Identifying and funding successful ventures is the life-blood of every private equity organisation. And although most VC executives describe this ability as “an art” or something equally shrouded in mystery, all have very different ideas as to how it can be achieved. There are two deal sources to be addressed: those that come to you and those that you go out and find yourself.
Attitudes to the first source vary dramatically. A very clear distinction is made between business plans that reach your desk via some sort of personal recommendation however tenuous and those that are unsolicited. “We have never invested in a company that approached us cold,” states Michael Elias, managing director of London-based Kennet Capital. “We have found the difference in quality between those plans that are solicited and those that are not is enormous.”
The issue of what to do with unsolicited business plans is a fundamental one for all firms as they simply do not have the time and manpower to go through each plan that arrives but they run the risk of missing a gem if they dismiss such proposals out of hand. Elias estimates that Kennet receives roughly 30 to 40 business plans a week, half of which are unsolicited. “We have too many deals to look at and we cannot study every business plan,” he says. “We therefore took the decision around 18 months ago that we would not look at plans that are unsolicited and would concentrate on those that come to us via some sort of connection.”
Discounting all unsolicited business plans is, however, far from the norm. James Brocklebank, principal at Advent International believes that it is vital to get back to everyone that approaches you, however unsuitable. “We will always get back to people. These could be the jewels of the future,” he says. He does, however, admit that this does raise a manpower problem. “It ties up manpower and takes you away from being proactive but it is a question of balancing your resources,” he says. Clearly, the question of how much manpower this ties up is a question of how long it takes to get through and evaluate each plan.
Anne Glover, chief executive officer at Cambridge-based Amadeus Capital Partners, explains that the firm has reached a compromise on unsolicited plans. “We ask that all unsolicited plans are submitted through our website which forces them to be summarised into a couple of pages,” she says. She reckons that Amadeus receives around 400 unsolicited plans a quarter a level similar to Kennet at around 30 a week. “Some people aren’t happy about this as they have spent a lot of time putting together their business plan but it makes us a lot more efficient.”
Glover explains that the policy has the added advantage of demonstrating how coherently the team can express themselves in a confined space. “This enables us to respond to everything even if it is a very fast no,” she says.
But while Glover agrees that it is very important to look at and respond to genuine unsolicited plans she reserves particular opprobrium for business plans that reach Amadeus as part of a mail shot. “This is email spam and it is rude and intrusive. It fills my inbox and is enormously intrusive,” she fumes.
But although most VCs extol the virtues of reading every business plan even if it is only the first couple of paragraphs it seems that the likelihood of an unsolicited business proposal turning into a deal is very remote. “The probability of an emailed business proposal being worth reading is in the 100s to one,” says John Moulton, managing director at UK-based Alchemy Partners. “In most cases you can form a view by the end of page one but we look at them all as you never know where your next deal is coming from.” Brevity is again of the essence. Morton tells how he received an unsolicited proposal that was 800 pages long and he therefore replied with 800 rejection letters to make the point. He reckons that maybe two out of 40 deals that they do arise from unsolicited proposals.
One firm that gets a relatively high proportion of its deals an estimated 30 per cent – from unsolicited proposals is 3i. “It is easier to get our attention if the deal is from someone we know and respect but we try to look at everything,” says Mike Reid, investment director at 3i. “We source a higher percentage of deals from unsolicited proposals than the market norm as we have such a strong name in the market. People know the deals we have floated and will therefore approach us.”
Another source of private equity deals that is viewed as something of a mixed blessing is the intermediary. For the purposes of this article intermediaries are defined as the big five accountancy firms and the investment banks rather than other VCs or business angels. The usefulness of intermediated deals is in direct relation to the stage in the business cycle that you are aiming to invest. “At the early stage an intermediary is crucial,” says Brocklebank at Advent International. “There will always be deals that you do not pick up on your radar screen.” But not everyone agrees.
Some early stage investors interviewed felt that intermediaries were less likely to be used in this sector of the market than late stage. “The earlier in the cycle you are the less likely it is that an intermediary will be involved,” explains Glover at Amadeus. This is for one simple reason: “They need to get paid and the kind of people we are dealing with don’t have any money.” Elias at Kennet, another early-stage investor, explains that they have never sourced a deal through an intermediary and claims: “The deals the accountancy firms bring us are pretty ropey. They do not know how to evaluate technology companies.”
Not surprisingly, the intermediaries feel they are vital to early stage investment. “For mid-sized and larger deals people don’t like getting into auctions as they are highly competitive,” says Clive Hyman, head of the incubation unit at KPMG in London. “But at the early stage referrals from people like us are what makes the business tick,” he claims. “Early stage VCs can’t cope with the number of deals that are hitting them and we can de-risk’ the business proposition for them,” he says. Intermediaries such as KPMG feel their strengths lie in their market experience and their size: “We have 20 people in our team and have 14,000 employees in the UK to leverage from,” says Hyman. He says that discounting the role of intermediaries is a “nave and arrogant” attitude that is frequently seen in US houses. “US firms do not know how to network in Europe,” he declares.
There is certainly no doubt that all private equity investors early or late-stage hate auctions. “Nobody likes to be put in an auction situation,” says Reid at 3i. But the firm will participate in auctions and has sourced deals via this route. For example, its GBP2 million investment in Wireless Systems, a spin-off from Bristol University, was sourced via an auction conducted by local advisor Key 3. For the buyout sector of the market, auctions are viewed with even less enthusiasm.
