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If the record $2.6 trillion of dry powder currently held by private equity firms tells us anything, it’s that attractive deals aren’t as easy to come by as General Practitioners would like. The difficulty in sourcing value generating transactions is further underlined by 2024 data which indicates that unspent capital at private equity is increasing faster than ever.
At SourceCo, our role is to identify the value generating companies that would enable General Practitioners to effectively invest this cash pile. In this article, we look at six of the best strategies for private equity firms to source deals more effectively.
Private equity deal sourcing is the process by which private equity firms identify investment opportunities.
As growth of the industry’s dry capital indicates, private equity deal sourcing has been particularly challenging over the past decade, forcing many General Practitioners to rethink their deal sourcing practices.
The importance of deal sourcing - sometimes referred to as ‘deal flow’ - cannot be understated for the private equity industry. In a 2024 interview with the Financial Times, Goldman Sachs Head of Asset Management, Marc Nachmann, said:
“A lot of the returns [in private equity] will come from sourcing really good opportunities and then the operational improvements.”
This is easier said than done. The most attractive investment opportunities rarely present themselves to all but a handful of globally visible investors
To cite Standard and Poors:
“Deal sourcing is hard. Finding a target for acquisition has been likened to finding ‘a needle in a haystack’. Investors must sift through millions of opportunities and quantify what matters.”
This article aims to make a small, but hopefully valuable, contribution to that effort.
A commonly heard expression in private equity circles these days captures the current state of the market: Never has so much capital chased so few opportunities.
In 2000, private equity companies managed approximately 4% of America’s total corporate equity.
By 2021, this metric had grown to around 20%. In crude terms, that means that private equity grew about five times faster than the overall economy across the first two decades of this century. It also means there’s a lot less available on the market than there was back in 2000.
The upshot of this is that most private equity funds have been pushed into searching for companies in the lower middle market and below.
These companies are typically regional players with $50-100 million in revenue, often owned by baby boomers looking to fund their retirement. This describes most companies falling into this revenue bracket.
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Online deal platforms, brokers and deal networks are currently awash with these companies.
Daniel Kobayashi, SourceCo's president, recently said:
"Today there are more companies that will do 10, 15, even 20 add ons or more over five years, as opposed to 1-2 deals 10-20 years ago, and they hire sourcing partners to help them execute on this investment strategy and realistically close such high volume of deals."
Many of them are reliable performers with steady returns and unexceptional growth.
But by sourcing deals in the same way as their competitors, private equity buyers end up competing with other private equity firms, leading to inflated seller premiums.
Online investment networking platforms, once the harbinger of a brighter future for investors has instead served to dampen investment returns.
In 2024, private equity deal sourcing has largely been commoditized.
Tomos Mughan, CEO at SourceCo, said:
"The competitive intensity for off-market deals in private equity is rapidly increasing as buy-side groups, brokers, bankers, and PE firms all compete for owners' attention. Many firms rely on the same 1-2 data providers, meaning they end up with the same information, the same percentage of the market, and the same companies as every other firm with their thesis."
And added:
"This makes data more important than ever"
To achieve different outcomes, private equity investors need to leverage differentiated, modern approaches.
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Below, we look at some of the most prospective of these approaches, while bringing to bear some of our own extensive deal sourcing experience:
Proactive deal sourcing for private equity firms involves identifying potential investment opportunities before they come to market. This is a resource-intensive approach, often requiring several junior employees engaged in constant company search. The advantage is that it tends to lead to more exclusive deals and more attractive valuations.
Proactive deal sourcing tends to fall into three separate subcategories: Propriety deal sourcing, thematic sourcing, and data-driven sourcing. We look at each in more detail below.
Proprietary deal sourcing involves building and nurturing relationships directly with company owners, executives, or other key stakeholders to access off-market deals. These relationships can come about through initial cold reach-out, networking events, industry conferences, and even through the networks of the private equity firm’s existing portfolio companies.
The idea is that your relationship with the company owner has developed to the point that they’ll turn to you when the time comes to sell. Although this is a slow burner, it has a higher chance of securing exclusive, off-market deals, with less competition and potentially more favorable terms.
Related:
Thematic sourcing is a top-down approaching, where private equity firms develop an investment thesis which will inform their deal sourcing efforts. Thematic sourcing begins by Identifying sectors, industries, or niches that align with the investment thesis and focusing sourcing efforts within those areas.
This approach enables private equity firms to gain deeper expertise in their chosen sectors, and to identify the value drivers within those sectors. Initial investment theses are confirmed by industry reports and in-house market research, before being complemented by sector-specific networking and hiring.
As the name suggests, data-driven sourcing leverages big data, AI, and machine learning to analyze large datasets and identify potential targets based on specific search criteria. This usually involves identifying some traits which are specific to firms that might be attractive to the private equity firm.
