By Nadim Malik
Our firm, Sutton Place Strategies, has long advocated that deal sourcing is a key component of better fund performance.
While private equity returns continue the trend of regression to the mean due to increasing competition and efficiencies in the market, the intense fragmentation of middle-market-deal sources creates an opportunity for best-in-class deal originators to invest in companies that their competitors didn’t even have a chance to review.
The takeaway from the 2016 edition of Sutton Place Strategies Deal Origination Benchmark Report is that PE firms are seizing this opportunity, evidenced by better overall deal-sourcing results.
The annual report compares the “market coverage” of a private equity firm — the percentage of relevant, completed PE transactions with a sell-side adviser that the firm reviewed — against all private equity firms as well as its peer group.
The median market coverage improved to 17.7 percent for the year ended June 2016, up from 15.6 percent a year earlier. Furthermore, each of the fund categories in the report — generalist, quasi-generalist, sector focused, upper middle market, and lower middle market — had equal or better market coverage in 2016 compared with a year earlier. Private equity firms on average improved their coverage by 11.6 percent over the past year.
Where the improvement may have the greatest impact on fund returns is market coverage of boutique advisers, defined as intermediaries that sold only one to two businesses to a PE buyer over the past year. More than half of boutique advisers run more limited processes, as proved with the launch of Sutton Place Strategies’s new intermediary Sell-Side Process Index in 2016. Through a proprietary algorithm, the Sell-Side Process Index classifies the type of marketing process that intermediaries employ (broad, moderate, or limited) on a relative basis.
While difficult to cover due to sheer volume and higher turnover, the appeal of these lesser known intermediaries is less competition and greater opportunity to get to know sellers more intimately, compared with a broad auction process typically run by large-volume shops. On average, market coverage of boutique advisers improved to 11.4 percent in 2016 from 9.2 percent in 2015.
One way private equity firms are rising to the challenge of sourcing through boutique advisers is by having dedicated business-development professionals, whose primary focus is originating deal flow. Half or more active PE firms today have dedicated business developments people or teams, a trend that is likely to continue.
It’s important to note that while just half the firms included in this year’s analysis have dedicated business-development professionals, each of the best market-coverage performers in the Sutton Place Strategies peer groups in the accompanying table had a dedicated business-development person or team.
Limited partners are taking notice of the need for best-in-class deal origination as well. Many general partners claim that after fund return, deal origination is the second most critical area of scrutiny on the part of LPs, and for good reason. By having higher market coverage, a private equity firm is essentially giving its investors access to transaction opportunities that its competition does not possess — a powerful differentiation in the eyes of LPs.
Given the current economic climate and increasing competition, greater emphasis on deal origination will enable PE firms to unearth quality transaction opportunities at reasonable valuations. While the most important component of a successful sourcing strategy is having the right professionals in place to build the requisite long-term relationships, utilizing more robust and sophisticated metrics to intelligently drive their efforts can be a competitive advantage for both GPs and LPs in their quest for better returns.
Author Nadim Malik is founder and CEO at Sutton Place Strategies LLC. Reach him at NMalik@suttonplacestrategies.com.