Deal Flow Sharing Sounds Good, But Will It Work? –

Of all the industry jargon that tumbles off the lips of buyout professionals, none has the power to seduce more than “proprietary deal flow.”

The phrase is designed to conjure up the image of a firm which avoids vulgar auctions, never overpays and frequently hears about great deals before the rest of the world. And in a fund-raising environment where investors are skeptical of plain vanilla, general partners increasingly are using deal flow as a marketing tool-a way to differentiate a fund and build confidence in the team that will invest it. In addition to selling themselves as savvy and experienced investors, some G.P.s-especially in the middle-market-are explicitly selling their relationships.

The most common approach so far has been for a middle-market firm to align itself with a large entity and claim to be first in line for any deals the bigger firm deems too small. Buyout firms that have raised, or are raising, a fund with this profile include Gryphon Investors, Winston Partners, Halifax Partners LLC, Dorset Capital and Blue Capital Management.

Some established private equity firms, such as Summit Partners and Saunders, Karp & Megrue, have expanded their franchises by starting in-house small-deal vehicles.

A second kind of deal flow touted by some recent buyout funds is one which ostensibly derives from an association with a consulting firm. Examples of this approach include funds raised by Parthenon Capital, Monitor Clipper Group and George Capital.

All of the above funds have emerged only in the past year, and investor reaction to most of them has been very positive, which makes the proliferation of these types of funds in the coming year even more likely.

As for how much value the deal-flow relationships bring to the funds, the jury is still out, according to market observers. The G.P.s of these funds and other sources say regardless of how much proprietary deal flow was touted during marketing meetings, these types of investment vehicles must still be evaluated mostly on the investment history of their managers. Where relationships and deal flow are considerations, sources say, the affiliated larger firms or consulting firms should be well incentivized to want to send deals, and advice, the way of the new firm.

“What is the value of deal sharing? I don’t know how much value you can point out,” says Dale Meyer, head of private placement at Banc of America Securities. “The only time it works is if there is some real hard-core economic interest attached to it.”

Look Who’s in My Fund

Fund management doesn’t get any more hard core than when you’re managing the personal wealth of Henry Kravis, George Roberts, David Bonderman and J.T. Crandall. But that is exactly what David Andrews does with the just-closed Gryphon Partners II, L.P. (see story p. 4). Andrews, president of Gryphon Investors, launched the fund earlier this year with the idea that institutional investors would want to be in a fund that would get deal referrals and advice from the founding partners of Kohlberg Kravis Roberts & Co., Texas Pacific Group (Bonderman’s brainchild) and Oak Hill Capital Partners (Crandal).

“The vision I had was that I recognized that more and more of the bigger buyout shops could no longer look at smaller but attractive investments,” Andrews says. “They often just went into the wastepaper basket.”

Gryphon Investors launched the earliest of many similar funds-other efforts include funds from Winston Partners, which has an affiliation with Thayer Capital Partners; Halifax Partners, which, along with Gryphon Investors, will look at deals passed down by Texas Pacific; and Blue Capital, which has an affiliation with Fenway Partners.

Early indications are that quality deals are indeed flowing from the big brothers to the little brothers, albeit not in very large quantities. Of the six platform companies invested in by Gryphon Investors’ first fund, one was referred to the firm by one of its all-star L.P.s.: A partner at Texas Pacific knew of an executive who was in discussions to buy Bright Now!, a family dental practice chain, but the deal was too small for the Texas giant. “They said, Go to Gryphon,'” Andrews recalls.

Since closing its $171 million fund in June, Dorset Capital has closed on two deals and is working on two more. Three of these deals involve co-investments from Weston Presidio Capital, a larger private equity firm with which Dorset Capital is affilated. Of those three, one was referred to Dorset Capital by the larger firm.

It may turn out that having access to the brains of a large buyout shop or consulting firm will end up being more important than having access to castaway small deals.

“It is very clear that they have a very deep network of deal sources, and we clearly are benefiting from that network,” says John Berg, a managing partner at Dorset Capital. “But we also have our own proprietary network.”