“Alchemy Partners will not participate in an auction,” states Moulton. “This is a fairly unusual policy but they waste a lot of time. I don’t find it easy to believe that we can offer something materially better than 20 to 30 other VCs putting GBP35 million equity into a deal.” He admits that this policy “cuts out 85 per cent of the market” but says that this doesn’t matter because of Alchemy’s focus on “difficult” deals half of which are public to private. “Our most frequent competitor is apathy rather than anyone else,” he says.
One thing all VC’s agree on is that their most important deal sourcing tool is their own network of contacts, and they universally prefer investing in management teams they know and have worked with before. But given that this is not always possible, how do they go about finding new deals?
Most firms seem to adopt the approach of breaking their staff up into sector teams devoted to identifying particular hotspots of opportunity within that particular sector. But once those hotspots have been identified, strategies are again very different. All firms use trade journals, investment banking research and the Internet to identify potential companies, but some will then continue the selection process before making a first approach. “You can get a reasonable amount of information from a website enough to decide whether to call or not,” says Michael Elias at Kennet. But Brocklebank at Advent International believes once you have made your decision on a sub sector you should call everybody. “You should not try to screen too hard,” he warns. “If you try to screen yourself you will end up missing stuff.”
Advent International adopts a slightly unusual approach in that it places huge emphasis on cold calling. It runs a dedicated calling programme in most countries in which it has offices and recruits people specifically to cold call. It runs a unique web-based database called Dealog that has the details of 39,000 companies that have been approached and the details of that approach. Brocklebank claims the results speak for themselves: 22 per cent of the deals in Advent’s GBP1 billion GPE3 fund were the result of cold calls (compared with 43 per cent proprietary) and 25 per cent of the deals in the GPE2 fund were sourced through cold calls (35 per cent proprietary). “This works across all sectors and we have had success in both early and later stage,” says Brocklebank.
He notes that the quality of research from the investment banks has improved dramatically over the last four years, saying that analysts are now much more aggressive in picking up early stage companies and going to see them quickly. “But even then it is almost too late as everyone else has also seen it,” he admits. Cold calling led to Advent International’s 1999 investment in Danish company Cybercity, which provides broadband DSL services to small business and residential customers. Another investment in Lightbridge, which provides software for cellular operators to improve their customer acquisition process and was exited in December 1999 at an IRR of 63 per cent, emanated from a cold call.
Clearly, identifying what you consider to be a hot technology is one thing, but getting in as a seed investor before everyone else does is quite another.
This is where the role and attitude of the University research departments themselves is crucial. A new initiative introduced by the UK government over the last two to three years aims to encourage an entrepreneurial culture at the universities and could help to improve the flow of information and money between them and their potential investors. The government originally put aside GBP50 million to be invested in University Challenge Funds whereby the university can apply for the money on the basis that it matches government funds with its own.
In the first round of funding 15 universities were successful (from a list of around 30) and a series of these funds was set up. They have a limit on individual investments of GBP250,000. One such fund, the White Rose Technology Seed Corn Fund involves Sheffield, Leeds and York Universities and is managed under contract by Aberdeen Murray Johnstone Private Equity. “These funds are being used in two ways,” explains Gerry White, investment director at Aberdeen Murray Johnstone Private Equity. “Some are using the money to set up businesses attractive to incoming VCs and others are funding the actual technology itself.”
The University Challenge funds can only invest in research coming out of their Universities but they enable the University to develop a business strategy for each of their investments and to bring in experienced people. White Rose has made nine investments so far and has appointed someone to each company as a business mentor. “From the VCs point of view this programme is giving them access to technology deals that they otherwise wouldn’t have seen,” says White. In March this year White Rose invested GBP245,000 in drug development company Asterion set up on the basis of research from the University of Sheffield and in June GBP250,000 was invested in Pro-Cure Therapeutics, based on cancer research from the University of York.
“The concept of the University Challenge Funds is great as it is starting to bring the Universities into the commercial world,” says Reid at 3i. But, not surprisingly, he says the amount of money involved is far too small and that the GBP250,000 cap on investment is far too low. Reid emphasises that Universities need to improve their relationships with their partners and should be looking to help people set up on their own as VCs. “The seed and early stage market is very informal. They should be looking to build their relationships with entrepreneurs. Just throwing money at the problem isn’t going to help.”
But one way VCs can build their relationships with the Universities is to invest in these Challenge Funds a prospect that White at Aberdeen Murray Johnstone sees as quite likely. “There is nothing to stop them [the challenge funds] raising more money and getting other investors in alongside the seed investor,” he says. White indicates this is something White Rose is considering.
The fund itself stands at GBP6 million, GBP1.5 million of which was put up by the Universities themselves and GBP4.5 million from the government. The government has earmarked GBP15 million for a second round of funds aimed primarily at those Universities that were not successful the first time.
University Challenge Fund-funded companies have first refusal on opportunities from the Universities with which they are associated. Is this one step closer to the spectre of VCs having exclusive arrangements with certain research departments? Glover at Amadeus, which has very strong links with the Universities of Cambridge, Southampton and Bristol, dismisses such an idea as “nuts for them and nuts for us.” But Reid at 3i is not so sure that it will not happen. “There is a strong incentive for a department to get a big cheque on the table upfront it may happen.”
Given the volume of business plans that they are deluged with, it must be easy for VCs to forget that the deal sourcing process should place much more emphasis on pro-active research on their part rather than just picking out the wheat from the chaff that crosses their desk. But as 3i’s unsolicited deal rate shows, the higher profile you are, the more good deals will come your way. “Our marketing spend for the year is the advert we put in the FT for our birthday,” smiles John Moulton at Alchemy Partners.