A new Deloitte survey found that three out of four M&A professionals expect deal activity to continue rebounding into 2017. But this optimism comes with a caveat for private equity firms: the pressure is on to strike good deals.
That’s partly because corporate strategics have the benefit of sitting on the sidelines without having to answer to impatient stakeholders, partly because money continues flowing into the sector at such a rate that we’re calling it private equity’s greatest test yet to come, and partly because investors still expect private equity shops to deliver outsized returns.
In fact, a Coller Capital LP survey found that 77 percent of investors plan to make US mid-market funds their main focus in 2017; and about the same expect private equity bets to deliver 11 percent annual returns in the medium-term. Yet that same survey found 64 percent of investors fear “too much money [is] pursuing too few attractive opportunities”. So investors seem to be aware of their own herd mentality, but trust the private equity sector enough to continue delivering satisfying returns during this anticipated M&A uptick.
Can private equity deliver? That depends on a number of factors, but private equity firms must fully leverage their core strengths of relationship building and due diligence if they want to win the best deals. Not every firm accomplishes this. Or at least isn’t accomplishing this to a sufficient enough degree. Below, we list three of those under-leveraged deal strategies.
1. Analyze who’s bringing the best deals
Many GPs believe that reaching as many intermediaries as possible is a surefire way to maximize deal flow. The problem with this mentality though is that there are only so many phone calls, emails and business lunches that can be scheduled in a day, so inevitably some relationships receive more attention than others. Smart firms know which relationships to prioritize by analyzing which bankers and brokers bring them the most promising opportunities. Managers can accomplish this in any number of ways, including by deals that most closely match their investment criteria, or deals that reach a certain stage of the investment process, such as a signed LOI.
Centerfield Capital’s Mark Hollis made this very point during a Navatar roundtable on the expected competition increase in the mid-market. Mark said he uses Navatar Private Equity to “create different tiers of intermediaries for different levels of engagement,” with bankers showing him the best deals prioritized for phone calls first. Even if Mark makes the same number of calls per day as the competition, he knows that the most fruitful intermediaries receive his limited time and attention for relationship building first.
2. Call bankers who bring you bad deals
Another simple sounding yet surprisingly underleveraged strategy is eventually calling bankers who bring you bad deals. What happens at most firms is a junior analyst will come across a deal that doesn’t match the firm’s investment criteria and quickly turn their attention to the next opportunity. They waste little time following up with intermediaries who bring them bad deals because the firm’s next investment homerun is out there waiting to be found.
That’s a missed opportunity. While every banker need not receive a phone call (see point one), it’s effective to set expectations that certain bankers should be contacted periodically to share a richer taste of the firm’s secret sauce. Edgewater Capital’s David Duke said he uses dud deals as an excuse to ring a banker and say “Hey here are the four or five reasons it wasn’t a right fit for us…and that goes a long way.” The point is to not only provide intermediaries a clearer sense of what he likes, thus increasing his chances for receiving better future deals, but to strengthen his overall relationships with the banker.
3. Exercise restraint during the early stages of due diligence
It’s true that, to a degree, a hot M&A market intensifies a scramble for the most plum deals. This is already playing out. The market is observing an increasing number of mid-market firms signing Indication of Interest (IOIs) letters without an in-depth evaluation of the target company. The thinking is that it’s better to express immediate interest in a prize deal rather than allow rivals to run away with it. What too few firms realize, though, is that decision speed comes at the cost of valuable collaboration early in the diligence process. Without enough internal agreement, team members exhaust time and energy on dud deals that could have been identified earlier as such under a more cautious approach.
During the roundtable, Rob France of High Street Capital explained how he puts this principle into practice. Rob said he brings in operating partners into the due diligence process as early as possible to provide their thoughts. “We actually have these folks reading the offering memorandum…whereas before we would think ‘Well, these are operating professionals, so we’ll bring them in only if it becomes more serious.’” What High Street Capital understands is that sacrificing a bit of speed for richer deliberation in the short-term, increases the chances of winning highly-sought after deals in the long-term. In this example, operating partners can help identify early warning signs in a target’s sector that could materially affect the bid price, or even kill interest in the deal, that rival bidders may only discover after signing a LOI.
As the competition for deals picks up, it may be these small adjustments that are all that’s needed for private equity firms to win the best deals and meet investors’ return expectations in 2017. For more tips, you can watch a recording or our special private equity mid-market roundtable below: