Notes – Best Practices in Deal Flow Origination

These notes are from an article entitled “Where Are The Deals?” by David Teten. He also has resources on adding value to portfolio companies which are worth browsing. For notes on a related topic, check out the “Notes – Stanford Graduate School of Business Search Fund Primer” post.

• the median investor in private companies had to review 80 companies in order to close one transaction
• investments sourced through personal and professional networks have been shown to yield better results
• in order to train your relationships, it is important that you provide them with simple, clear investing criteria, not lengthy checklists; provide them a narrowly defined niche of interest (“Retail brands with $50M in annual revenues”)
• on average it can take 1-2 years between the first meeting with a target CEO sourced through a network and the close of the deal
• market mapping, identifying key macro and micro drivers of an industry and creating a database of all key companies; identify those with greatest growth potential or competitive white space
• specialization enhances deal origination through deeper knowledge base, ability to add value through enhanced network and likelihood of being top of mind to key deal sources
•  monitor target sector for cyclical opportunities and structure shifts; M&A creates orphan divisions and downturns cause strategy refocuses; 30-46% of PE returns over last 30 years driven by EBIT arbitrage (market timing)
• other valuable sources of deal flow:
  • regional surveys
  • “fastest growing company” lists
  • trade association membership lists
  • commercial vendors
    • Amadeus
    • Capital IQ
    • Dun & Bradstreet
    • Hoover’s
    • InfoUSA
    • Lexis-Nexis
    • Thomson-Reuters
    • OneSource
• set up alerts in a blog reader based on key words important to your target or industry focus
• “A large portion of my deal flow comes from people I have rejected in the past.” be kind to everyone, even those you don’t do a deal with
• consider having a dedicated, SEO-optimized website and blog for your acquisition fund/team that explains what you’re looking for, why, what you bring to the table, etc.; many VCs and most PE investors are not using basic internet marketing techniques (competitive advantage opportunity)
• Accel Partners and Khosla Ventures post detailed analyses of their target investment sectors; blogging and posting of internal analyses is the “VC freemium model”
• PE investing is a relationship business and the most important relationships are with LPs, entrepreneurs, executives and intermediaries which are relatively few in number
• blogging is the best tool for VC investing according to one experienced observer; helps investor gain information, credibility and relationships through improved visibility
• look for access to secondary interests through directly approaching funds (particularly distressed), markets for secondary interests (SecondMarket, NYPPEX, PORTAL Alliance) and approaching ibanks specializing in secondary interests (Cogent Partners, Probitas, Triago, UBS)
• service providers such as accountants, lawyers, etc., are typically not good sources of deal flow because they require too much education and often have a fiduciary responsibility to their client; on the other hand, connecting with service providers in a specialized domain that is being targeted can be a good source of insight
• trawl the Q&A portion of sites such as LinkedIn to identify domain experts for further outreach
• measure your deal origination efforts with activity measures, deal flow by source, pipeline analytics and industry benchmarking measures
• many professional services firms do not use a global CRM system such as Salesforce.com, Act, Saleslogix, Microsoft Access or Angelsoft (angel/VC network)
• Key data sources for CRM systems include employee networks (ContactNet Enterprise Relationship Management), business cards (Cardscan, IRIS, Neat, Presto), data from email and files (eGrabber, Gwabbit, Grab-Text, Broadlook), the “cloud” (LinkedIn, Spoke, Plaxo) and direct from target companies’ websites, media, etc.

Key attributes of top originators in order of importance

1. persistence (every no gets you closer to a yes)
2. personality (people do business with those they like)
3. business and financial judgment
4. adequate financial sophistication
5. seniority and appropriate title (decision-maker)
6. internal authority to get transaction executed
7. creativity

Important deal signals when identifying targets (utilize commercial databases, social media, data mining and targeted phone research to uncover)

