In Depth

Malik: The Science of Deal Sourcing 201

Aug 27 2015 | 5:35pm ET

Editor's Note: Effective deal sourcing critical to the success of any private equity firm, but it requires significant time, money and attention to do well. This is why many PE firms focus on courting the busiest intermediaries – because they have the most deals. But is that the right strategy? Not necessarily, says Nadim Malik, CEO of Sutton Place Strategies.  

In this contributed article exclusive to FINalternatives, Malik takes a quantitative approach to the question of deal sourcing, and offers a data-driven alternative that may significantly improve access to less-competitive deals - and thus the potential for superior returns.

The Science of Deal Sourcing 201

By Nadim Malik

When it comes to deal origination, there are a handful of common methods private equity firms deploy to create a target intermediary list. PE firms have long since ranked intermediaries by activity, ideally carved for their specific investment criteria, as a means to identify the relevant firms to form relationships with.

Another common approach among investors is to look at their own deal flow to identify and qualify the best opportunities, and then place a higher emphasis on the firms that brought them those deals. Many firms have a tier-type system ranging from high to low priority firms to allocate time to, which should surely be getting fine-tuned and made current on a frequent basis.

What if there was a way to analyze intermediaries not just by relevant activity, but also in the context of whether they typically run broad (competitive) vs. quiet (more relationship-driven) processes? The fact that they are active in terms of closed deals is important because it indicates that they know how to get deals done and aren’t just wasting your time. And the fact that they run less-competitive processes is also insightful because it means that your relationship with them is a differentiating factor, and you’ll have the opportunity to be included in more limited processes.

One approach to evaluate this is to divide how many buy-side candidates an intermediary typically reaches out to in their processes by how many deals they actually close.  We discovered that the lower the ratio, the potentially more attractive the relationship.  Here’s how we came up with the numbers:

Step 1: We ranked intermediaries by the number of deals they closed that had been shown to our clients in 2013. This number of closed deals is the denominator. In total there were 534 different intermediaries that made the list.

Step 2: We then looked at the number of PE firms these intermediaries showed a deal to in 2013 out of the 89 PE firms included in the analysis (this number is the numerator), and divided that by the number of deals they closed from step 1. A visual might be helpful. In the scatter plot chart below, each dot represents an intermediary. A firm below the line is more attractive because it’s doing an equal number of deals as a firm above the line, but showing their deals to fewer potential buyers.

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Step 3: For an even more meaningful takeaway, we took into account the number of different times the intermediary appeared across our various clients’ deal logs in 2013. (Caution: this chart is not for the data challenged and may cause confusion, dizziness, and even nausea). The size of the circle indicates the number of appearances, hence, the small circles below the trend line are potentially the best sources of deal flow.

Click to EnlargeClick to Enlarge

The result of this analysis is a first-of-its-kind listing of the most active intermediary firms, qualified by the quiet or broad nature of their processes, which can be further customized for any particular target criteria.

In today’s competitive environment, where effective deal sourcing is a key driver of investment return and success in raising a subsequent fund, this perspective could offer a great strategic advantage in a PE firm’s business development approach.

As the scatter plot suggests, the results can’t be interpreted just from looking at the entire list of firms and targeting the intermediaries with the lowest ratio. The number of relevant deals they actually closed needs to be taken into account. For example, a firm that closes 20 relevant deals a year could have a ratio of 3, versus a firm that does 3 deals with a ratio of 2. If only the lower ratio was considered, you may be tempted to focus your resources on the lesser active intermediary. However, this approach would be flawed. The real question is, what kind of ratio do other firms closing around 20 or so deals a year in your market have and how does this compare? Similarly, what are the range of ratios for intermediaries that close 3 deals in your target market?

LOOKING AT TIERS OF ACTIVITY

It might be best to break down the level of activity into different tiers. Let’s start with the most active firms. Out of the 534 sell-side advisors that qualified for our analysis, 40 did ten or more deals, ranging from Houlihan Lokey having closed 66, to PwC and Deutche Bank which closed 10. The ratio among these 40 firms ranged between 4.6 to 1.1, and it doesn’t always decrease as you move down the list ranked by most active. This means that it’s not necessarily true that the more active the intermediary, the broader their process. 

Moving on to the second tier of firms based on activity, 225 firms closed between 2-9 deals, and their ratios ranged from 21 to .3. In this middle category, the firms with a lower ratio really stand out given the broader range of possibilities.

The most compelling analysis, however, can be drawn from the firms that closed 1 deal, of which there were 269 intermediaries. The ratios for these firms range from 38 to 1. In fact, there are 43 firms with 1:1 ratio of firms shown to closed deals. If you were one of the few fortunate PE firms that closed one of these deals, you have truly proprietary relationships with your deal sources.

GAINING AN EDGE

In conclusion, any perspective that gives PE firms an edge over their competition, while also enabling them to source deals more efficiently, should be considered closely. For those GPs that believe that deal origination is one of the keys to unlocking value in today’s market, spending some time analyzing your deal flow and continually improving your overall deal sourcing strategy can pay great dividends in the long term.


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