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Reviewing Your Portfolio Strategy in a Bear Market

by Eduardo Rios January 26, 2023
Office Strategy review

The US public markets had dropped to a two-year low, and Private Equity’s deal-making activity had lulled to 2020 levels by the end of 2022. 

This was happening whilst PE returns came down from their heights in Q1 2021. Fears of inflation and the consecutive hikes in interest rates brought about by the Central Banks’ actions to fight it has dominated this environment. Among these significant changes, the private and public tech sector has seen an important drop in valuations. 

In this new economic phase, the market should eventually accept the drop in equity value, at least by historical standards[1]. And this lower-value environment will make some relatively “cheap” companies available for acquisition. Because of this, it's a great time to think about your long term vs short term investment plan.

But, as the bear market rally of the summer of 2022 showed, a pure price-driven approach to acquisition can result in a relatively rapid loss of equity. For instance, the trackers purchased at the bottom of the bear rally of 2022 (17 of June) would have risen c.20% in the middle of August and would have still lost c.-3% relative to the bottom of the bear rally by the end of 2022. 

But how can you define your portfolio strategy, build investment goals, and why is essential to first conduct a review?

How to Conduct a Portfolio Review

Firstly, it's good practice to consider your portfolio performance and financial situation. In this economic situation, firms could benefit from a strategic reconsideration of their inorganic growth strategy. In fact, this should already be part of your portfolio management process.

The first step in a redefinition of a firm’s acquisition strategy should be a competitive performance review. In the case of a PE/VC fund, this takes the form of a portfolio review. This allows you to benchmark against competitors, so you are prepared to make the most of exit opportunities and low-valued potential acquisition targets that may be available in this bear market.

We will be exploring the three steps that lead to an inorganic growth strategy redefinition and how this can then be translated into a multi-step acquisition strategy, normally referred to as programmatic M&A*. 

1) Risk evaluation 

2) Competitive review

3) Strategy assessment (second-gap analysis) 

1. Evaluating Risks in Your Portfolio.

The evaluation of a portfolio helps prioritise the companies in which a fund has equity and how strategic these are based on short and long-term trends and a financial scoring matrix.

The first stage in this process is to assess the key growth trends in the sector via expert interviews and an analysis of secondary sources. This exercise can be combined with a market sizing analysis and an estimation of growth by industry. It showcases the specific technologies or sub-sectors that will generate the largest revenue or have the strongest growth. As summarised by Tommaso Palermo in Risk and performance management: two sides of the same coin (p6), 

Several instruments can become part of the risk management process…risk maps and registers; SWOT and PESTLE analysis, statistical modelling, one-to-one interviews and workshops, risk committees.

This framework then allows for a double layer of scoring of companies. 

>The first scoring establishes which companies have the most strategic positioning based on the market trends. 

>The second scoring shows which companies have the best financial performance and how this compares with other players in the market.

By the end of this first stage, a fund can say the key growth trends and the key risks to their portfolio companies in a specific industry. And they can clearly determine which companies have the best financial positioning and are in the most promising growth sectors within an industry. 

On the contrary, it can show which companies are the ones that will require the most investment to become competitive in a given industry. This type of analysis is highly contingent on how long the company has been in a fund’s portfolio and will create a priority based on the maturity of the investment.

Your portfolio review should consider your past financial goals and their success or lack of. You may notice poor asset allocation, projects that weren't inspected from their level of risk or concerning tax efficiency.

2. Competitive Review.

Once the strategic performance of the portfolio has been established through analysing capacity by industry, capacity by company, financial performance, key growth trends and main risks, you can then use this framework to evaluate other funds’ competitive positioning.

For example, you can use models like Porter’s Five Forces, a competitive opportunity matrix (as shown below), or other models. 

In the second stage of the portfolio review, the fund can evaluate its key competitors (PE/VC backed or not) and who could be the key acquirers for their portfolio companies. This competitive review allows you to benchmark companies against key players in the industry and portfolios in terms of their aggregated capacity.

At the end of this process, a fund can evaluate which companies are the best placed for an exit strategy and which companies still need to build on their capacity in order to become competitive in the space. 

3. Gap Analysis and Etching of a Stepped Investment Strategy.

The last step is to help funds combine the risk/performance framework and the competitive review process to assess key investment strategies and the need for organic development** that can make sense in any given scenario.

Competitive opportunity matrix

Step 1. Establishing financial and operational performance:

Firstly, the fund can evaluate its key competitors (PE/VC backed or not) and who could be the key acquirers for their portfolio companies. This competitive review allows you to benchmark companies against key players in the industry and portfolios in terms of their aggregated capacity.

This first gap analysis helps identify the biggest changes needed in the current strategy, including pushing for a more aggressive roll-up approach in the space or, on the contrary, the need for starting to envision a series of exits of non-core companies in the portfolio. 

This is particularly important for companies that have large market shares in industries that might become more scrutinised by market authorities[2]. 

Step 2. Defining competitive risk: 

Once the strategy has been assessed, the second step is to evaluate which companies have the widest capacity gap compared to their competitors. 

The second gap analysis can unveil the parts of the portfolio with the widest competitive risk and which would benefit from a divestment strategy or, on the contrary, further consolidation.

The aggregation of these two gap analyses (Financial and capacity performance and competitive risks) results in an investment strategy that suggests holding onto companies with the most strategic capacities and the lowest competitive risk. 

Step 3. Setting the competitive opportunity matrix: 

This first group (high-performance, low competitive risk) should gain in value in the mid-term and are perhaps the best firms to hold on to in a bear market. 

Companies with the lowest capacity and the most exposure to risk are worth considering for a - as rapid as possible - exit strategy. The framework can help evaluate selling companies with a good capacity and a high competitive risk as they will be the ones that can potentially have the most difficult performance, and finally, bolster companies with low performance but low risk as they can generate the widest appreciation.

Final Thoughts on a Portfolio Review 

This three-step approach to evaluating your portfolio helps funds navigate the current uncertain environment and can be an important part of your portfolio management processes. It also helps you prioritise urgent strategic transformations and justify holding onto assets that can be expected to appreciate the most when the same asset class grows in value - resulting in a higher return.

Assets class will most likely appreciate and depreciate together. Therefore a dynamic analysis of the intra-company capacity problems and the comparison with close competitors gives a way of understanding which part of the portfolio is more likely to appreciate and which parts of the portfolio are going to concentrate competition on an aggregate basis.

Times of change are good moments not to follow the trendline but rather seek the growth niches and trends, and this three-step approach is a good way to locate these areas based on your specific portfolios. It's always important to consider your investing strategies both in and out of the industry context.

In the next article for this series, we will focus on how you can translate this strategic portfolio assessment into a multi-layered and potentially multi-year investment strategy and a potential methodology for generating actionable information on your key markets.

[1] https://www.gmo.com/americas/research-library/entering-the-superbubbles-final-act/

*We will go deeper on this topic in the next article of this series, a practical strategy for programmatic M&A.

**This series focuses on inorganic growth strategies. If you are interested in organisational restructuring, please go to this article.

​Eduardo joined Freshminds in 2018 to work within the managed projects side of the business. He has experience in large-scale projects (generating over $100M in revenue) helping industry-leading clients find opportunities for partnerships and M&A in Finance and Tech.

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