Calculate Market Size in Private Equity

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 calculate market size.

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 equity firms get carried away when calculating market size 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 embellish a little when we calculate market size. 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 calculating market size 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 when you calculate market size 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 any calculation of market size 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 calculation to the available market.