Would you invest in a company that only sold to 1 out of 80 leads? Or a company that typically took one year and 3 professionals just to close a single client? (See presentation at end of post).
If you’ve invested in a private equity firm, you’ve already made that investment. According to data from Teten Advisors, the median investor in private companies reviews over 80 opportunities in order to make 1 investment. The median private equity fund required 3.1 investment team members to close one transaction in one year.
By the standards of most traditional sales processes, private equity origination is a very inefficient and labour-intensive process…despite the fact that an effective deal origination process is fundamental to successful investing. We’re particularly surprised by this, because private equity funds who employ a proactive origination strategy have consistently higher returns, driven by both greater quantity and higher relevance of incoming investment opportunities.
We recently completed the first-ever study of how private equity and venture capital funds originate new investments, published in full in the Winter 2010 issue of the Journal of Private Equity.
View more presentations from David Teten. Out of 5,923 investment professionals in our dataset, 916 (15.5%) were focused primarily on origination and marketing. This is a significant increase over the percentage a decade ago. According to a recent Parthenon Group study, 55% of surveyed private equity funds plan to change their origination processes over the next 3 years — a higher percentage than fundraising, portfolio management, or any other fund process. One of the implications of this: more and more funds are hiring dedicated origination professionals.
Castle Harlan, a $3.2b PE fund, completed an internal study in 2009 of the sources and returns of all their completed transactions (68 deals, 38 exited). The relevant deal team rated the importance of seven proprietary strategies to winning each deal, on a scale of 0-10 (10=maximum). For example, “finder” and “industry expertise” were two of the strategies. (“Finder” was typically scored as a binary, with either a 0 for no finder involved or a 10 for a finder playing a key role in sourcing the transaction.)
Howard D. Morgan, Co-President, Castle Harlan reported that the most proprietary deals (defined as those with scores of 31 or more, out of a maximum of 70) had a somewhat higher return than non-proprietary deals, while at the same time the firm tended to pay on average a premium for these proprietary deals. This implies that these companies were higher quality than non-proprietary deals; Castle Harlan perceived a lower uncertainty risk; and/or the fund was able to add more value to these transactions after a transaction closed.
Many of these sellers probably ran a limited auction, and by definition Castle Harlan won the auction. In any such situation, an investor doesn’t know if it is the smartest person in the room who is justified in paying a higher price…or if it suffered the ‘winner’s curse’ of paying above the real value. By having a proprietary angle, Castle Harlan increased the odds of being the smartest person in the room, not just the highest bidder.
By contrast, deals characterised as being sourced through external finders of any kind were associated with lower entry multiples, but also relatively less attractive realised outcomes. (Only 9 investments had a “Finder” score of 5 or more, out of the maximum possible of 10.) Deals sourced through affiliated investors; through relationships with current management; and/or through relationships with non-incumbent management were associated with slightly higher entry multiples, but also better outcomes.
Based on our study, we have identified five recommendations to improve the volume and relevance of dealflow.
- Build a specialised outbound origination program. Growth investors with dedicated, large-scale sourcing teams are almost all top-quartile performers across stage, vintage, and sector. The largest practitioners of these programs – including Battery Ventures, Great Hill Partners, Insight Venture Partners, Platinum Equity, Summit Partners, TA Associates, and TCV — typically have between 0.75 and 1.25 dedicated deal sourcing professionals for every generalist investment professional. Summit Partners and TA Associates have leveraged their origination programs to move into later stage buyouts. Middle market private equity firms such as the Riverside Company have developed a broad network of 24 senior, focused deal originators to produce top quartile results in 8 of their last 9 funds#. Other private equity firms have created a formal advisor network to augment their in-house origination teams, including 3i’s Business Leaders Network and Goldman Sachs Special Situations Group’s Chambers Street Executive Network.
- Create opportunities, instead of waiting for opportunities to appear. A number of the funds we studied use an origination approach that allows them to proactively co-create companies or opportunities. Frontenac Company uses a “CEO1st” strategy, partnering with “deal executives” to source investments in these executives’ focus industries.
- Use deal signals to look for targets which are both attractive investments and are likely to welcome an outside investor. In order to filter the universe of companies, some investors specifically reach out to companies flashing relevant “deal signals”. These investors are exploiting the wealth of information about private companies available online, increasingly leaked via social media. For example, an increase in Internet traffic is usually a sign of customer traction. A family-run company that hires an outside manager is flashing a signal that the firm may welcome an outside investor.
- Leverage social media. Historically, institutional investors kept their investing strategies very discreet. However, today about 10-15% of the 1,000 active venture capitalists blog, according to Jeff Bussgang, General Partner, Flybridge Capital Partners. These investors have found that openly discussing their investment theses increases their perceived expertise and trustworthiness, and thus generates dealflow. Although private equity funds have been slow to take up social media, some have been more aggressive. For example, HealthPoint Capital, a $750m fund, has made their blog a destination for M&A/investing information in the musculoskeletal sector — specifically orthopedics and dental. As the millennials reach decision-making roles in companies, an increasing number of senior executives and investors actively participate in gated online communities. An example is the International Executives Resource Group (IERGOnline.com), an online community only open to executives who were C-level (CEO, COO, etc.) or reported to a C-level executive, and earned a minimum of $200,000. A number of the members work in or advise private equity funds and use the IERG to stay top of mind with their peers. Many investors reported that they used Facebook, LinkedIn, and various email lists informally to keep in touch with their professional and personal networks. These can have direct business impact.
- Install an appropriate CRM tool. A surprisingly high number of funds do not have a formal CRM system. EquityTouch found in a 2009 survey of 61 private equity funds that 37% were using no formal CRM application; instead, they were typically using only Microsoft Outlook and Excel. Tim Lasonde, CTO, Equitytouch, observed, “What we are finding in the market is that the paradigm shift to the web 2.0 and collaboration mentality is hitting the alternative asset community last (slower).” Most funds reported that a formal CRM system (with enforced compliance) could be valuable, although implementing it often created political opposition. We asked one partner why he reported that he spent about an hour per day keeping his CRM system current. He said, “Because my boss said that I won’t get paid if I don’t.” The challenge with CRM tools seems to be getting adoption and customizability. While Salesforce.com and others have made inroads selling to private equity firms, their horizontal offerings and immense amount of general functionality are often over-engineered for the needs of private equity firms. Perhaps even more important, the deal business has been one of the most relationship-intensive industries historically. When deal professionals are asked to upload all those relationships for use by the entire firm, it can run counter to the culture of the individual producer nature of the deal business.
More data from this research project is posted at http://www.dealorigination.com.
David Teten is based in New York, NY. He is CEO of Navon Partners, a startup building a proprietary
technology platform to source transactions for private equity funds. The firm’s approach is modelled on
the algorithmic, data-driven process used by quantitative hedge funds. He formerly was Founder and
CEO of Evalueserve Circle of Experts, and is Chairman of Harvard Business School Angels of New York. He has started 3 companies, sold 2, and is a former Bear Stearns investment banker and Harvard MBA.
Chris Farmer is a Venture Partner with General Catalyst Partners, a leading venture capital fund based in Cambridge, MA. He is also Founder & Chairman of Ignition Search Partners, a leading boutique executive search and talent advisory firm based in San Francisco, CA.
We thank Yujin Chung (Andreessen Horowitz) and Neha Kumar (Anklesaria Group) for their invaluable help in supporting our analytics; David Teten’s former colleagues at Evalueserve for their initial help in creating our database; and our interns Dan Clark, Nitin Gupta, and Nikhil Iyer.