Malik: The Ever-Changing Middle Market and The Entering Class of 2016

Sep 2 2016 | 5:01pm ET

 Editor’s note: Deal sourcing and origination is only going to get more competitive given current market and economic conditions, argues Nadim Malik, CEO of Sutton Place Strategies in this contributed article, yet they remain critical to the success of any private equity firm. An origination strategy is only as good as the data that informs it, Malik writes, especially when targeting lesser-active advisors and sponsors. Accordingly, refreshing elements such as contact information and performance-based metrics on a frequent basis will lead to more impactful and efficient use of resources.

The Ever Changing Middle Market and The Entering Class of 2016
by Nadim Malik

If the fragmented nature of the middle market wasn’t itself challenging enough from a business development and market coverage standpoint, then the ever-changing landscape of players should push you over the top. A successful origination strategy requires ongoing refinement of who to prioritize your relationship building with, as well as a means to identify new relevant entrants in the market in a timely manner. Data that drives a firm’s sourcing strategy, ranging from something as simple as contact information to more sophisticated performance based metrics, needs to be refreshed on a frequent basis in order to be impactful and curtail inefficient use of resources.

An exploration of the “Entering Class of 2016”, i.e. firms that have completed a deal for the first time in 2016, sheds some light on the importance of acting on current information. In the first half of 2016 alone, there were over 90 new financial advisors that closed their first deal in the U.S. or Canada. Also, there were over 150 new investors, including PE groups, family offices, and independent sponsors. Having a system in place to form relationships with these new entrants ahead of your competition, and strengthen those relationships with ongoing touch points, is a key component of any successful sourcing strategy.

What about firms that do a deal, but never do one again? Isn’t this a little like a dog chasing its tail? There is indeed some substance behind this argument. According to SPS data, approximately 190 of the 776 different sell-side advisors that sold a company in the U.S. or Canada in 2013, or 24%, did not close another deal in the following two years. Having said that, since the vast majority of advisors do indeed return to the market but a method to discern them in advance has yet to be invented, marketing to all relevant firms and professionals is still essential. 

There is yet a stronger argument to focus on new entrants, which typically start out as boutique firms closing 1-3 deals in their first year. 112 of the firms that were classified as boutique in 2013 evolved out of this category closing more than 3 deals in either 2014 or 2015, thereby demonstrating the importance of building relationships early on, as many will translate into more robust sources of relevant deal flow in the future.

Part of the consternation around covering boutiques is that some close a small share of the overall transactions they bring to market, and there are hundreds of brokers and intermediaries every year that shop deals but never end up closing even one. Despite the lower success rate, covering these below the radar firms is vital to any successful sourcing strategy, because they often run less competitive processes compared to their larger counterparts. Additionally, logging deals that don’t end up trading can actually be beneficial. Being able to mine these transactions, some time after they were shown to you, is a great way to give your pipeline a fresh pass, and unearth quality companies that may now be in a better position to complete a transaction.

While covering the fragmented universe of lesser-known deal sources is no easy task, there are indeed numerous success stories among private equity firms building relationships and sourcing from boutique advisors. While average market coverage when a seller was represented by a boutique sell-side advisor was 12% according to the SPS 2015 Deal Origination Benchmark Report, some firms are now seeing as much as 25%. This is a remarkable achievement and not the result of an overnight success, given the fragmentation and turnover in the middle market. These firms utilize both committed and talented marketing professionals, backed with sophisticated data and technology tools that both serve as a compass as well as measure progress.

If you’re a lender with a sponsor coverage model as part of your business development strategy, you have your work cut out for you. Among the more than 1,700 financial buyers that closed at least one deal in the last year, over 80%, more than 1,400 firms, closed just 1-3 investments. These low volume shops are scattered all around the country, and are a veritable gold mine from a sourcing perspective. The larger institutional lenders often ignore them, and sourcing from them is very relationship-driven. Given the sheer number of firms, having the ability to qualify them in terms of geography, sectors, size, etc., and their overlap with your criteria is a key differentiator. The growing sophistication among lenders will surely enable professionals to source more methodically, instead of the typical shotgun approach.

Given current market conditions, and if the expected economic downturn keeps getting deferred, deal sourcing and origination is only going to get more competitive and critical to a firm’s overall success. A lender or investor that is using a list of contacts that is outdated, or not strategically directing and tracking their outreach, is wasting precious resources and doing so at its own peril.

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