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  • By Nadim Malik and Catherine Daly, Sutton Place Strategies

    Current trends in the M&A market suggest that there is an abundance of sell-side intermediaries compounded by stagnant deal flow. That begs the […]

  • If there was only one takeaway from the 2015 edition of the Sutton Place Strategies Deal Origination Benchmark Report, it would be this: that deal sourcing remains both a challenge, as well as an opportunity for […]

  • If there was only one takeaway from the 2015 edition of the Sutton Place Strategies Deal Origination Benchmark Report, it would be this: that deal sourcing remains both a challenge, as well as an opportunity for general partners to unlock value for their investors.

    The report compares the “market coverage” of a PE firm, which is the percentage of relevant, completed private equity transactions with a sell-side advisor that the firm reviewed, against all PE firms as well as their peer group. The results are based on the analysis of Sutton Place Strategies’s over 170 clients that qualified for inclusion.

    Average market coverage of 18.6 percent is down slightly compared to 19.3 percent in 2014. If you are a private equity professional you might be thinking, “But our firm’s deal flow is up over 10 percent compared to last year, so how can market coverage be down?” What’s even more perplexing is that according to Sutton Place Strategies’s proprietary database of M&A transactions in the United States and Canada, the number of completed transactions in the first half of 2015 is actually down 4.4 percent from the same period in 2014.

    So how can deal flow be up, closed transactions decline, and market coverage be relatively flat? There are two factors working together that help explain this. First, greater efficiencies in the M&A process are resulting in buyers getting “more looks.” In other words, a banker that may have shown a deal to 50 firms in the past, could now just as easily show it to many more. This explains the increase in overall deal flow among PE firms. However, since it continues to be a seller’s market, more owners are “considering” selling and talking to buyers but are really only ready to sell at their price. This mismatch in buyers and sellers expectations on valuation, and the increasing ability on the part of intermediaries to expand their network of potential buyers, may explain what on the surface may seem counter-intuitive.

    Meanwhile, below the radar deals, run by either boutique advisors and brokers, or in rare instances even negotiated directly, continue to get done. These transactions by their very nature are not causing an increase in overall deal flow in the market. They are the hardest to find and close, and require a disciplined, long-term, data-driven approach.

    This should give us that much greater appreciation for the firms that achieved the highest market coverage, particularly for transactions where the seller was represented by a boutique intermediary. Each of the top performers in the generalist, quasi-generalist, sector-focused, upper middle market, and lower middle market fund categories had a dedicated business development professional or team, which is especially noteworthy given that 54 percent of the firms included in the analysis actually don’t have a dedicated business development person. This is down from 59 percent when we ran the analysis last year. Given the trend, by the time we publish next year’s results, if you’re a PE firm without a business development professional you may very well be in the minority!

    So why should becoming a more effective deal sourcer matter? Who really cares how your market coverage is trending and if you are top quartile or not? Tracking that your share of relevant qualified opportunities from which to make investments is increasing, and that you are outperforming your peers, should give both you and your LPs comfort around your future performance. Especially if you are finding deals outside the broadly auctioned market, among the lesser known, boutique deal sources. This won’t be easy, but it will be worth it.

    How does your market coverage stack up?

    Average
    Max
    Min
    Top Quartile

    Market Coverage
    18.6%
    55.3%
    2.8%
    42.2%

    Market Coverage Boutique Intermediaries
    12.0%
    47.2%
    1.5%
    35.8%

    Market Coverage Most Active Intermediaries
    21.8%
    59.8%
    1.0%
    45.1%

    Generalist PE Firms Market Coverage
    17.0%
    31.1%
    5.5%
    24.7%

    Quasi-Generalist PE Firms Market Coverage
    17.1%
    41.3%
    3.1%
    33.8%

    Sector Focused PE Firms Market Coverage
    22.5%
    55.3%
    7.5%
    43.4%

    Upper Middle Market PE Firms Market Coverage
    38.3%
    50.2%
    27.6%
    44.6%

    Lower Middle Market PE Firms Market Coverage
    9.3%
    26.3%
    2.8%
    20.4%

    Source: Sutton Place Strategies

  • While there is buzz that the asset class is becoming mature and efficient, deal sourcing, one of the most critical components of a private equity firm’s success, is becoming tougher. This means there is greater opportunity than ever for outperformance on a relative basis by sponsors that are better at business development.

    The third annual edition of Sutton Place Strategies’s Deal Origination Benchmark Report, covering sponsor activity in the United States and Canada, highlights some stunning trends and takeaways. The report compares the “market coverage” of a private equity firm—the percentage of relevant, completed private equity transactions with a sell-side adviser that the firm reviewed—against all firms as well as their peer group. The results are based on an analysis of more than 125 clients of the information services firm that qualified for inclusion.

    Despite the trends and increased marketing spend on the part of private equity firms to improve their deal origination, on average sponsors are still missing over 80 percent of their target market deal flow (see table below). The average market coverage actually declined to 19.3 percent in 2014, compared to 23.0 percent in 2013. The greatest force at work here is the increased fragmentation of the intermediary community. According to our proprietary database, the number of sell-side advisers that completed at least one transaction north of $5-10 million in enterprise value in the 12 months ending Jun 2014 increased by approximately 10 percent to 765, compared to the same period one year ago, and the number of intermediary professionals increased approximately 12 percent to 2,371. In other words, there are more intermediaries out there to stay in front of.

    DealflowmarketshareAnother takeaway: if you are one of those private equity firms wondering if having a business development professional adds value—this is someone that spends a majority or all of their time sourcing deals—the answer is yes. While 59 percent of the firms included in the analysis did not have a business development professional, the top performers in each of our peer groups—generalist, quasi-generalist, sector-focused, upper middle market, and lower middle—had a dedicated business development person or team.

    One could argue that deal origination may be the most significant and easily assessable forward indicator of fund performance available. Stated simply, you can’t make good investments if you don’t see them. While returns won’t be realized until several years down the road, knowing today that you are seeing a higher share of relevant qualified opportunities from which to make investments than your competitors can help predict future performance. In many cases those opportunities will come from below-the-radar deal sources running quieter more limited processes potentially at more attractive valuations.

    If that’s not enough, another reason why private equity firms should be thinking hard about their deal origination strategy and making changes for the better is the increased attention from limited partners. LPs are more interested today than ever in co-investing and direct investing. A private equity firm that can show higher market coverage, which is essentially access to deal flow that others don’t have, can substantially differentiate itself in the eyes of investors.

    In the words of Socrates, “the unexamined life is not worth living.” The ongoing quest for improvement in deal sourcing requires periodic self-evaluation and an abundance of intelligently directed calling, emailing, and visiting. There is no substitute for hard work, but it helps to work smart, and above all else “know thyself”.

    Nadim Malik is founder and CEO of information services firm Sutton Place Strategies LLC

    This column originally appeared in Buyouts Magazine.

    Photo Credit: Image by Shutterstock

     

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