The Black Box of Deal Sourcing: How Private Equity Vets Companies
In the world of buying companies, cash is king whether it is a financial or strategic buyer. But how does a private equity firm find a good company to buy? Deal sourcing is an enigma to many. To the outside world it looks like a black box or even a black hole. What are the key factors PE firms use while buying a company?
1) Industry Focus PE firms traditionally narrow their focus by industry or market niche such as automotive, packaging, healthcare, food & beverage or technology. Many firms have a certain expertise in key industries and understand the trends, challenges, inherent risks, and market dynamics. “An industry niche only narrows the field a bit,” noted an Evanston-based PE executive. “Other factors also play a role in the deals we get done.”
2) Revenues PE firms are not in the business of growing early stage companies. They want to purchase an established business with revenues – which will grow through increasing market share and developing innovative products.
3) Customer Base “Having a strong, diversified, growing customer base is very important for PE firms looking for deals. It reflects the company’s ability to generate sales,” said Sean Gannon, co-Founder of The Deal League, which provides market intelligence for proprietary and brokered deals. “Another key component is profitability.”
4) Profitability PE firms are not usually in the turnaround business. Rarely will they purchase a company that is operating in the red. Having significant cash flow that can be leveraged with lender financing is an important part of the purchasing process.
5) Geography Where the company is located plays a role in the sustainability of the investment. Is the company located a few hours away by car or it is in a remote location that requires two plane rides plus a three hour car ride? Many PE firms want accessibility for themselves and for customers. This can be a significant factor in deciding whether to make an investment.
6) Add-on Acquisitions Another factor affecting geography depends on the investment strategy. Does the PE firm own another company in the space? Perhaps this investment will be a geographic expansion of the existing business. If that is the case, geography may be a key driver in executing the transaction.
7) Exit Opportunity At the end of the day, PE firms don’t hold companies for long periods of time. To them, five years may feel like a lifetime. So before a firm will buy a company, they are already thinking about the exit. “PE firms analyze their exit strategies from all angles, “said Nathan Gudritz, co-Founder of The Deal League. “Will it be an IPO, a sale to a major competitor or another private equity firm?”