• Status of the major equity owner
  • PE funds motivated to sell due to fully invested, raising next fund or current fund has aged beyond 5-7 years
  • Large corp raising cash by selling subsidiaries
  • Time limited tax incentives
  • Family in midst of succession battle
  • Death, disease and divorce (“three Ds”)
• Status of CEO
  • retirement
  • age
  • acknowledgement of limited competence
• Corporate performance
  • growth too rapid for self-funding
  • underperforming/distressed
• Industry/economic trends
  • industry consolidation
    • competitive pressure
    • seeing competitors liquidating equity for large gains
  • competitors raising capital; pressure to maintain parity
  • growth sector

Top considerations for deal intermediaries in directing deal flow

1. Possibility of future revenue
2. Integrity
3. Timely responses
4. “Fair” treatment of sellers
5. Experience with the industry or owner type
6. High certainty to close
7. Friendship
8. Feedback and referrals
9. Maintaining a single point of contact

Most valued aspects of acquiring companies by the acquired

1. Added operational value
2. No extra costs
3. Fair treatment of employees post-transaction
4. Brand
5. Long holding periods (no buy-to-flip)

Leading databases of institutional investors (use principles of SEO to optimize your profile here)

• Galante’s
• Grey House
• VentureXpert
• PE funds
  • Eurekahedge
  • Pitchbook
• VC funds
  • Angelsoft
  • CrunchBase
  • PWC MoneyTree
  • TheFunded
  • VentureDeal

Market Mapping steps

1. choose industries and geographies of initial interest
2. define your proprietary point of view
3. translate into investment theme (industries/geographies of interest)
4. list major players in target industry/geography
5. improve market map with feedback from industry contacts and investment targets
6. determine which activities offer the highest return and outsource the rest
7. identify areas of future growth
8. asses fit with your overall strategy
9. regularly update the market map with additional feedback and lessons

10 Simple Steps to Improve Your Origination

1. Analyze your network
2. Use market mapping to develop deep, proprietary insights about your target
3. Monitor target ecosystem for cyclical/structural opportunities
4. Align internal interests
5. Divide and conquer
6. Centralize data and become an information sponge
7. Develop a network with limited overlap
8. Take control of your virtual presence (marketing)
9. Join the in-person and virtual communities of your target market
10. Take a leadership role; find a way to stand out and attract others to you

Notes – Stanford Graduate School of Business Search Fund Primer

Notes on “A Primer On Search Funds” produced by the Stanford Graduate School of Business

“The Search Fund”

• Greater than 20% of search funds have not acquired a company
• Stages of the Search Fund model:
• Raise initial capital (2-6mos)
• Search for acquisition (1-30mos)
• Raise acquisition capital and close transaction (6mos)
• Operation and value creation (4-7+ years)
• Exit (6mos)
• SFs target industries not subject to rapid tech change, easy to understand, fragmented geographic or product markets, growing
• Highest quality deals are found outside broker network/open market due to lack of auction dynamics
• Research shows that partnerships are more likely to complete an acquisition and have a successful outcome than solo searchers (71% yielded positive return, 15 of top 20 performing funds were partnerships)
• Principals budget a salary of $80,000-120,000 per year w/ median amount raised per principal $300,000~
• Majority of the economic benefit of SF comes through principal’s earned equity; entrepreneur/partners receive 15-30% equity stake in acquired company in three tranches
• Investors typically receive preference over the SFer, ensuring investment is repaid, with return attached, before SFer receives equity value
• Individual IRR from 2003-2011 median was not meaningful, heavily skewed toward 75th percentile where median was 26% in 2011; 57% of individual IRRs were not meaningful in 2011; the median fund destroyed capital in 2009 (0.5x) and 2011 (0.8x); 58% in 2011 broke even or lost money
• Half of the funds that represent a total or partial loss were funds that did not acquire a company; biggest risk is in not acquiring a company at all
• Median acquisition multiples: 1.1x revenues; 5.1x EBITDA
• Median deal size, $8.5M

“Raising a Fund”

• Search fund capital should come from investors with the ability and willingness to participate in the acquisition round of capital raising

“Search Fund Economics”

• Search fund investors often participate at a stepped up rate of 150% of original investment in acquired company securities

“Setting Criteria and Evaluating Industries”

