The art of deal sourcing in a high-priced environment

Scouring the globe for companies to buy hasn’t been the most glamorous part of private equity in the past, compared to the more celebrated role of buyout king.

But the status of deal sourcing teams has risen in the era of high prices, as GPs work harder than ever to avoid overpaying for deals.

At last check, the average buyout multiple for U.S. buyouts tipped the scales at nearly 11x EBITDA in the third quarter, putting it among the highest levels ever, according to S&P Capital IQ. Buying right by finding good deals and trying to avoid traditional, competitive auctions, remain paramount.

Jeremy Holland, a principal at Riverside Co who heads up origination at the firm, said the art of deal sourcing has emerged as a coveted specialty developed with plenty of hands-on experience in the field.

Times have changed since he got into the business back in the late 1990s. “There were so few people focused on the market, you didn’t need to stand out and the investment bankers knew how to find you,” Holland said. “With the proliferation of funds and boutique investment banks, it’s been important to be more focused on origination.”

Some firms are known for cold-calling as many companies as possible to set up deals. Others have tried adding people with marketing backgrounds to promote the firm and win deals, but those hires may not offer the deal management expertise that’s needed to woo company owners. Riverside and other firms opted to add experienced deal professionals to beef up their origination efforts.

Holland works with a total of 17 people on Riverside’s global origination team to find deals across the firm’s fund family of lower middle-market buyouts.

In one of Holland’s favorite deals, Riverside Co paid a “market price” in a competitive auction for Emergency Communications Network (ECN) in 2011 because “every one of our logical competitors saw the deal,” he said. Then it got to work finding less expensive add-on deals through a combination of corporate divestitures and entrepreneurial businesses. The six add-on deals for ECN collectively lowered the purchase price multiple on the company by about 2x EBITDA, while doubling ECN’s customer base and moving into new markets, he said.

“None of the add-on deals were part of a formal sales process,” he said. “Most were very small companies. We did direct outreach to them, built their trust [and] explained private equity, so when they had a liquidity need they trusted us to share information about themselves that entrepreneurs are hesitant to share.”

Holland said deal-sourcing pros need to be self-starters, driven to get the deal done. The private equity business is best learned in an apprenticeship capacity over many years, he said.

“You need to have seen thousands, or even tens of thousands, of companies to really know which ones are worth pursuing and which ones aren’t,” he said. “When I look at 40 companies in a week there may be two I’m passionate about and then bring forward to the firm. You only develop that lens over a long period.”

Focus, focus, focus

Katherine Dowling, chief operating offering of Luminate Capital Partners, a private equity shop founded about a year ago, said the firm’s exclusive focus on the U.S. software space helped it close its first buyout, a deal for Professional Datasolutions Inc, a provider of back office software for convenience stores.

“Our sourcing largely stems from the depth of our industry knowledge,” she said. “Sector specialization allows you to identify opportunities and move quickly because you’ve already been deep in the end market. We definitely get inbounds [calls from investment banks about deals], but we also do outbounds when we see an opportunity from our investigation of the landscape. Sometimes a lead can be from a guy who knows a guy who knows us.”

Brian Ruder, a partner and co-head of technology at Permira, said the firm’s ongoing relationships with corporations has helped it land carve-out deals with News Corp, Alcatel-Lucent and, most recently, eBay.

“Most bigger companies have been acquiring assets over the last decade and they’re now under pressure from the boards, and sometimes activist shareholders, to create value,” he said. “They’re looking to rationalize their portfolios of assets. You’ll see a new wave of carve-outs.”

Sometimes the deal that results is different than what the corporate parent first envisioned, he said.

EBay anticipated one buyer for its eBay Enterprises units, but Permira ended up acquiring Magento Commerce, a provider of e-commerce solutions, and it teamed up with Banneker Partners to buy the marketing services unit of eBay Enterprises. The deals were announced in November.

In carve-outs, big corporations crave “deliverability” because these deals may include some thorny issues such as overlapping operations with the parent and fragments of businesses that may be shared for a time after the deal closes, Ruder said.

Overall, the tech sector continues to offer a range of deals both on the high end and low end. Industry knowledge remains key.

“Many companies in the tech world are trading at low multiples, but it’s not the obvious stuff. It’s companies that need operational help or where their revenue mix doesn’t translate well into a profit multiple,” Ruder said. “The value may be hidden, but it’s there.”

Sifting for nuggets

Jeff Lovell, chairman and managing director of Lovell Minnick Partners, said the firm hunts for “non-auction situations” to build relationships with management. The Los Angeles- and Philadelphia-based firm hopes to add to its 15-person investment team to help search for deals and manage portfolio companies.

The firm may also develop relationships with business owners over several years before inking a deal.

Lovell Minnick knew Bob Alexander, founder of ALPS Financial Services, from his days as a banker in Denver in the 1990s. The firm first pitched him on a deal in the early 2000s, but nothing came of it. Over the years, it kept communicating with him, which eventually led to an exclusive deal to buy ALPS Financial Services in 2005. Lovell Minnick’s commitment to ALPS grew to $45 million and a sale to publicly traded DST Systems Inc in 2011 for $250 million. Lovell described the exit as a “very strong outcome.”

Lovell Minnick is sifting for deals across the financial services sector, seeking subsectors offering growth, with a preference for smaller companies.

“Our investment teams research the smaller, growing companies in those areas and then we reach out to them directly,” Lovell said.

Overall, the financial services arena remains fragmented, with larger players under pressure both from regulators and activist investors, which will spark divestiture activity and possible deals.

Robert Covington, co-managing partner at RedBird Capital Partners, said the firm’s recent $35 million growth equity investment in business-to-business sales execution and marketing company N3 stemmed from long-time relationships with many business leaders.

“It’s emblematic of the other deals we’ve done and the deals I’ve done over my career,” Covington said. The CEO [N3’s Jeff Laue] was looking for a partner to help him grow and develop his business over the long term. He didn’t want someone who would trade in and out of the business. Having flexible, long-term capital was important to him.”

Many of RedBird’s deals start not with a call from an investment banker, but from a thesis, such as the rise of cloud computing. The firm may then line up an introduction through its network to owner entrepreneurs to get an inside track.

Covington praised Warren Buffett as possibly the top deal originator.

“Buffett is one of the best sourcers of all time,” Covington said. “He gets called by Goldman to bail them out. He gets the first call. My idea of a deal sourcer is: You get the first call.”

Photo courtesy of Shutterstock