Looking back on the past 16 months, I think it is safe to say two things. First, it has been a period of massive disruption. Something nobody could have expected. Second, the private equity (“PE”) industry has remained unscathed. Something everybody could have expected. Let’s rewind.
When the pandemic hit in Q1 2020, deal-making fell off a cliff. European PE deal volume dropped by 31.5% YoY. US PE deal value came down more than a third. Global PE exits declined by 70%. I guess it is safe to say it wasn’t just you and me that went into full lockdown. But let’s make one thing clear. It happened for good reasons. It was a time of crisis. And the secret of crisis management is not good versus bad but preventing the bad from getting worse. It’s a secret well-known to the PE industry. Ongoing transactions were put on hold. New deals were kept at a safe distance. Stabilisation of portfolio companies became the focus. Resilience used to be a nice-to-have. Last year it became mission-critical.
During its 50-year history, from ‘barbarians at the gate’ to today, the industry has reinvented itself many times over. It has been a period of many highs and lows. A period wherein crises have not been uncharted but rather familiar territory. The OPEC Oil Price Shock of 1973. The International Debt Crisis of 1982. The Financial Crisis of 2007–2008. The industry has learned its lessons. That is for sure. Because while ‘never waste a good crisis’ was one of the most (mis)used quotes of the past year, the PE sector lived up to the hype. COVID-19 posed a lot of questions, but the industry had its answers ready. Again, let’s rewind.
Remember when COVID-19 normalised over the summer in 2020? It was also the moment the PE industry went back to doing what it does best: executing deals. The numbers don’t lie. Total global transaction volume reached $168bn in Q3 2020. This was not ‘just’ a 90% YoY rebound. No, this was a three-year high. This brought the total capital deployed at $320bn in H2 2020 — almost on par with 2019. Everything was back to (the new) normal.
Let that sink in. The biggest health crisis of our lifetime. One of the biggest economic crises of this decade. And the PE industry emerged unscathed. Coming back to the introduction: this was something everybody could have expected. It shouldn’t be a surprise — at least, for those who take the time to look at the history books. What you read there is that the PE industry is not just resilient to periods of distress but has the ability to thrive in them.
It’s not rocket science. During downturns, funds catch distressed assets on their way down, to ride the cycle back up together. It’s a win-win-win. Companies are saved. The economy rebounds. Funds reap the dividends. Again, the numbers don’t lie. In the years following the past two economic downturns of 2002 and 2009, the average IRR was in the 17–21% range. The long-term PE average sits at 16%. I don’t know about you, but I would definitely call that a healthy premium for periods of stress.
The rewind is over
Let’s focus on today. The world is reopening. The economy is back up. Deals are being executed. Premiums are being paid. The industry is firing on all cylinders again. It’s like nothing ever happened. But there is one catch: something did. Whether we like it or not, the world will be different than it was. And if there is one sector that should realise this, it’s the PE industry.
Yes, funds managed to ride out the storm, but let’s be honest here. If there is one thing the pandemic made painfully clear, it is how labour-intensive and paper-driven the industry remains. It was learned the hard way. Portfolio company meetings for which a flight, hotel and a couple of days turnaround time used to be a no-brainer all of a sudden became a no-go. Video meetings were not only as effective but could be done faster and more frequently as well. As hard as funds were driving digitalisation at their portfolio companies, so they remained old-fashioned themselves. The pandemic happened to be the perfect mirror wherein the industry could have a good look at itself. And I have to say, it did. Platform tools were adopted. Digital analytics was embraced. And to be fair, they had to. There simply was no way around it.
But although now it may feel as if the market is back and nothing ever happened, something did. The world has changed. And while there was no way around it during the pandemic, there won’t be afterwards either. Platform tools used to be nice-to-have; now they are mission-critical. They used to be just another differentiating factor; now they are the key driver of success. Because let’s ask ourselves an honest question: what is it that truly makes a fund successful? Speed. Effectiveness. The quality of decisions. Oh… and a nice little bit of luck. I have not found the secret to luck (unfortunately). But the secret to the other factors is quite obvious. Funds have to go digital. You won’t survive without it.
