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Private equity and the real world

For the purposes of this article, I define a risk environment as one where outcomes are known: roulette is risky; all outcomes are computable. However, business in the real world is not only risky, but also uncertain; outcomes are unknown and their probability is not computable.

Private equity tends to look at the past as if it was the product of a risk environment; investors become uncomfortable when the present fails to conform. The reality is that the past was a product of uncertainty and only looks like the product of a risk environment with the benefit of hindsight. In the same way, the present and the future will be products of uncertainty. Risk and uncertainty are not the same thing.

Entrepreneurs have an instinctive understanding of how to thrive in an uncertain world. To an entrepreneur, business develops largely as a result of a series of happy accidents. Unpredictable events generate opportunities to capitalise on short periods of temporary advantage. Business is trial and error, lots of small risks. Monetising arbitrage then moving on.

Of course, where all this comes to a head is around the fully integrated forecast and business plan. For the private equity investor, when a number makes it into an Excel spreadsheet it becomes certain – the product of a predictable risk environment. For the entrepreneur, it is one of a range of possible outcomes, subject to the assumptions that got it there in the first place. The forecast is a useful measure, a way of allocating resources and understanding cash flows, especially if things change as they always do out here in the real world.

Private equity tends to look at the past as if it was the product of a risk environment; investors become uncomfortable when the present fails to conform

A private equity deal takes a little time to complete; during those long months of due diligence, the business will be working to a forecast and the real world will have a tendency to intervene. For instance, the unseasonably warm weather in October has reduced the sales of knitwear in clothing retailers. As you read this article a private equity investor is seeing a potential investee fail to hit one of those “sacred numbers in a box” and fears something is fundamentally wrong with the business model. In all likelihood, they pull out or drag the due diligence on longer – the beatings will continue until the world falls into place with the forecast.

So how can we square the entrepreneur’s instinctive understanding of uncertainty with the private equity investor’s linear approach to business?

Firstly, we have to understand that each is a product of his or her environment. Entrepreneurs have real skin in the game; mistakes are costly as seen in their high mortality rates and those who survive have evolved an ability to benefit from uncertainty. Private equity investors on the other hand are, to a large extent, the product of the education system, conformists who made it all the way through those O levels, A levels, top universities, Big Four accountancy training contracts, boxes ticked, exams passed, all predictable, safe and sound without much exposure to the real world of business.

What this means is that the entrepreneur needs to realise the private equity investor thinks completely differently; he’s uncomfortable with surprises. In short, don’t miss your numbers during due diligence.

Private equity investors on the other hand? Ironically, a little more education wouldn’t hurt. A course in complexity theory or reading some Nassim Taleb might help in understanding that it’s the entrepreneur who has the maths right, even though it’s usually instinctive. Instinct is a subtle tool where intellect can be a blunt instrument.