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
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Getting More Out Of Venture Capital

In “We Have Met The Enemy, And He Is Us” (PDF), the Kauffman Foundation gets radically honest about the world of institutional venture capital investing and their own experiences with the asset class:

Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years.

Specifically, they found that:

  • The average VC fund fails to return investor capital after fees.
  • Many VC funds last longer than ten years—up to fifteen years or more. We have eight VC funds in our portfolio that are more than fifteen years old.
  • Investors are afraid to contest GP terms for fear of “rocking the boat” with General Partners who use scarcity and limited access as marketing strategies.
  • The typical GP commits only 1 percent of partner dollars to a new fund while LPs commit 99 percent. These economics insulate GPs from personal income effects of poor fund returns and encourages them to focus on generating short-term, high IRRs by “flipping” companies rather than committing to long-term, scale growth of a startup.

And who is to blame? As hinted at in the title, the authors believe the cause is primarily a fundamental misalignment of incentives and weak governance structures allowed by the LPs:

The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will—generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.

Their conclusion is utterly damning:

There are not enough strong VC investors with above-market returns to absorb even our limited investment capital.

The Dismal Asset Class

Is the average VC fund manager earning their keep? According to the Kauffman report, “since 1995 it is improbable that a venture fund will deliver better net returns than an investment in the public markets.” The “mandate” for most VCs in terms of investment returns that justify their existence is that they return 3-5% per annum over a typical benchmark like the S&P 500 as a proxy for public financial market returns. But in reality:

Investors are still attracted to the ‘lottery ticket’ potential VC offers, where one lucky ‘hit’ investment like Zynga or Facebook can offer the potential to mitigate the damage done to a portfolio after a decade of poor risk-adjusted returns.

VC is a proxy for gambling and the average fund is consistently not justifying its fees.

3 Ideas For Improving The VC Investing Experience

I took away three ideas for improving the VC investing experience based on the report. I think these three ideas have applicability outside of VC and speak to the need for improved corporate governance in any investment situation:

  1. transparency; eliminate the black box of VC firm economics
  2. incentives; pay for performance, not empire building
  3. accountability; measure fund performance against the “Public Market Equivalent” concept

A venture capitalist considering an investment for his portfolio will demand to know the internal economics of the business he is investing in as a normal part of due diligence. He wants to know this to ensure the business is being operated in a safe and sustainable manner so his investment will be secure. In particular, he puts emphasis on the incentives of managers and other owners of the business as indicated by their ownership stakes and decision-making structure and their compensation agreements. While an LP investor is not technically an investor or owner in the GP that manages the fund, the arrangements and incentives predominating at the management company level WILL have an influence on the way the portfolio is operated. Rather than argue for a right to know, LPs should ask their GPs to defend their right to privacy. If they’re to be business partners and in a relationship of joint risk taking, why shouldn’t their be sufficient trust to share information such as the following?

  • Partner capital contributions (by partner), partnership ownership
  • Partner comp amounts and structure– salary, bonus amounts and structure, and the allocation of carry, management company agreement
  • Quarterly firm financials– balance sheet, income statement, cash flow
  • Full-year firm projected financials, annual budget
  • Partner track records, investment cash flow data for public market equivalent (PME) analysis

Further, LPs should have other value-adds besides the cash they bring to the fund. Often this comes in the form of specific industry or personal experience which could be useful to the GPs in evaluating investments for the portfolio. But active agency in a corporate governance structure is another important value-add, missing in too many firms of all sizes, types and industries. Additional transparency could be achieved by involving LPs in the following:

  • The right to elect LP representatives to fund Advisory Boards
  • Information rights to detailed firm quarterly and annual financials
  • Right to review and approve annual firm budgets

According to the Kauffman report, almost two thirds of VC fund revenues come from management fees, NOT carry on performance generated. This means that most funds are incentivized to maximize assets under management by continually building new funds rather than to maximize performance by making outstanding investments while minimizing losses. Why should VC managers get rich regardless of the performance of their investments? The owner of a wholly-owned business only makes money when his business is profitable. He can’t pay himself a big paycheck forever just because he put a lot of capital at risk.

Instead of the standard “2 and 20” model, a VC could manage under an operating budget and a sliding carry system. Under this system, rather than charging a fixed 2% on all AUM regardless of how much or how little it is (and regardless of how many funds paying 2% have been raised historically), the GP tries to estimate its operating expenses needed to manage various levels of scale in advance, including office, support and vendor expense, travel and reasonable salaried compensation for the investment professionals in the firm. This budgeted expense would be spread across all funds and would likely decrease as a percentage of total AUM over time. To enhance the incentive and reward for strong performance, a sliding carry could be instituted in which the GPs are compensated at higher levels of total profits generated as they achieve increasing levels of outperformance against Public Market Equivalent hurdles. (Of course, this system could also employ hurdles such as returning some minimum multiple of invested capital net of fees before performance carry participation, ie, 1x, 1.1x, etc.) An additional recommendation for aligning incentives from the Kauffman report was constructing the VC fund as an “evergreen” fund:

Evergreen funds are open-ended and therefore not subject to the fixed timeframe of a ten-year fund life or the pressure and distraction of fundraising every four to five years. Without the pressure of regular fundraising, evergreen funds can adopt a longer timeframe, be more patient investors, and focus entirely on cash-on-cash returns, rather than generating IRRs to market and raising the next fund.

The final idea is to utilize the Public Market Equivalent (PME) concept to gauge investment performance, versus an indicator such as Net IRR or Net Multiple. The PME is calculated as a ratio of the value of capital in the strategy to the value of capital in a public market equivalent (such as the S&P 500, Russell 2000 or other comparable index based on risk, market cap, volatility, etc.) For example, if an investment was worth $15M at the end of the fund’s life, but would’ve been worth $10M in the Russell 2000 over the same time period, the PME is 1.5, or a 50% out performance. This is useful because it can reveal relative underperformance even when the VC fund achieves a high IRR or other performance metric but the public markets achieve a growth rate still higher. It is also useful because it can put a loss of capital in perspective when the public markets lose even more. The PME measures investment skill relative to the market environment. For Kauffman, “we have used PME to prioritize our best-performing funds, and to concentrate our investment activity and increase our investment amounts in those partnerships.”

Closing Thoughts

After their grand survey, the Kauffman fund managers have become more skeptical about VC as an asset class:

If they are not top-tier VCs, you are very unlikely to generate top-tier returns… Being a better investor in VC for most LPs will translate into being a much more selective investor.

Kauffman suggests there may be as few as 10 (!) such funds worthy of investment in the entire VC universe.

Part of that selectivity involves choosing to invest only with the most talented managers. Another part of the selectivity is sticking to funds whose total committed capital is not so enormous as to make them unwieldy and unsuited for the initially small, risky ventures they’re supposed to back:

Big VC funds fail to deliver big returns; we earned an investment multiple of two times our invested capital only from venture funds whose commitment size was less than $500 million.

According to a study conducted by Silicon Valley Bank, having a discipline about relatively small size is an important determinant of future investment returns:

  • The majority (51 percent) of funds larger than $250 million fail to return investor capital, after fees;
  • Almost all (93 percent) of large funds fail to return a “venture capital rate of return” of more than twice the invested capital, after fees.
  • Small funds under $250m return more than two times invested capital 34 percent of the time; a rate almost six times greater than the rate for large funds.

Incentives matter, and rather than serving as a failed example of economic and investment theory, the VC industry is efficiently responding to the incentives created by LPs who lack the discipline or data to make informed investment decisions.

Why Do Former Presidents And Politicians Need “Jobs”? And How Do They Manage To Find Them In Silicon Valley?

I got a good chuckle out of this today, “Obama hints at a future in VC“:

“had I not gone into politics, I’d probably be starting some kind of business,” said Obama. “The skill set of starting my presidential campaigns—and building the kinds of teams that we did and marketing ideas—I think would be the same kinds of skills that I would enjoy exercising in the private sector. … The conversations I have with Silicon Valley and with venture capital pull together my interests in science and organization in a way I find really satisfying.”

The rest of the article contains quotes from VCs good-humoredly sniffing Obama’s jock strap and suggesting candidly that he would make an excellent high risk capital allocator. I don’t even need to provide examples of why these disclosures are a bunch of bald-faced lies. You can make up your own punchlines.