But there is one catch. Although you won’t survive without it, you also won’t automatically prosper with it. Going digital is necessary; however, it is not sufficient. Your digital edge is like a good suit: it needs to be tailored. And just as every pair of trousers needs the most alterations at the ankles, your digital edge also needs to be tailored at ground level — the point where it all begins. Every entry. Every deal. Every exit. The start of the PE value chain: deal sourcing. It has never been as crucial as it is today.
Ahhhhh... deal sourcing
The word that has been buzzing around the market for over a decade now. That one thing that never seems to fulfil its golden promises. The focus point that assured dividends which were never paid. Fair point, fair point. But hear me out. I know it is probably the worst thing to say within the world of finance, but… this time is different. And let me show you why. No, see for yourself. It’s amazing how much you can see simply by looking.
Record levels of fundraising. New entrants flooding the market. Low interest rates. Fewer companies coming to the market with an increase in secondary buy-outs. Sellers becoming increasingly sophisticated. Deep-pocketed strategics developing into tough buyout competitors. PE strategy institutionalisation limiting the number of investment opportunities. All while LPs are piling money into the industry faster than GPs can put it to work, with hills of dry powder as a result.
The list is endless. It is a perfect storm — with each gust of wind blowing in the same direction: towards an ever-growing demand–supply imbalance of available deals vs. PE firms. Simply put, in this low GDP-like growth environment, more and more participants are chasing a stable number of investment opportunities. When more people fish in the same pond, it is harder to catch one. When demand goes up while supply remains stable, prices rise. That is what a fisherman will tell you. That is what Economics 101 teaches you. And that is what is happening. Again, the numbers don’t lie.
Buyout multiples averaged 12.6x EBITDA in Europe in 2020. It is therefore rather unsurprising that one Preqin survey (December 2020) indicated that investors see sky-high asset prices as the biggest challenge in trying to generate strong returns. Not the pandemic. Not the economic slowdown. Not the new normal. No, the high valuations are seen as the biggest challenge. The hunt for assets has never been as competitive as it is now. And these valuations leave little room for error. Every sailing instructor always tells you that when the wind is turning, you need to adjust your sails. Allow me to pass on that advice. The wind is turning. The industry needs to adjust its sails. The days when origination was something that investors could just do in-between deals are finally over.
It’s nothing new, really
PE firms that proactively built, maintained, structured and optimised their deal sourcing efforts have always been the most successful. If you double down on your origination efforts, you end up with the best deals. That’s just common sense. I keep on repeating myself, but here also the numbers don’t lie. That is what the famous ‘Where are the deals?’ study of David Teten and Chris Farmer showed us. Funds that employed a proactive deal origination strategy consistently outperformed the market. Returns were almost always in the top quartile. But it does not stop there. These funds were also best able to raise funds equal to or larger than their preceding ones in the economically challenging period 2007–2010. Regardless of stage. Regardless of vintage. Regardless of sector. Deal sourcing was what pushed the needle. So… how did they do it?
Let me cut right to the chase. There is no silver bullet. Without labour, nothing prospers. What it took them was 0.75–1.25 dedicated deal sourcing specialists for every generalist investment professional. This also shouldn’t surprise you. Again (and again), the numbers don’t lie. Research of Tenten Advisors showed that the average PE firm has to evaluate 80 asset opportunities before actually investing in one. I don’t have to tell you that analysing all these sell-side IMs is extremely inefficient. It often leaves very little mind space to go after those businesses for which you’re not even sure whether an IM will ever arrive. I also don’t have to tell you that proactive deal origination is a slow, labour-intensive, sometimes even frustrating process. It’s like with most things in life: on paper, it’s simple — in practice, it is anything but.
But if you think the intensity of deal sourcing is insane, you could call the evaluation phase madness. Tenten Advisors also analysed what it (on average) takes to close a deal. Curious? Twenty management meetings, 4 negotiations, 3 due diligence reviews. All done by 3.1 FT investment team members. Let that sink in. It can take a team of three institutional investors up to a year to capture just a single transaction. If you still don’t realise how critical deal sourcing is, I fear you never will.
