The formulas, tricks and trade secrets of Private Equity

Porters 5 Forces

Sample Chapter

Maybe I’m not speaking for everyone when I say this, but I found many of the models and theories presented at university to be largely theoretical and not very practicable. CAPM comes to mind immediately, as do many of the monetary policy theories. However, on reflection, a few make honest sense. There’s some difference in Porters 5 Forces.

For example, I recently posted on the principal-agent problem and it’s salience in regard to public vs. private markets. It is a model that underpins the very existence of these markets; no complexity, few assumptions, and a concept of much clarity. I concede that it is hardly a solution to a common problem, but I think it goes quite far in supporting the concept of private equity.

Similarly, Porter’s 5 Forces model won’t give you the meaning of life, but it is an honest, simple, applicable and highly useful model for the private equity industry. Again, it won’t give any profound answers, but it will go a long way to understanding whether an industry is attractive. I say this because as private equity pros, we know there are many sources of value creation, but an attractive industry is always a salubrious start. Something to keep in mind though, is that the model is designed to analyse industries, not businesses, sectors or markets. Be diligent with your definition of an industry or see web resources for further guidance.

I’ll give a very brief description of each of the Porters 5 forces (see the image above for a pictorial representation):

  1. Substitutes: understand the threat of substitutes within the industry. A moderate to high threat will result in high price elasticity of demand because it will be easy for consumers to swap when prices move (if networking costs are low).
  2. Competitors: if barriers to entry are low and competitors can enter the market easily, then a business won’t enjoy economic profits for very long. Equally, it will be difficult to maintain a competitive advantage and the associated high margins.
  3. Competitive Rivalry: high levels of competition can turn industries into price wars, which doesn’t help anyone, including the consumer, if quality is affected. Rivalry is less intense when the fundamentals of the industry hinder it: think scale economies, differentiation and diversity.
  4. Customers: if customers have high bargaining power, industry players will have a low likelihood of securing an economic profit. The customers will use this power to shift value to themselves. This power will also lead to higher price elasticity of demand.
  5. Suppliers: similar to customer power, high supplier power can lead to a loss of economic profit and lower margins. Power on either side of an industry player typically leads to a shift of value along the value chain. The ideal industry to be in is one at the most profitable point in the value chain.

Based on each of these porters 5 forces, an industry receives an arbitrary rating. For example, a 5 star industry is one that is attractive and one that receives a positive rating for each force. A 0 star industry is unattractive for similar reasons. However, this doesn’t necessarily mean that a particular underlying business is given the same porters 5 forces rating; great managers use differentiation to stand out in any industry; their job is just easier (and success is more likely) in attractive industries.

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