A straightforward example is provided by a company which exhibibts growth during a downturn in the economy, hinting at a strong management team or business model, or a resilient industry segment. Private equity firms now use a combination of proprietary data tools and web scrapers that enable them to identify these opportunities.
Reactive deal sourcing is a more passive approach to private equity deal sourcing. Private equity firms that use this approach respond to opportunities that arrive through various channels. Although this approach inevitably leads to more competition for deals with other private equity firms, it is far less resource intensive.
Many company owners looking to sell their businesses hire intermediaries to oversee the sale process. Having made the company’s confidential investment memorandum, these intermediaries - typically investment banks, brokers, or legal firms - will begin marketing the company to a broad range of potential buyers.
This approach works best when the private equity firm maintains regular communication with intermediaries - particularly those with strong deal flow, subscribe to deal platforms, and participate in auction processes. Essentially, it is about the private equity firm maintaining a visible presence in the market so that deals will find them rather than the other way around.
Auction processes are technically a subcategory of intermediaries and advisors, who sometimes hold competitive bidding processes for companies they have brought to market. These companies’ owners are aware of wider interest among sellers and task their intermediary to hold competitive auctions.
From the private equity firm’s perspective, there are less obvious benefits here than most other deal sourcing strategies. There tends to be limited room for negotiation, with sellers usually setting a floor price for their business. Furthermore, competition among buyers in the bidding process significantly increases the risk of overpaying.
Effective Inbound deal flow is an unfulfilled dream for all but a handful of private equity firms. While blue chip private equity firms will receive details of hundreds of unsoliciated and potentially gamechanging deals every week, most private equity firms won’t be so lucky, instead competing among the rest for leftovers.
Inbound deal flow refers to those deals that come through unsolicited channels such as cold emails, company referrals, or inbound inquiries. This is a low-cost and low-resource approach to deal sourcing but typically leads to much lower quality opportunities as intermediaries seek to hawk unremarkable companies on buyers.
Hybrid deal sourcing is a combination of proactive and reactive deal sourcing strategies that uses technology to enhance the process.
Hybrid deal sourcing turbocharges traditional deal sourcing methods with technology such as LinkedIn for targeted outreach or participating in virtual industry events. By leveraging technology, the private equity firm can make the process smarter, for example by identifying the right person to speak to within a company.
Hybrid deal sourcing also enhances the process by enabling companies to scale their networking efforts and achieving a broader reach. Even smaller private equity firms can now avail of a plethora of CRM tools that help them to manage mulitple relationships at once, even as they continue to source new deals.
Portfolio companies offer an obvious entry point into an industry for private equity firms, as the people working in the operational roles within these companies are by nature more familiar with the sector, its trends, its players, and its supply chain partners. This can create opportunities for bolt-on acquisitions or other synergistic buys.
The universal decline in response rates to emails and cold calls means that private equity firms need to position themselves as thought leaders to generate more inbound opportunities. Creating content which is relevant to the firm’s target audience enables it to attract interest from, and eventually build relationships with, company owners.
This is a slow burner but has been shown to be highly effective and explains why many of the largest PE firms regularly publish white papers and industry reports, host webinars, and participate in industry panels. High quality content also tends to be cited in visible places, thereby amplifying the impact of the content.
The final deal sourcing strategy for private equity companies is outsourcing to experts.
As the Standard and Poors article stated at the outset, deal sourcing is hard.
Hiring a deal sourcing firm enables private equity companies to access their specialized knowledge and networks, fast-tracking the deal sourcing process often for less expense than in-house hired resources.
The most sophisticated of these companies now use proprietary technology which is fine tuned to specific industries, geographies, and investment theses, enabling the private equity company to gain an overview of the universe of companies falling within their chosen criteria.
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This can also be used to ramp up deal flow or explore new markets far more efficiently than with traditional deal sourcing methods.
Perhaps the biggest determinant of the deal sourcing strategy is the private equity firm’s investment thesis. Understanding what is being searched has the biggest impact on how and where to search for it. An investment thesis that takes a broad outlook can benefit from a combination of strategies, while a narrower focus will require more a more tailored deal sourcing strategy.
Resources and capabilities will have a major say on which deal sourcing strategy to implement. Some strategies, including proprietary deal sourcing, are time and labor intensive and should be overlooked unless there’s an in-house team to manage the process. Similarly, unless it’s practical to develop technology for proprietary deal sourcing, alternatives have to be considered.
By market conditions, we mean how many potential target companies are there, and approximately how many private equity companies are competing to acquire them? This opportunity-to-competitor ratio should frame your thinking. As a general rule, the higher this ratio, the more you need to consider means to gain an edge over the competitors by developing deal sourcing technology or leveraging somebody else’s.
The desired scale and speed of deal flow will also have a bearing on which strategy is used. Private equity companies that require high deal volume cannot rely on reactive deal sourcing if they’re to meet their investment goals. Similarly, brand building and thought leadership creates time. In deal sourcing, volume demands scalable methods such as technology, outsourcing, and proprietary platforms.
