A sure-fire way to get private equiteers talking nonsense
Normally, private equiteers are calm, controlled and objective when dealing with just about any business issue. They pride themselves on considering the full facts and making carefully measured decisions. But, there’s one certain way to get a private equiteer to leave it all behind and spout a tidal wave of utter nonsense… just ask them to size a market.
A market refers to the total sum of potential buyers for a group of products or services. The market we refer to in private equity is the target market, which consists of buyers actively looking to purchase and whom can afford our type of product or service.
Private equiteers get carried away when sizing markets because they want other partners in the firm to like their new deal and to think the market is large enough to support exponential growth. In many cases, markets really aren’t as large as we hope and there’s no way to measure them accurately, so we embelish a little. But it doesn’t do anyone any good in the long run.
In a previous post (the amplifying effect of diminishing sales), I wrote that even small changes in a market can have a devastating affect on investee equity value. So while exaggerating the size of a market may get a deal done, it will also likely explain why your investee is having a lot of trouble in challenging times or not able to grow in prosperous times.
The step of the market sizing process that allows private equiteers to embellish is the one in which you define the market. For example, does the market for an arborist (tree surgeon) include landscaping? Does it include soil and sand supply? Or to really push the friendship, does it include operating a florist? Although these sound outrageous, I’ve heard it all before and I’ve seen partners regularly lap up the reasoning behind these claims.
The way to get around this embellishment is to understand the different levels in a market and be honest with yourself about how each relates to the firm in question; the levels include the following:
- Penetrated market – this includes the buyers that the firm is currently servicing
- Target market – this is the market segment that the business has targeted for strategic reasons; it is bigger than the penetrated market because it includes those customers that haven’t bought from the firm
- Available market - this market includes all buyers whom want and can afford your product/service; it is larger than the target market because it includes segments that the firm has labelled as a lower priority
- Potential market – this includes all of the buyers who need or want your service, but that can’t necessarily afford it or don’t have access to buy it; sometimes regulations or other restrictions also keep buyers out of reach
Personally, I think that sizing a potential investee’s market should focus between the available and target markets. However, most analysis I see goes way out of even the potential market and includes groups of products or services that would require new acquisitions, new people, new skills and new experience to even contemplate servicing the market. If you want to conduct honest analysis, stay within your potential market and limit your sizing to the available market.
[...] my last post, I complained about private equiteers talking nonsense when sizing markets. But in this post, I [...]
Market due diligence in private equity | The Private Equiteer
8 Jul 09 at 13:15
great post but i think it’s not helpful to think about market size without thinking about market share in tandem.
ie i think it’s perfectly acceptable to talk about a very large potential market, as long as you have a matching acceptance that in the larger market, your market share forecast is much lower.
Alex
13 Jul 09 at 09:22
Thanks for the comment Alex.
Agreed that it’s acceptable to “talk” about the broader potential market, but I worry about due diligence based on the broader market. The fact is, you should only be paying for what you’re getting now, not for what could potentially be created if all of the planets align in perfect formation.
With millions of potential investees, I don’t think it’s prudent to be overly optimistic with market analysis, which really underpins your investment. With that said, I love to talk about far away possibilities and don’t enjoy people whom are too pessimistic. But just as you aptly mentioned, I think the broader market is generally only okay to “talk” about; you’re never going to regret making an investment because you weren’t optimistic enough.
The Private Equiteer
13 Jul 09 at 22:36
interesting stuff.
the other main reason one normally sees market analysis at the higher end of your scale (“potential market”) is that in mid-market deals you are unlikely to find reliable estimates of market size for smaller segments of markets, often without their own specific trade associations. e.g. you would certainly find an estimate for the Facilities Management industry, would probably be able to get that cut into blue collar / white collar etc, but you’d be unlikely to find one for outsourced reception services for 10-100m turnover corporates
i find this post interesting because i had always assumed that PEq’ers (so to speak) looked primarily at backing strong management teams in above average companies, and that the market the company operated in was kind of a hygiene factor- ie the market would have to have very poor prospects to kill the deal.
Alex
14 Jul 09 at 11:06
Maybe it’s more the experience gained through trying to conduct market analysis than the estimates. Sure, if there’s no market, you don’t want to invest, but I actually think it can be a blessing in disguise not to find market estimates from firms like IDC, Gartner, etc. So, in your example of outsourced reception services, it may be best that I actually have to call up competitors, customers, etc to discuss the industry so I really know what I’m investing in.
You make a good point about “investing in management teams” and the question of market importance. PE firms love to talk about having the best managers, almost to a point that it’s now a throw-away line. I think firms are realising that even the best managers aren’t immune to economic downturn and market gyrations. I’ll make sure to write a post on my thoughts on this topic in the next few days.
The Private Equiteer
23 Jul 09 at 04:09
Thanks for the comment Alex.
Agreed that it's acceptable to “talk” about the broader potential market, but I worry about due diligence based on the broader market. The fact is, you should only be paying for what you're getting now, not for what could potentially be created if all of the planets align in perfect formation.
With millions of potential investees, I don't think it's prudent to be overly optimistic with market analysis, which really underpins your investment. With that said, I love to talk about far away possibilities and don't enjoy people whom are too pessimistic. But just as you aptly mentioned, I think the broader market is generally only okay to “talk” about; you're never going to regret making an investment because you weren't optimistic enough.
The Private Equiteer
11 Jan 10 at 01:47