The days when private equity fund managers pursued proprietary deals at their own pace are long gone. As more investment capital flows into the market, deal makers find themselves in a scramble to court potential targets using sourcing strategies ranging from hiring marquee-name rainmakers like Jack Welch, to hiring brokers, to relying on old-fashioned cold calling. According to experts from Wharton and private equity practitioners, deal sourcing techniques are becoming increasingly important as firms look for any kind of lead in the competitive market.
John Cozzi, managing director of AEA Investors, says only about 20% to 25% of the firm’s deals are proprietary, with another quarter coming from affiliated funds and half from bankers. Last year, the company looked at 600 companies and invested in three. A year ago, he says, AEA would only have had to meet with 100 companies to secure three deals.
Relying on relationships and reputation are not necessarily enough to bring deals through the door, he says. “Today, you need a much more process-oriented approach.”
Industry wide, only a third of respondents to the most recent Association for Corporate Growth/Thomson Financial DealMakers Survey are able to make half their deals exclusive. In most cases, private equity firms prefer a proprietary deal, but the reality is that more and more companies are hiring investment bankers to stage auctions, forcing quick decisions about transactions which fund managers fear they may ultimately regret.
“We have historically not been active in auctions,” says Michael Doppelt, managing director at Bear Stearns Merchant Banking (BSMB), where he is responsible for marketing and deal-sourcing. “You don’t really build a good relationship with management that way, so you tend to not get quite as much information. That’s a formula for lower returns, as opposed to cultivating people for years and having them come to you. It’s much more harmonious.”
Doppelt says that private equity firms need to invest in cultivating companies for the long-term, even before they think they are interested in selling. “If you take whatever business is super-hot today and knock on its door, it has most likely had pitches from 10 investment banks. You need to network early.”
Todd Millay, executive director of the Wharton Global Family Alliance, says private equity investors are teaming up with entrepreneurs they have already financed to find new deals. He gives the example of an entrepreneur who builds a successful medical supply business and sells to a private equity firm. The entrepreneur often goes on to become an investor in other medical supply companies. “The private equity firm would love to come in side-by-side in some of these other investments, because the entrepreneur knows what’s going on. If a private equity firm is smart, it can turn its investments into future investment partners.”
Cozzi notes that networking with managers of potential targets can be difficult. “A lot of managers don’t want to meet with private equity firms because they think we will come in there and fire them all.” AEA attempts to engage managers at different levels, from the board room to the executive suite and below, as a way to get into the company using any entrance that is open. “We go out to the company and develop relationships with people at multiple levels,” says Cozzi. “Just by having dialogue with a person, you get a lot more information.”
Advisors, Stars and Private Clubs
Increasingly, companies under pressure to find deals are turning to investment banking advisors for help.
“What an M&A advisor brings is relationships,” says Kent Weldon, managing director of Thomas H. Lee Partners, who participated on a panel about mega funds at the 2007 Wharton Private Equity and Venture Capital Conference. “We who work in private equity all have a lot of years doing the same thing and we have similar financial training. When you pick an M&A advisor, you’re getting a senior person with 20 years of relationships for deal flow. That creates a channel for communication with people that takes many forms.”
Cozzi from AEA says his firm is often able to attract deals because of the nature of its client base. AEA was an early private equity firm founded in 1968 by the Rockefeller, Mellon, and Harriman family interests and S.G. Warburg & Co. “Ownership families like to sell to us because families are investors in the fund,” he notes.
Doppelt says Bear Stearns maintains a Chinese wall between the private equity fund and its investment banking operations. Still, there are some advantages to being part of a sophisticated banking business. “We work with other investment banks quite a bit, but our relationship with Bear Stearns is a good one,” he says. “Bear Stearns is a vast institution with tremendous resources, and we benefit from that.”
For example, private equity executives have been able to tap financial expertise at the investment bank to price and evaluate securities as part of a private equity transaction. Doppelt adds that BSMB does deals through Bear Stearns investment bankers, but they do not represent a majority of the firm’s transactions. BSMB works with other investment banking houses, too, he says. “It’s a very competitive environment. If we’re not paying fees on the street, we won’t get services.”
While investment bankers can be useful, companies can get a better edge on deals with the use of corporate executives who sign on as consultants or special advisors. These advisors, like Welch, are often star-power names who can provide firms with deep and rich industry contacts instantaneously. Doppelt notes that BSMB hires operational partners with long experience in industry who can bring credibility to deal sourcing by demonstrating knowledge of the business. “We want to show more than some Wall Street guy sitting in front of a screen.”
