1 First Thoughts on Deal Sourcing

      Key Topics in Chapter 1:

Introduction to Deal Sourcing

Private equity begins with finding a suitable investment opportunity. Preferably, a great one. The first three chapters of this book discuss exactly that—the process of finding a private equity deal that represents a perfect fit for your investment mandate. In my personal experience, I have found this to be a tedious and frustrating process. Why? The private equity industry has been operating for nearly half a century, yet there is no one source that educates others in a granular and systematic way about how to build a solid private equity origination capability. Therefore, I set out to put my own detailed thoughts and experience in writing in order to share my perspective with others about this complicated process. My aim is to be as thorough as possible so that, after reading these first three chapters, you will walk away with a couple of solid and useful frameworks that will positively transform your deal sourcing outcomes.

      Let's begin.

      Why is understanding deal sourcing important? There are two primary reasons. First, creating and sustaining a flow of high-quality deal ideas is one of the core competencies of a successful private equity professional. This competency resonates very closely with the perceived brand of every private equity fund and, eventually, with your personal brand. Every limited partner (“LP”) investing in private equity funds is looking to identify a team of rainmakers who can demonstrate that they are capable of developing differentiated investment themes, finding sustainable sources of deal flow and closing successful transactions. As you get more experienced in private equity, the people you report to will increasingly expect you to originate your own deals proactively.

The second reason is that deal sourcing—while being critical to investment success—remains remarkably obscure. There is extremely little written specifically about private equity deal sourcing and how to master it. The books on private equity that I have researched seem to include only a high-level discussion of this topic. If you are interested in private equity, chances are you regularly come across articles in the trade press discussing the challenges of finding a good deal. If you have attended private equity conferences, as I have, then you've also heard a good number of deal origination war stories. However, I wasn't able to find a single resource that sets out a detailed private equity deal origination framework in one place. Hence, I believe I can make a contribution to this area with my deal sourcing guide.

      In my research, I was able to identify only one study, conducted by Teten and Farmer (2010), analyzing deal sourcing strategies across the private equity industry and outlining a number of actionable steps aimed at improving the deal origination process. Unfortunately, I could not use the valuable lessons of this study in my own career because this research was published many years after I had been tasked with originating my own private equity transactions. In the study, the authors reaffirm the importance of deal sourcing in private equity: it turns out that late-stage venture capital and growth equity investors with proactive origination programs are almost all top-quartile performers across stage, vintage and sector. This makes sense. You can now understand why LPs might be very interested in examining your firm's deal sourcing process in agonizing detail.

      When I started my first private equity job at a firm focused on large leveraged buyouts (“LBOs”), I found the process of deal origination and initial review fairly exciting. It was great to think through numerous business models and admire new ideas. However, it was also extremely exasperating. I was a member of the consumer team and it was not unusual for us to analyze over 100 large buyouts a year, bring 10–12 deals to the investment committee and work on three or four full deal execution processes in order to close just one transaction that year.

Yes, you read that correctly: the goal of my team was to review over 100 potential deals in order to close one deal per year. If you are lucky enough to complete one transaction a year, you are right on track! Sometimes, even this modest goal was out of reach. For example, when a target company was sold through a highly competitive auction process, our team would often not be chosen as the preferred (or highest) bidder. This means that there were years when we, as a sector team, would close no deals at all. Yes, we would still review over 100 potential deals that year and close zero. Talk about a low-energy Christmas party.

      This is a rather frustrating, yet typical, fact in private equity: a lot of work goes into deal sourcing yet there is no guarantee of a successful outcome. Sometimes several years will pass from your first meeting with the management of a potential investment target to the time they are ready to consider a transaction. Sometimes the company will even go through multiple rounds of ownership until the management team is prepared to meet with you again. Sometimes the company shareholders are finally ready to accept a private equity investment, just not one from your firm! However, the stars do align at some point and, with perseverance, you can manage to get a private equity transaction to a final close.

      What influences the successful outcome of sourcing and closing a private equity transaction? If you had asked me this at the beginning of my private equity career, I would have said that there was a fair degree of randomness and luck in this process. It is about being connected and about maximizing your options by doing 1,000 things to cover more ground. And being in the right place at the right time. And balancing cold-blooded investment analysis with the animal spirits of a competitive auction. Back then, I would have said serendipity deserves its fair share of credit, too.

Would I give the same answer now? Actually, I would not. I no longer think of sourcing and closing transactions as a game of chance. While the rules of probability do apply to finding good deals, I think there are steps that you can take to skew the odds in your favor. Sometimes significantly. Depending on what your competitors are doing in your sector or country of focus, you can definitely enhance your deal origination prowess by a considerable margin. I have certainly seen this in my own efforts of sourcing private equity transactions.

      First, let's take a look at a broad overview of these action points and then I'll delve into each one in more detail.