• Desirable characteristics for a target industry: fragmented, growing, sizable in terms of revenues and number of companies, straightforward operations, early in industry lifecycle, high number of companies in target size range
• Desirable characteristics for a target company: healthy and sustainable profit margins (>15% EBIT), competitive advantage, recurring revenue model, history of cash flow generation, motivated seller for non-business reasons, fits financial criteria ($10-30M in revs, >$1.5M EBITDA), multiple avenues for growth, solid middle management, available financing, reasonable valuation, realistic liquidity options in 3-6 years
• Key challenge is “know when to take the train” lest a SF never leaves the station waiting for the perfect opportunity
• Ideally, seller is ready to transition out of the business for retirement or personal circumstances or has something else they’d like to do professionally
• Experience shows it is better to pay full price for a good company than a “bargain” for a bad one
• Idea generation: SIC and NAICS codes, Yahoo! Finance, Thomson Financial industry listings, Inc. 5000 companies, public stock OTC and NASDAQ lists and even the Yellow Pages; generate a list of 75 potential industries to start
• Target industries buoyed by a mega-trend
• Can also target an industry in which the SFer has worked and possesses an established knowledge base and network
• Some focus on 2-3 “super priority” industry criteria (eg, recurring revenues, ability to scale, min # of potential targets, etc.)
• Objective is to pare down the industry target list to 5-10 most promising
• Basic industry analysis (Porter’s five forces, etc.) is then used to narrow from 10 to 3; SFers use public equity research and annual reports for market size, growth, margin benchmarks; also Capital IQ, Hoover’s, Dun & Bradstreet and One Source
• Industry insiders (business owners, trade association members, sales or business development professionals) and industry trade associations or affiliated ibanks and advisory firms are primary methods of research and often have general industry research or white papers available
• Next step is to create a thesis to codify accumulated knowledge and compare opportunities across common metric set in order to make go/no-go decision
• In order to become an industry insider, SFers typically attend tradeshows, meet with business owners, interview customers and suppliers and develop “River Guides”

“The Search”

• Median # of months spent searching, 19
• 54% spend less than 20 months searching, 25% spend 21-30 months, 21% spend 30+ months
• Track acquisition targets with CRM software such as Salesforce, Zoho, Sugar CRM
• Bring up financial criteria and valuation ranges as early as possible when speaking to potential acquisition targets to save everyone time
• A company that is too large or too small as an acquisition target may still be worth talking to for information
• You must immediately sound useful, credible or relevant to the owner; deep industry analysis should already have been performed at this stage
• Trade shows can be a critical source of deal flow
• If a particular owner is not willing to sell, ask if he knows others who are
• “River Guides” are typically compensated with a deal success fee, usually .5-1% of total deal size
• Boutique investment banks, accounting firms and legal practices specializing in the industry in question are also a good source of deals
• The business broker community itself is extremely large and fragmented; could be a good rollup target?
• Often, brokered deals are only shown if a private equity investor with committed capital has already passed on the deal, presenting an adverse selection problem
• Involve your financing sources (such as lenders and investors) early in the deal process to ensure their commitment and familiarity

“Evaluating Target Businesses”

• Principles of time management: clarify goals of each stage of evaluation and structure work to meet those goals; recognize that perfect information is an unrealistic goal; keep a list of prioritized items impacting the go/no-go decision
• Stages: first pass, valuation/LOI, comprehensive due diligence
• It is in the best interest of the SFer to tackle core business issues personally during due diligence as it is the best way to learn the details of the business being taken over
• Adding back the expenses of a failed product launch rewards the seller for a bad business decision; adding back growth expenses gives the seller the double benefit of capturing the growth without reflecting its true cost
• Due diligence may also uncover deductions to EBITDA or unrealized expenses that reduce the “normalized” level of earnings (undermarket rents, inadequate insurance coverage, costs to upgrade existing systems, etc.)