The firm also has created a special fund open for high-level executives with whom BSMB would like to develop deeper connections. “We’ve limited it to c-level executives at important companies in our space as an incentive for them to have a connection to us. If they come across a deal, we will be an early call,” says Doppelt, who was about to meet with an investment banker representing a company in search of capital to make a retail acquisition. The former chief executive of the target is in the BSMB fund. “That can be powerful stuff.”
Another new trend in deal sourcing is the rise of so-called “club deals,” in which several large private equity firms band together to finance a transaction that otherwise would be so large the company would need to seek backing from the public markets.
Weldon says that many publicly traded companies are now open to overtures from private equity. New regulations following the scandals at Enron and other corporations, such as the Sarbanes-Oxley Act, are making public ownership less attractive, he said.
Activist hedge funds demanding change at public companies are also creating new sources of private equity deals, according to Weldon. “A year or two ago, we wondered if the hedge funds would become competitors and leapfrog over us in doing private equity deals. In fact, they have been a great source of transactions for us. They have a shorter horizon than we do, and as a result they are putting a lot of companies into play and forcing companies into our hands.”
Building a Brand
Developing industry specialization is another way firms try to position themselves for potential deals, promising operational strength that will boost returns for investors.
For example, BSMB, which focuses on private equity in the middle-market, has expertise in branding and consumer products, says Doppelt. BSMB’s chief executive, John Howard, became interested in Seven jeans when the women in his household were all wearing them. His interest as a passionate consumer convinced Seven’s management to enter into a private equity deal with BSMB.
The company’s retail and global souring experience made also made it an attractive partner for Stuart Weitzman, the footwear company. According to Doppelt, founder Weitzman was not looking for cash but wanted expertise to expand. BSMB bought a 40% stake in the business after Weitzman asked: “How much do you need to invest so this matters to you?”
Tim Berkowitz, president and managing director of HealthPoint Capital, a private equity firm specializing in the narrow health care arena of orthopedic devices, has not only developed a highly specialized industry focus — it has also positioned itself as an information broker for the fragmented industry.
HealthPoint has its own research staff that writes regular news columns and blogs appearing on the company’s web site. The site has become a go-to location for industry news about everything from public company earnings, to FDA approvals, to changing insurance reimbursement policy to technology developments.
“It is our deal engine. It creates brand recognition,” says Berkowitz, adding that the founders of the firm took the unusual approach because they “did not want to be two more private equity guys eating our dinner on Park Avenue hoping for the phone to ring.”
Instead, they have developed a brand for the company among orthopedic surgeons and other key sources of deal flow. Berkowitz notes that many companies in the space are small and owned by doctors working at medical centers in far-flung locations around the world. HealthPoint’s web site, he contends, is now their gathering place. “There is no Silicon Valley for orthopedic devices,” he points out.
When the industry convenes for conferences, HealthPoint sends a research team to compile articles, but it also sends deal partners to meet with doctors who may someday become the source of transactions.
Berkowitz does not mind sharing information, even though that commodity is usually closely guarded in the highly competitive private equity environment. “It’s a totally different approach. Traditionally, the buyout firm has a scintilla of an idea and protects it as if it is the most important piece of information there is,” he says. “Our approach is to leverage our relationships with the key surgeons, management teams, distributors and medical centers to drive the growth of all our companies at once.”
The Old-fashioned Way
A final strategy to drum up private equity deals is at least as old as door-to-door encyclopedia sales: cold-calling. Brian Conway, a managing director at TA Associates who prefers to call the strategy “investment origination,” says three-quarters of the investments the firm has closed have been originated by TA.
Conway stresses the firm does not exactly knock on doors like a private-equity Fuller Brush man. The firm organizes its staff around industry groups, and within those groups analysts look for sectors that seem most promising. Within finance, for example, TA has built expertise in financial technology with two partners and 15 investments in that sector. Then, within each sector, TA burrows deeper into specific segments. For example, within the area of financial technology there are plays to be made in back-office automation, credit derivatives or foreign exchange.
“We look and find the leaders in each segment,” he says. “We’re well prepared and have a reason for wanting to call on a company.” Often, he notes, TA is the first private equity firm that has ever approached the company. Many times it takes years of informal visits to learn about the company before a deal is done.
“We don’t think that makes the relationship proprietary,” he says, but if a transaction does come up, TA generally has more information about a company than competitors and is better able to make an offer that it can live with long-term. “I think the [current] market requires [firms to] come in on an investment-banking timetable, learn a business, understand it and then pay the highest price with the most certainty of close. I question whether that is a long-term strategy that is sustainable.”