Deal sourcing can be arduous, and many private equity firms can spend a lot of time on the wrong deal that, for one reason or another, is never executed. But the most effective private equity firms efficiently reject the wrong deals so they can spend more of their valuable time on good deals.
It’s critical to find the “deal killers” — such as undisclosed liabilities, declining revenue, toxic business cultures, etc. — early on so that you can resolve them before spending valuable resources and save immeasurable frustration for both the buyer and seller.
Ultimately, the typical problem associated with deal sourcing is a case of missing the forest for the trees. The PE firm might like the management team, the business model, or the industry, but it often fails to see the factors that may prevent the deal from closing.
Sourcing Deals
There are two ends of the spectrum when sourcing deals: totally proprietary deals and totally auctioned deals. Auctioned deals have a lot of prospective buyers and typically go for a much higher price; proprietary deals, by definition, have no other buyers and typically go for a much lower price.
Clearly, no firm wants to pay the most; it’s too difficult to get good returns doing that. Yet there’s much risk in pursuing solely proprietary deals: Oftentimes, the seller hasn’t gone through a structured auction precisely because he isn’t inclined to sell. As a result, many proprietary deals don’t close because the seller won’t resolve issues that arise.
So you have a high price with the auctioned deals and a high fallout with the proprietary deals. The trick is finding deals that have a committed seller without a broad process. But finding a committed seller requires identifying the deal killers and eliminating them early on. Ring a bell?
The Challenge of Finding a Good Fit
The phrase “there’s no home delivery in private equity” resonates because it takes legwork to find a company, meet with the owners, compel them to sell, find an optimal structure, and consummate the transaction.
Not only that, but because a lot of money is circulating in the PE world and the stock market has done well since the last recession, sellers now have high expectations for a deal’s value. There will be a lot of challenged transactions given current sky-high prices.
But sellers are often uneducated about private equity. At our company (like almost every leveraged buyout private equity company), we typically use debt to facilitate the purchase (it’s difficult to generate high enough returns with just equity), and sellers often don’t understand this.
Sellers may use local accountants and lawyers whom they trust but who are not necessarily familiar with mergers, acquisitions, or private equity. You might as well ask a pediatrician to perform brain surgery. Sellers also underestimate how long completing a deal can take — which is thousands of hours, literally. Some buyers transact more quickly or are less thorough, but anyone preparing to spend millions will usually be thoughtful. And sellers often fail to objectively look at their businesses and recognize the challenges new owners will face.
For these reasons, a collaborative approach between the investor and the investment company from the get-go and a consistent process of sourcing deals is the best tactic. Here’s how:
1. Know Your Criteria.
Our company looks at 5,000 to 6,000 deals annually. We must reach “no” quickly by having clearly defined parameters. To ensure everyone is on board, we’ve written down our criteria. We target $20 million to $100 million in revenue and $2 million to $10 million in earnings before interest, tax, depreciation, and amortization — more specifically, family-owned industrial companies based in North America where we can add value.
This strategy allows us to eliminate 95 percent of deals in 10 minutes or less, which means we spend less than half of a full-time equivalent on evaluating deals each year and we can focus on the deals that fit.
2. Find the Deal Killers.
We focus on identifying the deal killers early. A customer may fear reduced sales with a seller, a macroeconomic change in the industry, or a key quality failure at the company. We determine whether we can surmount those hurdles quickly and, if not, move on.
3. Use CRM Technology for Sourcing.
Generating leads takes work: making calls, writing emails, sending outbound mailers, making visits, and creating the capacity to generate leads. We use Navatar, a customer relationship management tool based on Salesforce yet designed specifically for private equity technology, to measure our progress, volume, and sourcing efforts.
4. Build Relationships to Overcome Inevitable Challenges.
Problems will arise. If we’ve established a close relationship with a seller, it’s easier to weather the inevitable choppy waters encountered when navigating a deal. Great relationships also make a successful deal process feel great for all parties: The seller can brag, and the buyer learns about the company he’s investing in so that he can add more value. The activity strengthens the management team of the seller, and the business is properly valued.
Once we find a deal that’s a fit, we get it under a letter of intent. In the past five years, nearly every deal we’ve signed under a letter of intent has succeeded because we vet our companies and don’t commit unless we’re going ahead. This approach should have you at execution quicker, saving time and resources.
See the forest, not the trees. Identify the deal breakers, eliminate them (or ditch the deal), and succeed with the deals that are the best fit for you.
Martin Stein is the founder and managing director of Blackford Capital, focused on dramatically transforming lower middle-market industrial enterprises through exponentially profitable growth. Since receiving his Bachelor of Arts from University of Chicago and his MBA from Harvard Business School, Stein has had almost two decades of private equity experience. Among other awards, Stein has been honored as the nation’s Private Equity Professional of the Year by M&A Advisor.
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