Is Your Reputation Hurting Your IRR?

Sometimes it just doesn’t make sense.

You go to conferences. You source hundreds of deals. You do everything a good private equity group should do. But somehow it just doesn’t feel like you’re getting the returns you should be getting. There’s an advantage that the best firms have, and it’s an advantage that you could be using as well.

In the market one major thing separates all firms: reputation. Firms with the best reputations see more deals, close on better companies and get better terms from banks.

Think about the compound effect of those advantages.

The quality of the deals you see determines the quality of the companies you can close. If your reputation allows you to close a higher quality segment of the better deal flow, and you get better terms from the bank, the advantages quickly compound into a much stronger internal rate of return (IRR). It’s no wonder then that “buyouts sponsored by high reputation private equity firms are less likely to experience financial distress during the 5 years after the transaction.¹” So how do you develop a solid reputation in private equity?

To better understand, we spoke with Hanson Li of the Hina Group, a China focused merchant bank, who sits on both sides of the table in a country where reputation is paramount. He spoke to us about three major pieces that can help you enhance your firm reputation.

Focus and Be Known in a Single Sector

In previous articles we’ve talked about the importance of specialization; this was the first thing on Li’s mind. He described how to evaluate a potential counterparty, saying that one of the most important criteria “is how deep they are. Their depth of expertise in a single sector gives them quite a bit more credibility. It makes me more likely to do a deal with them if I know they’re very good at one thing in particular.”

The other significant value in specializing is that your firm becomes well known by the interconnected circle of banks, advisors and other service providers in a single sector. By hearing your name repeatedly, other firms become more familiar with you, and in turn, more likely to work with you. The more related your business interests are, the easier it becomes for a bank or advisor to evaluate and trust your firm’s next investment.

Li told me that the Hina Group is known for working with growth companies in China, a reputation that comes directly from the founder, Dr. Hong Chen. As Li said, “[Dr. Chen] was the first mainland Chinese person to take a company public in the US, which gave him a tremendous reputation here in the US and also back in China. His reputation is very strong as both a CEO and an entrepreneur; even now, while he’s been a financier for the last 8 years, his reputation [as an executive] has allowed our firm to create a real market presence as a group that drives value and growth in companies.”

Develop Strong Informal Networks

Li told me that the second way that he evaluates potential counterparties “is through my informal network. Who do they know? What does my network say about them? It’s an implied reputation based on the circles of people they interact with.“

While attending general deal conferences like ACG Intergrowth is great for reconnecting with colleagues, it can be a tough way to build a network around a particular industry or sub-sector. Often, more specialized events can be a good opportunity to raise your profile among a specific set of deal professionals and business owners. As a recent paper discussed, “it is reasonable to argue that frequent interactions among firms…and investors are a necessary condition for business transactions and a viable system of alternative institutions.²”

Another way to strengthen an informal network is to leverage someone else’s. As Li told me, the Hina Group does this regularly for other groups entering China. “Often we’ll work with foreign groups who are trying to make investments in China. We offer them the ability to understand the people they’re working with and we are often able to check on deals through back channels that they don’t have access to. It’s built up over time.”

Consistency is Key

From Li’s perspective, reputation ultimately comes down to being consistent in your actions. He explained, “That’s why we have 50 people on the ground in China. You have to be in the flow of the deals and the business to understand who is worth working with. We know all the PE players and a lot of the companies in China. Over the last 8 years we’ve developed a really deep level of proprietary knowledge that helps us make those decisions.”

Recent research backs up his assertions. A recent paper published in The Review of Financial Studies concluded: “an LBO firm that is one standard deviation higher in bank relationship and cross-selling potential will have… a potential increase in equity returns of 4 percentage points. These results suggest a new way in which LBO firms enhance value – through their repeated interactions with banks.³”

While everyone talks about building a reputation, many don’t take seriously the impact it can have on real dollar returns. Those who do will reap the rewards.

¹ https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1032781
² https://fic.wharton.upenn.edu/fic/papers/12/12-05.pdf
³ https://rfs.oxfordjournals.org/content/24/7/2462.abstract