“Transitioning Ownership and Management”

• Create a detailed “Transition Services Agreement” with the seller, a legal contract where specific roles, responsibilities, defined time commitments and compensation are agreed prior to the transaction close
• The first 100 days should be dedicated to learning the business
• Businesses consist of people, and people need communication; great leaders are always great communicators
• “Don’t listen to complaints about your predecessor, this can lead to a swamp and you don’t want to be mired there.”
• The goal is to learn, not to make immediate changes
• Outwork everyone; be the first person in and the last to leave
• Many SFers insert themselves into the cash management process during the transition period by reviewing daily sales, invoices and receipts and signing every check/payment made by the company
• The company’s board should be a mix of deep operational experience, specific industry or business model experience and financial expertise
• The seeds of destruction for new senior leaders are often sown in the first 100 days

Fees, Firepower & Funds: The Incentives Faced By Private Equity

I know very little about the private equity world, mindset, incentive structure and investment strategy, but I am eager to understand it better. I found a recent post, “Too Much Is Never Enough” at the Epicurean Dealmaker blog, to be informative reading, assuming the author knows what he is talking about. Plus, it came chock full of Seven Samurai quotes, which is pretty awesome:

Tempting as it may be to imagine Steve Schwarzman and Leon Black dressed in top hat, tails, and duck bill masks whooping and hollering atop $10 billion mountains of gold coins in swimming pool vaults deep under Midtown Manhattan streets, private equity firms almost never get to hold the actual money nominally under their control for longer than it takes to keystroke a wire transfer into somebody else’s bank account. The multibillion dollar funds they raise with such fanfare in the press represent commitments by their limited partners to invest up to that amount in appropriate investments described and limited by the master fund agreement, not actual currency sitting in a bank account. When the financial sponsor finds and buys a company, it levies a capital call on its investors, and they are contractually obligated to deliver those funds in a timely fashion so the general partner can purchase the target. The trillion dollars which Mr. Sorkin so gleefully describes is not actual money gathering dust under the Carlyle Group’s mattress but rather a promise to invest that much by the pension funds, university endowments, and other institutional investors who employ it and its brethren to make money.

Second, there is the issue of how long financial sponsors actually get to call that money from investors, the key issue at hand but one which Mr. Sorkin skips rather lightly over in his haste to portend doom. For while most private equity firms raise investment funds with lives of a decade or more, by the same token most of them have significantly shorter actual investment periods. Usually, if the general partner is unable to find appropriate companies to buy or other investments to make within four to six years of the initial closing of the fund, the limited partners’ obligation to fund further capital calls goes away. More importantly, from the private equity firm’s perspective, the fund agreement dictates that it can no longer charge its full (2%) management fee on the full committed amount. In other words, if financial sponsor Dewey Trickem & Howe only spends $4 billion of its $10 billion DTH Rape and Pillage Fund XXIII by year six, it can no longer charge its limited partners $200 million per year in management fees. Instead, it can only dun them for 2% (or less) of the actual money invested, $4 billion, or a paltry $80 million. Given that DT&H has lots of expenses to pay, including luxurious Park Avenue office space, oodles of advisors and consultants, and legions of sharp-toothed Henry Kravis wannabes, you can just imagine how little they want to let that $6 billion of uncommitted capital (and, more importantly, $120 million of annual income) slip through their fingers.

Gross these management fees up across the multiple funds which large asset managers run in parallel (Fund I, fully invested and in harvest mode; Fund II, recently fully invested; and Fund III, recently raised and currently being invested), and you can see the 2% management fees which these firms charge add up to some serious revenue. Spread it out across multibillion dollar investment firms which employ a relatively paltry few hundred professionals, and you may understand that incentives to make investments which actually make money for limited partners get materially blurred by the incentive to gather assets.

Aswath Damodaran: What Is Private Equity All About?

NYU Stern corporate finance professor Aswath Damodaran has a good summary of the types of private equity investors that exist in the financial markets, how they add value through their corporate activism and what motivates them on his blog in “Private Equity: Hero or Villain?“:

Here is an indisputable fact. If you are a stockholder in a publicly traded company, the entry of a private equity investor into your stockholder ranks is good news, since stock prices go up substantially.

Overall, a useful post for anyone looking to understand the basics of private equity, just don’t pay too much attention to his naive suggestion that the political problem facing this country is potentially just “mismanaged” government.