Using the Principles of Sabermetrics in Private Equity
According to the Society for American Baseball Research, “Sabermetrics is the search for objective knowledge about baseball through analysis of the statistical record.”
In Moneyball, the utilization of sabermetrics to create a winning baseball team - in this case, the Oakland A's - seemed like a no-brainer. What manager or owner wouldn't want to build a successful team on the cheap by utilizing informed-statistics to create a detailed view of the minutiae of the sport and individual players? Not only did sabermetrics prove effective, but it showed that relying solely on numbers to create something successful is only one small part of the equation.
In other words, don't just look at batting averages or RBIs to derive the value of a player. Look deeper.
Taking that same thinking to Private Equity requires looking at atypical data to assess the viability of business operations. This same empirical analysis of businesses has been adopted by hedge fund managers and VC firms but has yet to see wide-scale use in private equity. As Kevin Wang writes in What Can Sabermetrics Teach Us About Measuring Business Success:
Just as batting average may not provide a full picture of a baseball player’s success, your business’s key performance indicators might not provide a full picture of your company’s success either.
The number of hours and resources spent on a project may not reflect the value of new efficiencies that your team members identified in their work and research that will improve future projects.
Your company’s statistics about acquiring new customers may not reflect the solid relationships that were established that will fuel a partnership between your team and your customers for years to come.
Your employee demographics may not be able to measure willingness of all team members to constantly seek improvements and be open to change—a crucial element of true success.
Your growth in revenue won’t reflect the value of cohesiveness and collaboration among your service offerings or departments that contributed to new innovation.
Your business’s philanthropic activity is often measured in hours, which often fails to capture the true impact that is being felt throughout the community because of your company’s influence.
For instance, a company's EBITDA may look fantastic. They may have multiple returns year-over-year. But if you're overlooking objective evidence such as low employee morale, poor public perception, or mediocre environmental initiatives, you may have an investment that looks good on paper but is at risk of crumbling from the inside.
Once you've established key metrics, the next logical step is utilizing machine learning to study these data points to predict the success of an investment. A machine learning model can be built using data sets from past investment wins, research of "unicorns," and, of course, business failures. This model will give probability estimates for the outcome of specific businesses or the performance of teams and business units within an organization. These estimates are increasingly accurate when applied to a large number of events over the long term. The outcomes (success/failure) are treated as having a binomial distribution.
Additionally, predictions can be made using a logistic regression model with explanatory variables including team productivity, supply chain efficiencies, deadline failures, and leadership changes.
The advantages of using sabermetrics in Private Equity is that the acquisitions, for the most part, already have the data we're looking for. Venture capital and hedge funds need to rely on information from competitors or historical trends. But PE can look at the company itself, the data wake it's given off, and develop highly-informed models to determine an investment's viability.
In closing, it's necessary for you, your LPs, and your team to understand, forecast, and derive key findings from the straight numbers of a particular investment. But it's equally beneficial to look at "outside-the-box" metrics that can also inform the health and potential success of a company.
