By: Tim Dissen
Account Executive, Enterprise Equity
March 12, 2024
Private equity firms pour a tremendous amount of resources into turning potential investment opportunities into closed deals. And with no guarantee that a lucrative opportunity on paper pans out to be a smart investment, firms need a way to evaluate risk vs reward at the sourcing phase. With proper deal sourcing, private equity investors keep a steady pipeline of opportunities flowing in, with each one marked for their potential return.
Consider, for example, the risk-reward calculations that went into the $15 billion Toshiba buyout by Japan Industrial Partners in 2023. Although Toshiba is one of the most successful technology conglomerates in the world, it experienced accounting scandals and revenue losses that nearly resulted in a stock market delisting. Japan Industrial Partners absorbed these inherent risks and took Toshiba private to turn their purchase into a worthwhile investment.
How did deal sourcing play a role in this, and how much emphasis should your firm put into due diligence? Let’s break down deal-sourcing strategies that can help firms source deals faster and provide more effective results.
Understanding private equity deal sourcing
Private equity is a type of investment capital used by high-net-worth individuals and firms to finance privately owned companies or those that are publicly traded or listed but are looking for additional financing.
When investing in publicly traded companies, private equity firms typically gain full ownership and take the purchased companies private. In most cases, these established companies may be realizing revenue losses or underperforming in certain areas, warranting financing via a private equity deal. In the example above, Toshiba’s scandals warranted a major company-wide reshaping, which would be easier to do under new ownership and leadership.
With private equity ownership, these mature companies can recover their value, protecting their assets and other business interests, including partnerships that have been developed and nurtured over time. The potential downside to relying on private equity funding is that the future of the now-privately owned company largely depends on the expertise and oversight of its new financier.
Why deal sourcing matters in private equity
Without the right tools, it can be challenging to find the right investment opportunities in a crowded market. On one hand, extrinsic factors like market conditions (e.g., rising inflation and interest rates) can influence the overall state of private equity financing. According to McKinsey’s Global Private Markets Review, the volume of private equity deals plummeted in the second half of 2022, resulting in an 11 percent decline in fundraising across global markets.
With a strong deal sourcing pipeline, firms can continue to evaluate opportunities even in a crowded or poor-performing market.
Private equity investors typically rely on systems or processes to find lucrative investment opportunities in line with their objectives. At the top of the funnel, for example, a private equity fund might start evaluating as many as thousands of potential investments to determine which would be the most ideal opportunity while keeping within specific target metrics.
Yet between finding new leads, pitching them, and nurturing relationships with investor networks, a private equity fund must have the right knowledge and expertise to identify suitable deals and then source these deals timely.
Screening the deals that stand out during a systematic opportunity search is typically done against investment criteria, which can be anything from growth potential, market position, or industry trends.
Types of private equity deals
So, what are the different types of private equity deals? Let’s explore the three most common:
#1 Buyouts
With a buyout, a private equity manager purchases a controlling interest in a mature company, privately owning it to add value before selling it to another entity or putting it up for an initial public offering (IPO).
Buyouts may take on different forms, including:
- Take private – Here, a private equity firm funding a buyout will pay off shareholders and take a publicly traded company off the stock exchange to control its assets.
- Private company buyout – Rather than purchasing an entire publicly traded company, a private equity firm can instead purchase shares of a privately owned one to hold a controlling interest before selling off the investment or putting it up for an IPO.
- Leveraged buyout – Often, a private equity firm will purchase a company using borrowed funds and leveraging the company’s assets as collateral for the acquired loans. This buyout approach tends to be risky because the private equity financier only funds the deal with a portion of its capital and finances the remainder through debt.
#2 Growth capital
Private equity firms can also provide capital to mature companies to help them expand, especially when these companies are undergoing a phase of exponential growth requiring much more cash than they currently have. For instance, a company entering a new market or expanding its operations across multiple sites may require additional financing to support these objectives.
By funding such initiatives through private equity deals, an investor secures a minority stake in the company it invests in. With a high growth potential, these investments also tend to carry moderate to low risk.
#3 Venture capital
With venture capital (VC), investors provide equity to less established companies like startups that are in the earlier stages of growth but with the potential for successful expansion.
VC financing is typically phased, meaning private equity investors will inject a seed round to kick off funding and then several “series” thereafter (i.e., Series A, B, and C) until a company adequately develops its assets to maturity.
