Sourcing an attractive investment opportunity as a private equity professional requires a tremendous amount of work. To provide an idea of the number of opportunities evaluated before making a new platform investment, I have included a sourcing funnel (see image below). This is actual data from a funnel I used in an investor presentation to explain our process, and I can tell you with confidence that the work required to maintain all of the data surrounding the figures in that image were the most tedious part of my job at the time. This is not an unusual funnel, most industry data supports 100 opportunities reviewed or evaluated for every 1 or 2 transactions consummated.
Investments Reviewed: Includes all transactions that have been reviewed by the investment team. This stage required reviewing a teaser and executing a confidentiality agreement. The remaining stages are fairly self-explanatory. The remainder of this series will explore what is involved at each of these stages in more detail.
In private equity, it has been my experience that the majority of an investment team’s effort is dedicated to filtering through transactions that never come to fruition with the objective of finding the few opportunities worth acting on. To maintain all of this information properly, and make sure that the investment team is responding to opportunities in a timely fashion, it’s helpful to have a dedicated Customer Relationship Management (CRM) solution to track all of the parties representing transactions. As the funnel above suggests, each transaction will have a unique timeline associated with the process. There will be deadlines for IOI and LOI submissions that the investment team needs to be aware of.
A well-maintained pipeline not only ensures that these deadlines are not missed, it also helps the investment team maintain a relationship with all of the entities presenting the private equity firm with opportunities. It is important to make an effort to decline each opportunity and provide the rationale for passing because it communicates that the investment team is taking the time to evaluate the materials provided. In an industry where passing on an opportunity is the norm, a cordial response goes a long way.
The Benefits of this Process:
Though it may involve considerable effort, this process is critical because it exposes an investment team to information that is not readily available. As an example, one benefit of this process is that it exposes you to businesses, industries and business practices that you may have previously been unaware of. In that capacity it can be genuinely fascinating. You will meet true characters and hear wild success stories. (Note: Exposure to new industries is less relevant for private equity firms that are industry focused.)
But the greater benefit is the exposure to the market. In investing, the single most important variable is price, and in private markets you spend all your time attempting to determine what that is. This is in stark contrast to prices in public markets, which can be plucked off a ticker tape. To get this right, you have to evaluate many opportunities to develop a feel for valuation and opportunity. Without this you will not know when to act quickly, which can be paramount in a competitive market.
Ultimately, the process of thoroughly evaluating 100 opportunities for every one that you close is an extraordinarily thorough means of evaluating the risk you are taking when you make the decision to more forward.
So while it may take substantial work, there is a lot of valuable information to be gleaned from the process. In the end, assigning value to this process helps justify the work required to find the needle in the haystack.