The formulas, tricks and trade secrets of Private Equity

Private Equity Deal Origination

Sample Chapter

Private equity deal origination involves finding, negotiating and securing potential investees. Since a firm seeks to invest in only 7-10 businesses for a particular fund, it is crucially important to select the right businesses. However, contrary to popular opinion, there’s more to private equity deal origination than just short-listing the hoards of entrepreneurs with new ideas knocking at the door.

One other important distinction is that the private equity deal origination process differs for different sized private equity funds. For a $10b fund, there aren’t many opportunities outside the public markets (and even then, the options are limited). For a $10m fund, there are innumerable opportunities, so deal origination methods are much different.

The channels for deal origination are as follows:

  1. Proactive: this involves a private equity firm proactively researching, short-listing and contacting businesses that fit certain criteria. A common approach is to select an industry with compelling fundamentals, spend a day on industry research, and then iteratively contact businesses in search of opportunities. The major benefit of proactive origination is that there is less competition with other private equity firms. The disadvantage is that it takes much longer to qualify leads.
  2. Intermediated: this refers to cases whereby an intermediary facilitates a potential deal. For example, a business broker or investment banker may introduce a potential to a private equity firm. Unfortunately, multiple buyers see the offer, which creates an auction and inflates the price. The advantage is that businesses are qualified as real leads before presented to the private equity firm.
  3. Passive: this is where a potential investee contacts the private equity firm directly. This can be through a link on a website, the phone book, or a related contact. As with an intermediated lead, the potential investee is already qualified. The perceived disadvantage is (and this has no technical basis) that businesses looking to sell equity probably aren’t the best businesses to be buying.

For larger funds, it is very difficult to originate proactive deals, as there’s so much competition with investment bankers looking to clip the ticket. At the mid-market end, proactive origination is more the norm. Firms like to think they’re differentiating themselves by originating private equity deals away from the brokers and bankers, but in reality, most low-value deals originate from proactive industry research. The advantages of not partaking in a process and not having to manage conflicts with intermediaries generally outweigh the extra cost of qualifying these cold leads.

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