Effective prrivate equity companies look at deal sourcing as an operational expense that leads to better investments, rather than an overhead. But unless developing high-cost in-house capabilities can guarantee better outcomes, they may be well advised to avail of outsourcing deal sourcing to trusted third parties. By doing so, they avoid large capital outlays, and open up the opportunity to sample various offerings on the market.
Good investment decisions can only be made with comprehensive company data, but this generally isn’t available through desk research.
The problem is exacerbated in niche markets, where industry averages can’t easily be assumed. Furthermore, public databases often lack the depth and specificity that investors require.
All private equity investors are familiar with the ‘email bounce’ that occurs even when a targeted email outreach is employed. Similarly, as email campaigns become the norm among everybody from boutique investment banks to individual brokers, their impact is reduced. Without the right tools, approach, content, and data, firms fail to reach inboxes and build relationships.
Many private equity companies fall back on traditional networks, missing out on deals elsewhere. One of the issues with this approach is that private equity companies can miss deals that aren’t being marketed as a given point in time. The narrow focus inevitably results in a narrow choice of deals.
A solid deal pipeline involves deals which are on market, will come on the market in the foreseeable future, and those where a relationship with the company owner is in its early stages. A well-structured deal sourcing strategy ensures a steady flow of opportunities, thereby enabling the firm to deploy capital effectively and achieve sustained portfolio growth.
The investment thesis dictates which deal sourcing strategy to implement. And by getting the deal sourcing wrong, a private equity company can’t successfully execute its investment thesis. Aligning one with the other is key to value generating deal making.
Accessing niche opportunities can be particularly challenging, especially in less transparent or emerging markets. For example, if your fund focuses on 20+ year family run HVAC businesses only, they might not even have an online presence, maybe they’ve been getting their business by word of mouth - and these targets are invisible to an inexperienced team with reliance on publicly available data.
Check also: Top Private Equity Podcasts Investors Listen To in 2024
Deal sourcing companies tailor opportunities to the private equity company’s investment thesis. A combination of deal sourcing expertise, advanced systems, and industry databases means that these companies can deliver a range of targets that are aligned with its objectives.
Time is everything in private equity. In the months it takes to gain an overview of an attractive industry segment, many potentially attractive targets are already on the radar of competitors. Deal sourcing firms streamline the process, managing everything from data aggregation to outreach, reducing the burden of private equity firms, and enabling them to focus on strategic decision making and portfolio management.
SourceCo is the only firm which aligns its performance with that of its clients. It only gets paid when a deal closes, underlining the strength of its deal sourcing platform and its value to private equity firms.
For instance, at SourceCo, we offer our clients the following:
Expect to receive between 2-4 opportunities each month that have been thoroughly vetted. These off-market companies will match your investment criteria and their owners have been earmarked as serious sellers. This significantly reduces the time spent on initial screening and increases the likelihood of deals closing.
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The firm handles everything from data aggregation to initial outreach, ensuring that your in-house team can focus on due diligence and strategic decision-making. This faster access to relevant target companies reduces the chances of missing out on deals to competitors.
SourceCo clients obtain customized data solutions that cater to the specific needs of their firm. The SourceCo platform possesses broad and deep data sets with information on niche sectors and hard-to-find private companies, offering insights that public databases or generic data providers are not built to provide.
The best deal sourcing firms have teams with deep expertise in specific industries and markets. This knowledge, combined with proprietary tools, provides a competitive edge which ensures that the deals presented are both viable and strategically advantageous.
SourceCo’s unique model ensures that you only pay when a deal successfully closes, minimizing financial risk. This approach aligns the sourcing firm's interests with yours, guaranteeing that the opportunities presented are of the highest quality and aligned with your investment goals.
Ensure that the firm specializes in sourcing deals that align with your specific investment criteria and sector focus. Before committing, ensure that the deal sourcing firm understands your space and possesses the resources to deliver on its commitments.
Look for a firm that offers tailored rather than generic solutions. The deal sourcing firm should be able to customize and adapt their search to meet your firm’s evolving requirements, whether it’s targeting specific types of companies, geographic regions, or deal sizes.
Evaluate the firm’s ability to provide high-quality, reliable data and actionable insights. Ask about their data sources, how they vet opportunities, and what kind of market intelligence they can offer beyond basic financial metrics. Gain an understanding of which metrics they’ll focus on in your chosen industry segment.
Choose a firm with deep expertise in your industry and a strong understanding of the private equity landscape. Experienced deal sourcing firms bring valuable market insights and connections that can significantly enhance your deal flow. Inquire about their team’s background, industry knowledge, and success stories within your target sectors.
Consider how the firm’s engagement model aligns with your risk tolerance and budget. For instance, SourceCo’s performance-based model, where you pay only when a deal closes, may be ideal if you’re looking to minimize upfront costs and ensure alignment with your success. Compare different firms’ pricing structures and choose one that offers the best value for your specific needs.
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