Most private equity (PE) funds look for private companies with strong growth potential.
They contribute funds and other resources to help the targeted company grow and improve its profitability. Then they sell off their stake and exit through a public listing.
Some PE funds like Sequoia Capital and IDG Capital Partners specifically target start-ups that have yet to make profit. They invest in about a dozen of these small start-ups every year, although most of these targeted firms will be gone after a couple of years.
But if one or two of these targets succeed, that could make up for all their losses and even generate a lucrative profit.
There are other PE funds that invest in profitable companies in the hope that they could help these firms grow bigger and boost their value through listing. Also, some PE funds acquire a company and restructure its operations before a divestment.
Softbank chief executive Sun Zhengyi said he was touched by the fire in Alibaba founder Jack Ma. In fact, the background, vision and habits of an entrepreneur could make a huge impact on investment decisions.
For example, if the boss of a target company loves gambling or has extramarital affairs, that could lead to big trouble in the long term for the company even if it is in a fast-growing industry and has a strong growth momentum.
As such, PE investors have a sort of “friends and enemies” relationship with the boss of the target company. On one hand, they need to build up the relationship to ease the way for negotiations and due diligence work. But on the other hand, they need to do background check on the boss secretly.
In many cases, PE funds hire professional organizations to look into the background of the boss, who their friends are, potential links with gangs and other unsavory characters, or any unhealthy hobbies like gambling or cheating on their spouses.
Some target companies appear to be quite attractive as far as its financial records are concerned, but a little more sleuthing will show that the boss has several romantic affairs, which could affect shareholder structure if a divorce takes place. And the boss could also be very much distracted from the business by personal affairs.
The principle also applies to small start-ups. The founder’s character could have a deep influence in the future direction of the company. Big companies usually have a professional management team, which is why, for example, Mingsheng Bank manages to keep the business running despite a high-level personnel reshuffle.
Therefore, making the right judgment on people is a key skill set for venture capital or PE funds. And one can develop that skill after meeting with a dozen entrepreneurs each year.
This article appeared in the Hong Kong Economic Journal on Thursday.
Translation by Julie Zhu
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