Instead, I am pondering the following: does something like this represent a sign of how crony Silicon Valley is and how dependent upon government privilege it is for the profit it generates? Or does it represent how pragmatic this community of businessmen is in co-opting the enemy that is continually placing new obstacles on its road to riches?

I am not sure I am comfortable with either reality but the latter has merit in that one could at least argue one is acting in self-defense, and that’s more noble than getting behind the guns and pointing them at competitors and customers as in the case of the former.

 

What’s The Yield On Saudi Prince Alwaleed’s “Strategic” Twitter Investment?

Saudi Prince Alwaleed bin Talal has made a $300M “strategic” investment in Twitter, according to Bloomberg.com:

Alwaleed, who leads the 2011 Arab Rich List, and his investment company agreed to buy a “strategic stake” in Twitter, Kingdom Holding said today. A strategic holding means more than 3 percent, Ahmed Halawani, a Kingdom Holding director, said in an interview. That would give the San Francisco-based company a valuation exceeding $10 billion.

Alwaleed is described by Bloomberg as a businessman and an investor. But Alwaleed is a politician, not a businessman– he is a member of the Saudi royal family, and his capital and wealth are continually generated by the Saudi royal family’s political control over Saudi oil fields. Similarly, Alwaleed is an “investor” in businesses like Citi and Twitter in the same sense that the CIA “invested” in Google and Facebook– for information and for control, not for economic or financial profit.

If this is a challenging view to accept, let’s consider just this recent purchase of his Twitter stake from insiders. According to the article, an industry research group recently cut their forecast for Twitter’s 2011 ad revenue from $150M to $139.5M. What kind of value multiplier did Alwaleed “invest” in if he paid $300M for more than 3% of the company which is now valued at over $10B?

Let’s give Alwaleed the benefit of the doubt and say that Twitter’s 2011 ad revenue comes in at $150M. Let’s further assume that Twitter is a highly profitable company and 30% of their revenues drop down to the bottom line and become net profit. That’s $45M of net profit in 2011.

At a $10B market cap, Alwaleed’s investment was made at 66.6x Price-to-Revenues and 222.2x Price-to-Earnings. I should hope I don’t need to do the math for you to show what kind of growth expectations you have to factor into those ratios for them to make sense.

Now, ask yourself, have you ever heard of the “Best Investor In the Universe”, Warren Buffett, investing in companies at these kinds of multiples? Ask yourself, what kind of margin of safety does Alwaleed have here when paying so much for so little. Ask yourself, is it a credible idea that Alwaleed is truly a successful businessman and investor who has managed to grow his personal fortune to $19.6B (according to Wikipedia) since 1979 by investing at such high multiples?

Alwaleed “is a savvy investor and the hot thing in the IT world is social networking,” said Nabil Farhat, a partner at Abu Dhabi-based Al Fajer Securities.

Historically, how do even “savvy investors” fare investing in the latest “hot thing”?

As hinted at earlier, there is a more reasonable explanation for why Alwaleed invested in Twitter, why he has invested in Citi and News Corp., and why he invests in almost anything– Alwaleed is part of a political front and he makes investments as part of a political agenda. Politics is not an economically efficient system, it cares not for scarcity and cost in the economic sense of productive effort and opportunity cost. Political systems get their revenues from coercion, and they use economic resources as but another means to their arbitrary political ends.

Why did Alwaleed invest in Twitter? Because Twitter played an embarrassing role in the recent “Arab Spring” of revolutionary fervor across the Middle East this year and Alwaleed and his sponsors want to be in a position which allows them the knowledge and influence of the insider, of control. This is what is meant by the savvy Mr. Alwaleed’s “strategic” investment in a not-so-profitable social media favorite.

Why did Alwaleed invest in Citi? Because Citi is a centerpiece to the financial chicanery involving the global drug trade controlled by the CIA, the power-politics of world political intrigue and espionage and the dangerous, corrupt game of arms dealing and the financing of imperial military adventurism.

Why did Alwaleed invest in News Corp.? To control the news!

Let us not confuse legitimate businessmen and investors with political operatives and speculators any longer!