All private equity firms need quality deal flow to stay competitive. Particularly in the US small buyout market, where companies with up to $100m in turnover are plentiful but information on them is scarce, a good deal-referral network can mean the difference between smart investing and hopeful floundering.
Then there is so-called “proprietary deal flow,” a higher, almost mythical level of business network connectivity. A proprietary deal, in theory, means not only that the buyer learned of the investment through their network, but also that no other buyer ever stood a chance to get close to it. Instead, the seller enters into exclusive negotiations with the prospective buyer early on in the process.
Small buyout firms have been trumpeting their proprietary deal flow for as long as there has been a small buyout market. They have a point – proprietary deals are more likely to occur in the small buyout sector in part because of the vast amount of companies that inhabit it, coupled with the relative dearth of investment firms targeting the space. Practitioners active in the segment point out, rightly, that bigger assets purchased by larger private equity firms, especially those with mega-funds to invest, are almost always represented by investment banks who show the deal to every financial buyer available. In the small buyout market, although insiders say sellers are becoming increasingly sophisticated about their options as well, assets are typically not shown to as many suitors.
Where this is the case, purchase prices can be significantly lower. According to Erik Hirsch, chief investment officer at fund of funds manager and investment advisor Hamilton Lane, the firm's buyout portfolio shows significant discrepancies in terms of purchase price multiples at which recent transactions have closed. He says: “The mid-market is more erratic. We recently saw a small public-to-private deal get done at an EBITDA multiple of 4x. That same week, a similar business, albeit in a different industry, was aquired for 11x EBITDA.” Hirsch adds that part of what this phenomenon shows is that some transactions are completed on a proprietary basis whereas others are not.
Othon Prounis, co-head of the private equity transactions group at law firm Ropes & Gray, observes that in today's US buyout market, there are relatively few investment banks focused on smaller transactions. As recently as in the mid-1990s, he says, there were approximately 50 investment banks that focused on these types of transactions, but today, largely due to consolidation, only about a dozen remain, and many of them have shifted their focus to larger deals.
An array of deal brokers continue to service this niche, but buyers and seller still have a harder time connecting with each other than is the case in the larger buyout world. Despite the appeal of proprietary transactions, most small buyout firms are eager to be shown good deals by intermediaries. Prounis says that his private equity clients have even started coming to him for ideas, asking that Ropes & Gray pass along any promising small companies in need of capital. “And that's not our business,” Prounis said when speaking as a panelist at an August small-buyout conference hosted by Broadgate Consultants in New York.
Clearly, even general partners managing small buyout funds can't rely on sourcing deals from only their immediate circle of contacts. But that doesn't make the small buyout market less attrac-' tive, proponents of the strategy say. Even where an auction is held, there are still plenty of opportunities to acquire a good company at a good price. A deal should not be judged by how it is sourced, these practitioners argue, but by the value created after the acquisition is complete. Some small buyout market participants even say – brace yourself – that “proprietary deal flow” exists more as a marketing spiel than as a market reality.
Paula Chester, the former head of private equity for the New York State Retirement Fund, and now a placement agent in the New York office of MVision, says she remembers well the many claims to proprietary deal flow during her years on the buyside. “From an investor standpoint, and from a marketing standpoint, you always hear that the small- and middle-market buyouts are less efficient,” she says. “[But] when you hear everybody say, ‘All of our deals are proprietary. We don't accept auctions. We don't take books from investment bankers,’ I think people are kind of sick of it.”
David Lobel, a founder and managing partner at New York-based Sentinel Capital Partners, says that proprietary deals do exist, but, like any other over-hunted species, they are rare. Of the eight deals done by Sentinel Capital's first fund, which closed in 1995, only two were truly proprietary, Lobel says, adding that the firm's second fund, which closed in June 1999 on $126m, did no truly proprietary deals.
Lobel says that where his firm has been granted exclusivity early on in the process, opportunities have come through industry executives his firm “keeps in its stable.” Beyond that, Sentinel, which looks for companies with no more than $10m in annual profits, has approximately 3,500 intermediaries in its database, of which 250 are considered “A list.”
“[The A list] are people who are the most productive, credible and who we spend the most time with,” Lobel says. Of those 250 individuals, Lobel estimates that about 20 have provided the firm with 40 per cent of the deals it has completed. A few of those have struck gold more than once.
“Creating that network takes time,” Lobel says. “I've been doing this for 23 years. Business is good business if you can do it with the same guy twice.”
When you hear everybody say, ‘All of our deals are proprietary’, I think people are kind of sick of it
Terrence Mullen, a managing director of New York-based Arsenal Capital Partners, agrees that all firms love proprietary deals, but admits that almost 90 per cent of deals that are around $10m in size now have some form of representation. “Everyone has someone assisting them to think through valuation and help a seller maximise value for their property,” Mullen says.