Win-win-win
Remember the win-win-win I spoke about earlier? Here is another one. The better you source, the higher the returns. The better you source, the fewer you have to evaluate. And the fewer you have to evaluate, the better you can source. It’s not just a win-win-win. It’s actually a positive feedback loop. Because the best way to minimise the waste of your evaluation phase is to maximise the quality of your deal origination one. Deal sourcing pays off not just because of volume, or because of relevance, but because of both. Resourcefully casting very wide nets to draw in multiple opportunities is the only way to increase your chance of landing that legendary one.
But then why are so few funds doing it? Well… it’s like with our annual new year intentions to eat less and exercise more: there is a big difference between knowing what’s right and actually doing it. Although I must admit this may not be the best comparison, I do see another similarity. Because in the same way that COVID-19 taught us that health is more important than anything, the market’s dynamics will teach us that proactive deal sourcing is key to survival. Not the old-fashioned approach, but in a different way — because simply throwing more bodies at this labour-intensive process is not going to cut it anymore.
Okay, one final rewind
James McNair, the Senior Managing Director of Corinthian Capital, once said:
“Deal origination is about how much hard work you can do in a year. There isn’t any secret”
He is right. Origination was, and still is, about how much hard work you do in a year. But he is also wrong. You can’t blame him: this statement was made over a decade ago. And during this decade, something changed. There still is no substitute for hard work. But it is the hard work that you can now substitute. Yes, there is a secret.
There’s good and bad news
There are no secrets that time does not reveal. So let’s start with the good news. The secret is up for you to grab. In fact, it has been here all along. It’s what we have been trying to tell you for over three years. And now that more and more investors and advisors are on the discovery, it’s safe to say that deal sourcing technology is no longer the well-kept secret of a few. It took some time, definitely. But that’s how all technological breakthroughs take place. At first, nothing happens. Then suddenly, the paradigm shifts.
Instead of pushing papers, you let our technology push it for you. Instead of updating your short lists, you let our technology update them for you. Instead of manually scanning opportunities against your funds’ investment criteria, you let the technology automatically match them for you. Instead of running harder, you make our technology run for you. That’s the secret. That’s the paradigm shift. That’s how investors (and advisors) of the future operate. That’s what we mean when we talk about ‘full visibility on your sweet spot assets’.
So the future of PE is a relaxed one, right? You can just press a button, sit back and relax. Sorry, but there comes the bad news. We are not here just to save your time and resources. We are here so you can reinvest this time and resources into those things that always got you excited. Those truly differentiated activities. Obtaining proprietary access to trusted operators and advisors. Building out differential market and business knowledge. Setting up management dialogues. Analysing different angles. In other words, to double down on what you do best.
You want to know how a paradigm shifts? It’s when the established way of seeing the world no longer functions. And that’s what has happened over the past 16 months. It used to be the case that you needed to proactively track your peers and clients. With deal sourcing technology, they are tracked for you. It used to be the case that you fell victim to your blind spot. With deal sourcing technology, you can develop your sweet spot. It used to be the case that you needed to find opportunities. With deal sourcing technology, opportunities find you.
You want to call that the ‘new normal’? That’s fine. But maybe, just maybe, the way how things were done in the past were never normal to begin with. And to those who feel like nothing happened. We fully understand. That’s the annoying thing about paradigm shifts. They are the least obvious when you are in the middle of one.
Deal sourcing used to be an art. Now it’s a science. It’s time to get the science right.
Sources
Axial. Three3 Ways to Augment Deal Sourcing. https://www.axial.net/forum/augment-traditional-deal-sourcing
Fugazy, D. Axial. The Rise of the Deal Origination Team. https://www.axial.net/forum/the-rise-of-the-deal-origination-teams/
https://www.bain.com/globalassets/noindex/2021/bain_report_2021-global-private-equity-report.pdf
Nead, N. Investment Bank. Deal Origination: Perhaps the Most Difficult Component for All Mid-Market Operators.
https://investmentbank.com/deal-origination-difficulty/Preqin (As of 5/2/2021). Retrieved from https://pro.preqin.com/ → Dry powder estimate 1.9tn
Steele, J. Zippia. What is Market Mapping and How Do You Do it? (2014). https://www.zippia.com/employer/what-is-market-mapping-how-do-you-do-it/
Teten, D. Journal of Private Equity. Where Are the Deals? Private Equity and Venture Capital Funds’ Best Practices in Sourcing New Investments. (2010). https://jpe.iijournals.com/content/14/1/32
