Given the current economic and regulatory climate, where banks have rapidly scaled back on their lending to SMEs, it is not surprising that growing companies are looking to other sources of finance.

It is not unusual for us to receive several hundred new business investment proposals every month, and that is on top of the ones that we source ourselves, so we have to be absolutely rigorous when it comes to our due diligence.

Our investors rely on us to make good decisions with their money, so what does a private equity firm look for when deciding whether or not to invest in a business?

Planning Ahead

One of the key issues that I face is having a management team that understands that they are part of a journey as, ultimately, private equity companies are judged by investors on the quality of their exits.

Therefore, the companies that we invest in have to bear in mind that we need to have an exit strategy and that starts right from the moment we have our first conversation.

It may sound strange thinking about an exit at the point when you are looking to invest in a business, but private equity investments are all about having a plan in place from the start, and then sticking to it.

At ISIS, we describe this as making the investment case for the next owner. Ultimately, when it comes to having the discussion with a private equity house about an exit strategy, there are generally three broad routes that can be taken: an initial public offering (IPO) on the stock market, a sale to a trade buyer or a sale to another private equity-backed entity.

Right now, the IPO option is, for most private equity firms, a distant third on this list as the turmoil in the equity markets means that getting a fair valuation for a business is an increasingly complex task.

The trade sale or a sale to another private equity-backed entity (or a secondary buy-out as it is known in the industry) are the two routes that the majority of private equity companies favour.

Horses for Courses

As it happens, at ISIS, of the 12 businesses that we have exited over the past 18 months, ten have been to trade buyers. However, the secondary market remains a viable option for a number of PE houses and for some businesses, such as shoe company Jimmy Choo, cleaning contractor PHS and shipping firm ISS, which have been owned by a number of different private equity-backed entities over recent years.

Companies whom we speak to about investment are just as keen to hear about our longer-term plans, and any discussion regarding a possible exit strategy flows naturally from this.

Moreover, we are looking for companies with robust business models and those that have the potential to be doing great things five years from now. So, while the economy is in the doldrums today, one thing we do not do is assume that it will stay that way indefinitely.

Flexible Friends

What should entrepreneurs do when meeting with potential private equity investors? Well, one of the first things they should consider is just how flexible they are when it comes to change.

Firms look for teams who are able to react to change and who are outwardly focused so, before the investment of capital, time needs to be invested in order for all parties to really know a business. It’s more than typical due diligence – it’s about understanding the culture, the market drivers and the personal drivers for success, as well as gaining a deep understanding of the entire fabric of a business.

As a private equity firm, we are typically looking for businesses that are capable of doubling in size over a five-year period, which sounds like a very tough call in today’s markets. What companies therefore need is a compelling service or product proposition to enable them to stand out from the crowd.

Growth can also come from diversifying away from the domestic market. While our export market is suffering from the Eurozone crisis, the weakness in the pound means that there are opportunities further afield such as markets in Asia, Australia, South America and Russia.

A lot of us also forget the US, and while it is not faring very well at the moment, it is still a huge market to crack, with significant opportunities.

While we carefully examine the market opportunity, we also look at the management team before we invest. What we look for is a management team that we can build upon and where the people understand that they are going to be embarking on a journey where we are just a part of a bigger story.

Wol Kolade is managing partner of ISIS Equity Partners, having joined in 1993. His role encompasses overall responsibility for the strategic development of ISIS and active involvement in investments. He was chairman of the BVCA in 2007/08, is a governor of the London School of Economics and Political Science, and is a trustee of the Guy’s and St Thomas’ Charity.