The Basics of Deal Flow and Selection for Private Equity Fundraising
Institutional investors have certain basic expectations for a private equity firm, including consistent upper quartile performance, low volatility, and strong leadership. In addition, investors want to see a well-defined strategy for investment that produces demonstrable results and, moreover, differentiates the firm from others in the same market or sector.
To attract investors, firms need to have a clear competitive advantage within their particular niche. This advantage often derives from the firm’s unique processes, especially in relation to how deals are sourced and ultimately selected. After all, the success of a private equity firm largely depends on its ability to identify and close on excellent deals. Clarifying deal flow and selection processes can help firms take a more systematic approach to investment while also attracting investors to a fund.
Key Points for Successful Private Equity Deal Flow
The approach to deal flow changes depending on the market in which a fund invests. At the small end of the middle market, deal origination is driven by relationship-building. Many of the best deals in this market come through smaller investment banks and brokers that do not always have brand-name reputations. Because of this, the private equity firms that get access to these deals have good relationships with the banks and brokers. Naturally, a firm’s overall reputation also has a significant impact on which deals it can access. This reputation depends heavily on how many deals a firm completes from the Letter of Intent to closing. Banks and brokers will not waste their time if they believe a deal has only a poor chance of going through after the firm expresses clear interest.
By and large, investors have grown wary of the term “proprietary deal flow.” Instead of saying that a firm has a proprietary flow, it’s more impactful to offer deep insights into their process. Firms should focus on how their individualized approaches create advantages, whether that means securing lower purchase price multiples or signing deals with higher-quality companies. Ideally, a firm would be able to demonstrate both these advantages. Firms should have a clear, systematized approach to generating deal flow. Moreover, this system should include clear deal criteria, communication channels, and calling programs. Depending on the focus of the firm, it can be necessary to show how buyer brokers can be engaged to provide a deeper entry point to certain industry segments.
Currently, the industry views dedicated deal sourcing personnel as a best practice for finding potential deals. Potential investors will want to see metrics such as deals reviewed, bids submitted, companies visited, Letters of Intent submitted and signed, and deals completed. This information can quickly demonstrate the quality of a firm’s deal sourcing process and hopefully show progress over the years.
Best Practices in Private Equity Deal Selection
Obviously, deal selection is an extremely important process for private equity firms as it determines their overall success and future viability. Within the industry, it is accepted that deal criteria should be extremely specific-so specific that the criteria become part of the defining characteristics of a firm (i.e., we only buy companies where there is at least 85% recurring revenue).
A firm’s deal selection criteria may evolve over time, especially as the firm learns lessons from problematic deals and identifies the reasons why other deals were successful. Generally, deal criteria should be quite granular with hard thresholds in terms of the target company’s key metrics, including sales growth, EBITDA margins, customer concentration, recurring sales, and competitive positioning. Firms should also consider the company’s defensible products or services, growth potential, and operational improvements.
By using highly specific criteria, firms can become more disciplined and comprehensive in their investment review process. This reassures investors. Still, the most important criteria for any firm to consider is the quality of a company’s management team. Third-party management assessments remain a tried-and-true way to gain insight into management teams and their ability to execute on the terms of a deal. These assessments are now considered a best practice.
Many small-end middle-market firms have also adopted risk management matrices that can help quantify risk for a potential investment. This matrix considers risks associated with commoditization, management, market expansion, and competition. Other risks that may be considered relate to intellectual property, operations, and regulations, not to mention any unique issues specific to the company.
Typically, risks are quantified (for example, on a scale of 1-best to 5-worst) and then plugged into the matrix; if the result exceeds the pre-determined threshold, the risk is considered too high. Involving operating partners in risk assessment processes is good practice, especially since these operators will be able to point to unseen risks that have not yet been considered by the financially oriented deal team. The quality of the operating systems is key, along with the ease or difficulty of upgrading them to the firm’s standards.
Originally published at https://charlesmckennarial.com on December 18, 2020.