Limit the downside but have upside exposure.

I’m naturally a positive person. Optimistic about the future, about what can be done and what value I can add. For me it’s a positive skill that I’ve used to pick myself up from setbacks and to keep going forward. Mixed in with resilience, optimism about the future has generally and on balance worked out well for me.

However, there have been times where this skill hasn’t worked in my favour. And studying Private Equity Investors approaches and methodologies highlighted one key area they focus on that I, at times, overlook. They limit the downside and have upside exposure – lets break this down in a bit more detail.

Limit the downside

Downside refers to the potential losses that could occur if an investment doesn’t turn out as expected. These can range from losing 100% of the investment or coming out even – getting back what you put in. Although 100% losses are usually the case when an investment goes bankrupt or goes into liquidation, as an equity holder.

The saying “limit the downside”, simply looks to kerb the quantum of losses. This could be done by staggering investments over time and investing in smaller instalment only once assumptions are validated or performance is achieved. This is a risk reduction technique.

Private Equity investors also invest in a variety of instruments, for instance, they could invest into a company through a convertible note. This is an asset that offers the protections of debt but can be converted into equity later. The reason for this is that debt, in the event of a bankruptcy ranks higher than equity. Simply put, if the businesses goes into liquidation, the assets of the business are sold off and debt holders are usually repaid first. Then if there are funds still available, they are shared by equity holders. As an example, debt holders could receive 10c on the dollar. Meaning they get back 10% of the value of their investment – not great but its at least something.

Upside exposure

Private Equity investors would not convert from debt to equity when the business is not achieving its targets, it would only convert into equity when the businesses prospects are looking good.

When the business is achieving and performing as expected, Private Equity investors would convert (change) their debt into equity of the company. This would allow them upside exposure. The share price could explore and rise rapidly giving the investors exposure to ‘super’ profits.

I’ve struggled to see how things can go badly and naturally focussed on how they are expected to go well. I’ve learnt to ask myself, “what could go wrong” or “if this went the opposite way to how I expect it, how bad can it get for me”. The lesson I’ve learnt from Private Equity investors is to always manage and limit the downside but have control to enjoy the upside.

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