Teten & Farmer: VC & PE Funds’ Best Practices in Sourcing Investments

Would you invest in a company that only sold to 1 out of 80 leads? Or a company that typically took one year and three professionals just to close a single client?

In fact, you’ve already made that investment: in your private equity or venture capital fund. According to our data, the median investor in private companies reviews over 80 opportunities in order to make one investment. The median private equity fund required 3.1 investment team members to close one transaction in one year.

Exhibit 1:Median Pipeline Size Necessary to Close 1 Deal

By the standards of most traditional sales processes, private equity origination is a very inefficient and labor-intensive process, despite the fact that an effective deal origination process is fundamental to successful investing. We believe managers have the opportunity to significantly improve their origination practices. Private equity and venture capital funds that employ a proactive origination strategy have consistently higher returns, driven by both greater quantity and higher relevance of incoming investment opportunities.

We recently completed the first-ever study of how private equity and venture capital funds originate new investments, published in full in the Winter 2010 issue of the Journal of Private Equity. We drew on our personal work experience with leading institutional investors, in-depth interviews with over 150 funds globally, and our proprietary dataset of their origination practices.

Based on our study, we have identified five recommendations to improve the volume and relevance of dealflow.

1. Build a specialized outbound origination program.
Growth investors with dedicated, large-scale sourcing teams are almost all top-quartile performers across stage, vintage, and sector. The largest practitioners of these programs – including Battery Ventures, Great Hill Partners, Insight Venture Partners, Platinum Equity, Summit Partners, TA Associates, and TCV — typically have between 0.75 and 1.25 dedicated deal sourcers for every generalist investment professional.

Summit Partners and TA Associates have leveraged their origination programs to move into later stage buyouts. Middle market private equity firms such as the Riverside Company have developed a broad network of 24 senior, focused deal originators to produce top quartile results in 8 of their last 9 funds. These funds typically use market mapping (Exhibit 2) to identify the sectors of greatest interest.

Exhibit 2: Key Steps in Market Mapping

Create opportunities, instead of waiting for opportunities to appear.

A number of the funds we studied use an origination approach that allows them to proactively co-create companies or opportunities. Frontenac Company uses a “CEO1ST” strategy, partnering with “deal executives” to source investments in these executives’ focus industries. Exhibit 3 lists the options funds have in working with outside operating executives.

Exhibit 3: Private Equity Fund Structural Options in Working with Executives

3. Use deal signals to look for targets which are both attractive investments and are likely to welcome an outside investor.

Measuring Investability

In order to filter the universe of companies, some investors specifically reach out to companies flashing relevant “deal signals”. These investors are exploiting the wealth of information about private companies available online, increasingly leaked via social media. For example, an increase in internet traffic is usually a sign of customer traction. A family-run company that hires an outside manager is flashing a signal that the firm may welcome an outside investor. Navon Partners has built an automated platform for sourcing new transactions based on these signals.
4. Leverage social media.

Historically, institutional investors kept their investing strategies very discreet. However, today about 10-15% of the 1,000 active venture capitalists blog, according to Jeff Bussgang, General Partner, Flybridge Capital Partners. These investors have found that openly discussing their investment theses increases their perceived expertise and trustworthiness, and thus generates dealflow. Although private equity funds have been slow to take up social media, some have been more aggressive. For example, HealthPoint Capital, a $750m fund, has made their blog a destination for M&A/investing information in the musculoskeletal sector — specifically orthopedics and dental. At ff Venture Capital, our blogs (any.biz and teten.com) have been very helpful in sourcing targeted deal flow.

As the millennials reach decision-making roles in companies, an increasing number of senior executives and investors actively participate in gated online communities. An example is the International Executives Resource Group, an online community only open to executives who were C-level (CEO, COO, etc.) or reported to a C-level executive, and earned a minimum of $200,000. A number of the members work in or advise private equity funds and use the IERG to stay top of mind with their peers.

Many investors reported that they used LinkedIn, Facebook (to a lesser extent), and various email lists informally to keep in touch with their professional and personal networks. These can have direct business impact.

5. Install a professional CRM system.
A surprisingly high number of funds do not have a formal CRM system. EquityTouch found in a 2009 survey of 61 private equity funds that 37% were using no formal CRM application; instead, they were typically using only Microsoft Outlook and Excel. Tim Lasonde, CTO, Equitytouch, observed, “What we are finding in the market is that the paradigm shift to the web 2.0 and collaboration mentality is hitting the alternative asset community last (slower).” Most funds reported that a formal CRM system (with enforced compliance) was very valuable, although implementing it often created political opposition. We asked one partner why he reported that he spent about an hour per day keeping his CRM system current. He said, “Because my boss said that I won’t get paid if I don’t.”

David Teten is a partner with ff Venture Capital and chairman of Navon Partners. He blogs here and tweets here. Chris Farmer is a partner with General Catalyst Partners, and chairman and founder of Ignition Search Partner; he tweets here. Views expressed here are entirely their own. The authors also wish to thank Yujin Chung (Andreessen Horowitz) and Neha Kumar (Anklesaria Group), Teten’s former colleagues with Evalueserve and Dan Clark, Nitin Gupta, and Nikhil Iyer for contributing to this post. More data from this study on sourcing and on operating executives and entrepreneurs-in-residence is on David Teten’s site. We very much value your feedback.