Sometimes a firm’s structure must be tweaked to maximize a deal-sharing relationship. Gryphon Investors’ Andrews notes that his firm’s first fund, which raised a total of $80 million, had to focus on deals requiring between $10 million and $25 million in equity, and as such was not in a prime position to benefit from KKR’s and Texas Pacific’s wastepaper bin deals.

“People know not to take a $25 million equity investment to [those firms],” Andrews says. “But the large firms get very interesting $25 million to $75 million equity deals” that they can pass along to smaller firms.

Gryphon Investors increased the size of its follow-on fund specifically to capitalize on this larger deal space. Andrews said Gryphon now sees meaningful deal flow from its L.P.s. “Anyone with an under-$100 million fund won’t get deals from the large firms,” he adds.

Gryphon Investors’ L.P.s have an incentive to pass deals to the firm because they get 80% of the fund’s carried interest. The partners at Dorset Capital take a slightly different approach to forging ties with a larger firm. The San Francisco firm has given Weston Presidio, which is not an L.P. in the Dorset Capital fund, the right to co-invest dollar-for-dollar in all deals. The two teams have invested together before-Berg has known Michael Lazarus, a founding partner at Weston Presidio, for over 11 years. The two used to work together at Montgomery Securities (now Bank of America).

The Consulting Connection

Another way buyout firms have been looking to differentiate themselves from the herd is by hooking up with consulting firms, which can source deals in addition to giving valuable advice. This structure was pioneered by Bain Capital, which was formed in 1984 as an affiliate of consulting firm Bain & Co. The tie between the two groups has since grown fairly loose, but the Bain idea has been revamped this year by at least three private equity groups, including Parthenon Capital, which Ernest Jacquet, a managing director at the firm, started with John Rutherford, chairman of The Parthenon Group. In addition, Jacquet is a former Bain Capital principal and Rutherford was a consultant at Bain & Co.

Since closing its fund at $350 million in June, Parthenon Capital has completed six transactions. One of them was sourced by the consulting firm: A junior partner at The Parthenon Group had a college friend who was starting a dotcom company. “He said, Jeez, I’ll just bring it to my firm,'” says Jacquet. “It’s that whole keiretsu [mentality].”

It would be hard to get The Parthenon Group any more enthused about helping Parthenon Capital make money-everyone at the consulting firm, from the top partners down to the receptionist, gets a piece of the private equity fund’s carry.

Jacquet says his group’s affiliation with a consulting firm helps close deals much more than it generates new deals. In addition to helping Parthenon Capital evaluate deals, the consulting firm helps run the portfolio companies. He says many business owners opt to sell to Parthenon Capital once they learn the deal includes consulting services.

“Our capital comes with help and support, arms and legs,” Jacquet says.

Vetting, Not Sourcing

Indeed, most market pros say the ability to vet deals is much more important than deal flow.

“Seeing more deal flow is always good, but it’s how you evaluate the deal flow that counts,” says Banc of America’s Meyer. “I’d rather have the ability to call up David Bonderman and say, What do you think of this business?’ than have David Bonderman scrawl a note to me saying, Saw this deal-too small.'”

Like other G.P.s at firms that purport to get deal flow from a larger entity, Dorset’s Berg says his group’s affiliation with Weston Presidio is based mostly on sharing expertise. “We believe this relationship is more than financial,” he says.

As for how much value the deal-flow relationships bring to the funds, the jury is still out.

It may turn out that having access to the brains of a large buyout shop or consulting firm ends up being more important than having access to castaway small deals, however large a pool that may be. And even if the small firm sees a robust deal flow, this is no guarantee that all of the small deals will be good ones.

“It’s too soon to tell whether this type of deal flow model will work,” says Steve Costibile, a vice president at Credit Suisse First Boston who runs the firm’s private funds group. “We’ll need to see how much time and effort the larger firms will give to the screening effort.”

In the end, market observers say, it will be the performance of the G.P.s at the smaller firm that will determine the return of the smaller firm’s fund. But for now, the ability to draw on the resources of an established firm certainly can lend credibility to an untested buyout firm-Dorset Capital’s own deal sources notwithstanding, Berg says the relationship with Weston Presidio helped his group raise its debut fund. “It was definitely a comfort factor for investors, who were looking at us as a first-time fund,” he says. “It helped them feel good about us.”