VC firm must work with
the company to bolster its performance. Hence, the importance of the relationship
between the investor and the entrepreneur is of critical importance. Publicly held
shares can be readily dumped when trouble arises. PHC investors must work with
management in a constructive way to remedy problems.

• VC investing requires active monitoring/management of the investment.


Typically on a monthly basis, the investment will report its operating results to the
VC firm. Off-plan results may lead the VC firm to initiate discussions with
management aimed at remedying the situation. It is common for the investor to
have a seat on the board and also to have contractual provisions in the investment
contract that allow their ownership percentage to increase if management is
significantly off-target. A good private equity investor requires skills in
identifying signs of trouble and the ability to initiate operational change as
needed. While public equity investors need to be able to spots signs of
deterioration, they need not possess skills in diagnosing and changing strategic or
operational mistakes. They simply sell their shares. The private investor cannot
exit, so he or she must be a timely and effective force for constructive change if
the investment is to be saved.

• There is no technical analysis. The average holding period for publicly-traded


common stock is less than one year. Some 30% of daily exchange volume is
program trading relying on technical analysis. Venture investors have no
assistance available from charts and trends. Instead, the game is won or lost
largely on one’s ability to evaluate the fundamentals of a business and its
environment. Having said this, certain sectors become “hot” in private equity
investing just as they do in public investing. During such times, the valuation
multiples may expand. The investor must have solid skills in business valuation
methods to know when a valuation is reaching its upper limit. Public investors can
simply look at the chart.
• VC firms must plan strategies for divestiture. They typically do not have the
option of selling their shares on the open market, at least initially. This can be
accomplished two ways: (1) by investing in sectors that demonstrate a propensity
for the larger companies to grow by acquisition of smaller firms. This is common
in the software and biotech sectors. (2) Alternatively, they can write put-option
clauses into the investment contract which require the company to buy out the
investor shares It is still relatively uncommon for a VC firm to exit an investment
through an IPO. Publicly-traded shares have a built-in exit strategy – sell on the
open market.

• Investments require extensive due diligence. Due diligence is not required


when purchasing publicly traded companies which are required by the SEC to
make accurate, standardized disclosures. Moreover, significant penalties are in
place to deter misrepresentation on SEC filings. The SEC exercises no such
scrutiny over private companies, increasing the likelihood that representations
may be inaccurate or incomplete. Moreover, it is not uncommon for start-up
companies to lack professionalism in their accounting and control functions
simply out of ignorance. The ability to coordinate thorough due diligence is a
critical.

• The costs of due diligence and legal contracting make small investments
generally infeasible. Legal contracting and due diligence are both extensive and
expensive. Brokerage firms that trade public securities have standardized the legal
contracting associated with buying publicly traded stocks so that it is virtually
transparent to the investor, and the costs are distributed over thousands of clients.
The legal contracting associated with private equity investing must be negotiated
on a deal-by-deal basis. It is not uncommon to spend $20,000 or more on the legal
documentation associated with the closing of a venture capital round. Due
diligence can also run $20,000 or more depending on the nature of the investment.
The lion’s share of this expense goes to IP audits, legal audits, financial audits,
and customer audits (to confirm the existence, terms of, and satisfaction with the
company’s customer contracts). This means that the private equity investor will
have to factor in considerable acquisition expense into the calculation of
investment returns.

The diagram below summarizes the five skill sets that are unique to private equity investors. The
“valuation” skill could certainly be argued to be a part of the public investor’s skill set. It is
included below to emphasize that valuation of companies that may have few sales, no profits,
and compete in new industries – common considerations for the venture capitalist – pose
significant challenges to conventional valuation methods. Concepts like Beta, a measure of
market risk that can affect value, become irrelevant. More precisely, projecting sales, EBITDA,
profits and cash flow – common valuation metrics – become even murkier than in established
businesses and industries. So doing valuation in this environment involves a different way of
approaching these tools.

SO WHAT?! IDENTIFYING FIVE SKILLS THAT VENTURE


CAPITALISTS MUST ACQUIRE

Table 1 and Exhibit 1 below summarize the skills needed to be a successful private equity
investor that are not generally needed by the successful investor in publicly traded stocks nor
taught in investment majors. The “application questions” are : (1) To what extent does the
curriculum your business school recognize the unique set of skills required by aspiring private
equity managers? Does your investments curriculum need to be updated? (2) To what extent
does your private equity investment firm seek to develop these skills in its junior (or senior)
members? (3) As a private equity manager, which of these skills do you need to cultivate to
improve your overall capabilities?

Note that I have listed publications that I have found to be quite helpful in developing these
skills in the far-right column of the table. Other resources are certainly
available as well.

TABLE 1

Task Unique to Skills Implied Helpful Resources


Private Investing
Generating deal flow and Networking with bankers, Content and process issue:
information lawyers, universities etc. to “Building Effective and
generate deal flow; Efficient Personal
Personal ethics/ trust- Networks”/Podolny
building, establishing (Harvard B.S. Press),
legitimacy with
entrepreneur to secure
confidential information.
Structuring the deal Knowledge of contractual Content issue: teach
mechanisms. contractual mechanisms of
term sheets. (Basic: Term
Sheets and Valuation/
Wilmerding. Advanced:
Advanced Private Equity
Term Sheets…/Bartlett et
al.)
Determining a price Valuing a business in the Content issue: Valuation in
absence of a liquid market private equity context. New
Venture Creation/8th
ed./Timmons (Chapter 15);
Securing an agreement Negotiation Content and Process issue:
Negotiatiing “Getting to
Yes” Fischer & Ury;
Convincing the Network development; Content and Process issue:
entrepreneur that your firm industry connections; Strategies for building a
can amplify his/her success, negotiation network “Building
making the pie bigger for Effective and Efficient
all. PersonalNetworks”/Podolny
(Harvard B.S. Press)
Coordinating due diligence Ability to assess material Content and Process Issue:
risks associated with the Virtually never taught in
company’s representations; business schools
ability to coordinate Venture Capital Investing:
competent due diligence Gladstone & Gladstone (the
effort. entire book)
Selling the investment Contractual terms of the Content Issue: Term Sheets
deal structure; Knowledge and Valuation/ Wilmerding.
of M&A activity levels in Also deep familiarity with
target industries; valuation the target industry through
trade journals, etc.

EXHIBIT 1

Skill Areas of the Private Equity Investor


Negotiation Skills

Personal
Contract Skills networking skills

Due Diligence Valuation Skills


Skills

CONCLUSIONS AND RECOMMENDATIONS

From the foregoing, it can be concluded that the “market-savvy” investor in public equities has a
lot to learn before he or she becomes a competent private equity investor. The task of private
equity investing requires a broader skill-set. As private equity becomes an increasingly large
proportion of the investment universe, academic institutions will have impetus to broaden the
offerings of their finance and entrepreneurship departments to include courses and modules
aimed at developing these incremental skill sets. Only one of the 5 critical private-equity
investing skills is commonly taught in university investment curricula – valuation. While the
depth of coverage of these 5 topics will differ according to a university’s particular emphases,
institutions who want to prepare their graduates for tomorrow’s investment climate should
consider working these skill-sets into their curricula.

The first recommendation is that business schools not rely on the “general business
requirements” to meet these skills. Rather, pedagogy for developing these skills should be
worked into the content of investment or entrepreneurship courses to ensure that the skills are
integrated into the investment context.

Secondly, some of these skills are process skills, which means they are developed by practice –
not merely through understanding the process. Network building and negotiating in particular
will require an experiential learning context where the skills can be developed and practiced.

Due diligence is not on anyone’s curriculum anywhere. Accounting departments may claim the
audit piece of due diligence, but what students of private equity need is a framework for
understanding what to look for and how to analyze it. The aforementioned book “Venture
Capital Investing” is devoted to this topic, as it approaches the art of investment selection as
basically one big due diligence effort. It makes an effective course module and provides a
framework for conducting due diligence.

Finally, a course in private equity investing can be demonstrated to accomplish the purposes of
the business capstone class in lieu of Strategic Management, for example. At the heart of the
course is determining whether a company is well-positioned in the industry for the future, and
whether it has the resources or competencies it will need to compete successfully. All of the
functional areas come under scrutiny as the company is analyzed. Students then can show their
confidence in the company by stating what they would be willing to pay for it and why.

It is hoped that this manuscript has been useful to those charged with developing curricula for the
entrepreneurship and investment tracks of academic institutions, and that it can serve to guide the
training efforts of private equity money managers.

REFERENCES

Fisher, Roger and William Ury (1991) Getting to Yes; Penguin Books, New York
Fong, Kevin in Ernst & Young (2004) Annual Venture Capital Insights Report, New York. p.5
Gladstone, D. and Laura Gladstone (2004) Venture Capital Investing; Prentice Hall Pearson
Education, New Jersey
Rosen, George (2005) Visiting class lecturer June 7 2005 from Corporate Investment
International, Orlando
Taetle, Alan (2005) Interviewed May 6, 2005, a general partner with Noro- Moseley, a venture
capital firm; Atlanta
Timmons Jeffry A. and Stephen Spinelli (2004) New Venture Creation, Irwin Publishing, New
York p.476-477; 501-518
Wilmerding, Alex (2005) Term Sheets and Valuations; Aspatore Publishing, Boston

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