These types of private equity deals are intrinsically high risk because there’s uncertainty around the success of any startup or early-stage venture, regardless of how promising its value proposition might appear.
Key strategies for private equity deal sourcing
When sourcing private equity deals, several strategic approaches can help firms effectively and swiftly navigate investment decision-making.
#1 Conduct research to identify potential deals
With thousands of potential investment opportunities available, private equity GPs are expected to analyze myriad data points to zero in on those opportunities that might yield success. Due diligence is critical to minimizing investment risks, especially when funding earlier-stage or underperforming companies.
Here, the extent of research will ultimately depend on factors like the industry of interest or the variation in market conditions. Using publicly available data, processes like financial modeling, historical stock market trend analysis, or asset valuation can help fund managers evaluate the performance of certain assets and garner sufficient insight into the risk of investing in one company over another.
#2 Build networks and nurture relationships
It’s not enough for equity firms to simply research their way into investment decisions. Networking with other investment professionals or industry experts not only provides insight into which opportunities will likely be rewarding investments but can also lay the groundwork for future referrals.
For instance, developing partnerships with brokers or industry consultants who have access to information about unique opportunities can offer promising leads that could materialize into successful deals once pursued.
#3 Utilize Technology and Data Analysis to Drive Deal Sourcing
These days, private equity financing must leverage technology and analytics to sift through large amounts of data, which helps eliminate those companies that are high-risk and unlikely to be successful. Plus, automated decision-making reduces the complexities associated with defining risk categories in a busy market where opportunities could be swooped by the next investor.
For example, software solutions like Allvue’s Research Management software provide fund managers with reports and analyses to help them make the right investment decisions, even when tracking data from disparate sources.
The deal sourcing process
Private equity firms are more likely to source deals effectively if they have robust processes to decide whether an opportunity is an ideal investment or not. And deal sourcing typically starts with private equity managers identifying prospective opportunities for the firm to invest in. This part of the process requires the firm to position itself as a reputable investment partner but also involves a fair amount of relationship-building to successfully navigate the complexities of each investment transaction. Upon conducting extensive research and due diligence, the GPs will pursue and finance the companies identified for investment.
Due diligence in private equity
Conducting due diligence is crucial when making private equity investments because of the inherent risk of financing any business venture. Beyond simply reviewing balance sheets and analyzing historical data, it’s critical to ask strategic questions, research information in the right places, and evaluate the breadth of insights gained throughout the process.
The viability of any private equity deal depends on the types of risks uncovered during the due diligence process. For instance, an underperforming company may look decent enough to finance on paper. However, due diligence might reveal significant flaws in the company’s day-to-day operations, which if unaddressed, might hinder its success even after a private equity acquisition.
Conduct proper private equity deal sourcing With Allvue
Private equity deal sourcing is essential for firms and investors to have a steady stream of opportunities to invest in—and identify those with potential for high returns. The success of most deals in finance relies on how much insight a firm has going into the deal, which then determines downstream factors like negotiation and, ultimately, closing.
With the help of Allvue’s pipeline deal management software, private equity funds can streamline their decision-making processes, automate deal pipelines, and quickly identify missing or bad data that may be compromising deal sourcing.
Contact us to learn more about Allvue’s suite of products.
Sources:
CNBC. Toshiba Board Accepts Japan Industrial Partners’ $15 Billion Buyout Proposal. https://www.cnbc.com/2023/03/23/toshiba-board-accepts-japan-industrial-partners-15-bln-buyout-proposal.html
Investopedia. Private Equity vs. Venture Capital: What’s the Difference? https://www.investopedia.com/ask/answers/020415/what-difference-between-private-equity-and-venture-capital.asp
McKinsey. McKinsey Global Private Markets Review: Private Markets Turn Down the Volume. https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/mckinseys-private-markets-annual-review
More About The Author
Tim Dissen
Account Executive, Enterprise Equity
Tim Dissen, Account Executive for Northern Europe, joined Allvue in 2022. Tim has worked with traditional and alternative investment managers for over 18 years. Tim was previously Global Sales Director at SEI, and prior to that, business development roles at DST, JP Morgan Chase, State Street & Intel Corporation. He is a BSc graduate of Lancaster University, UK and also holds a professional qualification with the Chartered Institute for Securities & Investment.