Mullen says most of his firm's deal flow is supplied by a “cabal” of business leaders. In its two years in operation, Arsenal has reviewed roughly 350 deals. Very few of those are what Mullen would describe as truly proprietary.
Since most small buyout firms must compete for the best deals, many are looking to increase their odds of success by offering target companies operating expertise once the deal is finished. The small buyout market is heavily populated with GPs who target the very industries in which they built careers as operating executives. To be sure, knowing all the CEOs and senior executives in your chosen sector can help stimulate deal flow. But more importantly, a general partner with operating experience is far more attractive to a seller, who isn't only interested in price, but in the long-term prospects for his or her business.
“Industry focus and a network of industry insiders is helpful,” Mullen says. “[But] having some meaningful things to offer a seller, whether it's industry knowledge or the speed and certainty of getting a deal done, is important.”
One recent Arsenal deal, the acquisition of Rutherford Chemical, went through an auction process where two rival bidders put in higher offers. But Arsenal won the deal despite its lower bid because, Mullen says, of the seller's faith in Arsenal's ability to keep its commitment.
“They were comfortable with us,” Mullen says. “They felt we would close the deal.”
Disciplined process required
The Riverside Company managing general partner Stewart Kohl is even more skeptical of firms that claim proprietary deal flow. He says industry expertise if fine, but it typically won't lead to substantive deal flow.
Kohl says his firm, which specialises in small- to middle-market buyouts, has had the most success going through what he calls a “limited auction process.” His firm prefers to go through intermediaries, largely because that entails a process which is good for ascertaining the real value of a business. “We want a disciplined process for looking at a company and determining whether the price we're paying is fair or not,” Kohl says.
Sellers who hire advisors also tend to be better informed about the acquisition process, which is a positive, Kohl says, not a negative. Selling a company is fraught with difficult choices that need to be made by the seller, and that usually requires advisers. “Selling a company is not simple,” Kohl says. “There are a lot of terms and legal things to deal with. I find that uneducated sellers are unwilling to do things that are commonly done, like they won't give warranties or indemnification.”
While Riverside's Kohl doesn't think proprietary deal flow is the only way to be successful in the smaller market, he says his firm does enjoy a deal market that is less “picked over” than the space shopped by large investment banks.
More than just price
Craig Nickels, a partner at Austin, Texas-based Alignment Capital, says that while small market buyout firms rarely see a truly proprietary deal, the market they target it remains more inefficient than the larger market because there are fewer firms bidding for any one deal. This inefficiency can lead to better pricing on a company for the private equity buyer.
Alignment Capital specialises in evaluating smaller buyout firms and other “emerging managers” for large institutional investors. The firm currently evaluates emerging investment opportunities for the Colorado Public Employees Retirement Association. Colorado has set aside $50m per year to invest in these small market buyout firms, Nickels says.
“What we have found is that the smaller the market, be it fund size or the deals they're looking at or the geographic area, the more inefficient it is,” Nickels says. “That allows for better pricing, and that's where profits come from.”
Nickels highlights one powerful factor that ensures the small buyout market will continue to see at least some proprietary deals: in many cases a seller isn't looking merely to get the best price for his or her asset; instead, the seller may prefer to engage only one private equity firm because he or she actually doesn't want, for example, the family business to go through an unseemly auction process, which can be long, stressful and, ultimately, unsuccessful.
Sentinel's Lobel gives an example of a proprietary deal his firm is currently working on that falls into this pattern. The company is a small, family-owned business with $60m in sales. The business was started by a grandfather who gave it to his three children upon his retirement. One of the children is the chief executive officer while his brother and sister are still financially tied to the business but do not have operating roles. The CEO is 57 years old and is largely financially responsible for the rest of his family. He wants to do a deal where he can get liquidity for his two siblings and decrease his share of the business to 25 per cent from 33 per cent, and he believes that a privately negotiated transaction is best suited for his needs.
“He's not looking at how much he can get paid,” Lobel says. “He wants to know how small buyout firms understand that what matters most is getting a deal done for a good price no matter where it is sourced from.”
While it is true that good investments can be made in proprietary situations, those types of deals are becoming increasingly rare, even in the wild and wooly small buyout market. “We try to get a look at all the opportunities,” Riverside's Kohl says. “We want a quick process to decide which of those opportunities meets our criteria. We want to be responsive to sellers and advisers and be certain we can close, and close quickly.”
Those who believe that access to proprietary deals in this segment will become harder to obtain going forward could do worse than to concentrate on honing their ability to close deals fast. If competition increases, speed of execution may well be one of the few remaining ways to secure an edge when bidding for a business.