A meteor is coming and it is going to kill your firm’s deal flow. There are signs of its impending impact already. Gone are the days when the phone rang with a hot deal just for you. Gone are the proprietary deals your cold-calling associates uncovered before anyone else. These days, even the household private equity names fight for every last deal.
But unlike the dinosaurs, private equity firms don’t have to become extinct. They can evolve and thrive in this new environment.
The sourcing challenge for private equity funds is twofold.
First, the industry is hypercompetitive. There are thousands of active funds, so sourcing has become an arms race, driving up deal volume. If your competitor calls 200 companies a month, then you have to call 500. And because volume is the easiest thing to track, it is also the easiest thing to incentivize.
We PE-types love to tell our portfolio companies that “what gets measured gets done.” In our own funds with billions to spend, employees across several offices and dozens of deals to close every year, the easiest way to manage people is to measure what’s measurable in the short term: more deals. This obsession with volume has caused us to lose sight of what really matters: finding the very best deal where we can truly add value.
Sellers are smarter
At the same time, we face another big challenge: sellers are getting more sophisticated about private equity. With every cold call they get, they learn a little more about who’s out there and what is happening in their market. Add to that the number of bankers and brokers who have proliferated since the mid-1990s, and entrepreneurs have plenty of data about comparable transactions and EBITDA multiples, so they have a pretty accurate idea about what their company is worth.
Compound all this with the prevalence of CEO clubs like YPO, EO and Vistage, and now entrepreneurs are a just phone call away from peers who have sold their companies to private equity funds who are happy to share their advice on how to manage the process and how to play the game.
Just like the dinosaurs in Jurassic Park, entrepreneurs are learning, testing the perimeter to find its weak spots. They don’t want to hear about your proactive deal flow or your value-add operational checklists. Instead, they want authentic relationships with trusted partners who care about their businesses. And this approach couldn’t be further from the current sourcing tactics at most middle-market firms.
Tools for survival
Overcoming these challenges isn’t easy or simple. It requires dismantling the deal-flow machine you’ve been building. You need to reconsider the volume-based approach, the trade show sweeps, the outsourced buy-side boutiques, and the biz dev director you just hired to manage intermediaries so you can focus on more important things. You need to reconsider placing the deal flow in the hands of those on your team with the least authority.
The new model for deal flow looks more like molecules than a well-oiled machine. First, you need to get down to the molecular level of an industry where you specialize. This is no place for generalists. You must be deeply immersed in a market. You need to know what you are looking for, why you are looking for it, where to locate it, and what to do with it when you find it.
And that’s not all. You need to shine a bright light on the molecules to heat them up, to help hone your investment thesis as you start bumping into things in the market. Then, as the molecules move faster, you dive in and start bouncing into industry CEOs, competitors, bankers, and experts who help you hone your thesis even more by redirecting your path in more fruitful directions.
When you find companies that might be potential investments, you have to connect all that knowledge from all the molecules you’ve been bouncing around with and articulate a clear vision about what you believe and make it resonate with the management teams who run those companies.
This organic process demands that you know your stuff. It forces you to have a thesis and then go test it in the outside world. That means getting out of your office and meeting people who live in the industry and know way more about it than you do. So check your ego at the door. You impress these folks by building credibility and relationships, not by proving to them how smart you are. It also requires that you have practitioners on your team who help you navigate the path and hone your thesis along the way. Maybe they even help you win the deal with their insight and the rapport they can develop with management from having been in their shoes before.
Don’t be afraid to write down your ideas and share them with the outside world. Can your investment thesis survive the interrogation of people who lived in that industry and competed in that market? Can you articulate your long-term view of the market opportunity and why this particular investment can out-perform the competition? Every investment thesis and every investment target should be treated as guilty until proven innocent. Those that can survive — the ones you can’t dismiss no matter how hard you try – are the best ones to pursue.
If you do this enough times, you will find plenty of interesting investment opportunities over your career. You’ll also develop two side benefits. One, you will eventually become an expert yourself. And, two, you will build a deep network of people who want to work with you. Over your career these side benefits become the key ways that you deliver great returns to your investors.
You really have only one choice at this point: Evolve and learn the new skills and behaviors you need to survive in this new world. Your other choice isn’t really an option: If you ignore the meteor careening toward you and continue to do what you’ve been doing, you will end up with the rest of the dinosaurs.
Devin Mathews is a Partner at ParkerGale, a small private equity fund focused on buying profitable technology companies from founders. He also co-hosts the weekly Private Equity FunCast, the PE industry’s only weekly podcast. You can find him on Twitter at @devinmathews or email him at firstname.lastname@example.org.