Experts predict that private equity deal flow will increase in 2024 due to the sheer amount of global dry powder (investable capital). Private equity firms are feeling the pressure to put $1.2 trillion in dry powder to work for the limited partners, but still find challenges to establishing active, repeatable deal flow.
In this comprehensive guide, we’ll review the factors that slowed down private equity deal flow in 2022 and the life cycle of a private equity deal, and what kind of deal flow services you can find to help you out, but first…
What is Private Equity?
Private Equity (PE) is an alternative asset class where funds are invested in privately owned companies. Private equity firms help their private company executives manage and optimize the company’s structure and strategies to generate high returns for the firm’s investors.
Unlike public market investments, the investment horizon for private equity is much longer. The typical investment time period is roughly 10 years, meaning the prime investors for private equity firms are pension funds, family offices, or large net worth individuals.
Venture capital firms (VCs) also invest in private companies, but there is one major difference between private equity and venture capital: company maturity.
VCs tend to invest in several, smaller startups betting that one of their investments will hit major growth goals, potentially even hitting the elusive “unicorn” status — a billion dollar valuation. VCs plan to gather high returns in subsequent investment rounds of funding (Series A, B, C, and beyond) and potentially even having their startup company go public with an IPO.
Private equity firms typically do not make as risky moves as VCs. PEs invest in fewer, more established companies that typically already generate profit. They plan, optimize, and sell the company at a higher valuation than they purchased it after several years.
The data suggests the returns are worth the wait. Historically, private market investing has outperformed the public markets.
According to Cambridge Associates, “ Zooming out from the one-year return and refocusing on timeframes where private market returns are better expressed, global private equity and venture returns delivered nearly double the equivalent public market performance over three-, five-, and ten-year periods.”
These incredible returns are only possible through private equity deal flow — the process by which PE firms identify investable targets.
Private Equity Deal Flow Services
There are banks and advisors to aid private equity firms throughout the deal sourcing life cycle. The deal flow services will look different depending on the size of the firm and the strengths of their internal team. Typically, deal flow services will fall under four umbrellas.
- Deal Sourcing – PE firms can find deal sourcing services that range from evaluating markets, developing strategies, to execution. For PE firms looking for holistic deal sourcing solutions, be sure to evaluate your advisor the technology they use (e.g. Do they incorporate any proprietary IP into their strategy?) and their expertise in your target industry (e.g. Do they have experience in the industry or demonstrated the ability to land off-market deals through their network?)
- Due Diligence – A wide variety of tasks fall under the due diligence step. PE firms can bring in advisors to help with legal and operation due diligence, as well as advisors who specialize in valuation multiples, financials, management and more.
- Tax Structuring – In the midst of finalizing a deal, tax optimization is a priority but likely not a speciality of a PE firm. PE firms will need to source experts in SPA (Sale and Purchase Agreement) negotiations, commercial tax efficiency, refinancing, and more.
- Value Creation – The final umbrella oftentimes fits under the deal sourcing strategy, but can be an ongoing service even after the deal is complete. PE firms can hire services to help them identify business opportunities that can create more value from their portfolio companies. These value creation recommendations can range from internal efficiencies or external add-on acquisitions.
Private Equity Deal Flow is Predicted to Increase
Private equity deals slowed down in 2022 as interest rates increased from their 2020 record lows. But many experts are hopeful for increased deal flow for one reason: dry powder.
Dry powder is the uninvested capital that private equity firms use to run their firm and find new targets. The amount of uninvested capital in PE has been growing for years. According to Bain & Company, 2024 marks a 26% record of global dry powder 4 years old or older, meaning the pressure is mounting for private equity deals to get done.
With over $1 trillion in dry powder, there is pressure for general partners at these private equity firms who are obligated to start investing this capital as soon as possible.
This high amount of dry powder also means stiff competition for the best deals.
Private equity firms often compete with other private equity firms, but PE firms are not the only dealmakers in the private markets. Depending on their mandate, PEs often compete with corporate development teams at large companies looking to expand through inorganic growth and search funds, solo dealmakers looking to acquire and run a private company.
In order to activate their dry powder, PE firms need to understand their deal flow strategies and optimize their processes to compete.
The PE Deal Flow Life Cycle
So how do deals get done in private equity?
The steps in a deal’s life cycle are fundraising, deal sourcing, valuation and due diligence, and ultimately selling the company. At large private equity firms, designated teams are assigned to each stage. For smaller firms, the general partners are likely juggling all these stages at once for multiple deals.
Fundraising
Private equity firms require large amounts of capital to purchase and sell private companies. The head of a private equity firm is called the general partner/s (GPs) and they are responsible for finding capital. The limited partners (LPs) supply the capital. They contribute to the private equity firm’s fund/s in exchange for a percentage of the fund’s returns.
Every PE fund’s timeline is different.
For example, the length of time to raise a firm’s first fund will likely be longer than the following funds. The GPs need to establish relationships with relevant LPs, pitch them on their firm’s investment thesis, and go through the LPs’ rigorous due diligence cycle. This can take months or even years to compete. For Fund II and beyond, the firm’s first fund investors who are happy with their returns are likely to re-invest in the next fund.
In theory, the fundraising aspect of PE deal flow gets easier over time, but macro-economic trends, personnel changes, and other factors will always impact the length of time it takes to raise a PE fund.
Deal Sourcing
While PE firms court their next investors, they are also on the lookout for their next acquisition. This process is called deal sourcing.
While there are ways to automate the deal sourcing process, it still takes time to assess which companies are the best fit for a particular firm and if those companies are willing to sell.
Dealmakers can find targets through several channels. For example, they can,
- Manually find companies through Google or LinkedIn
- Use company databases or deal sourcing platforms
- Partner with bankers and advisors to find the right targets
Even when a PE firm is not ready to immediately invest in a deal, deal sourcing should still be an active part of the PE firms’ day-to-day tasks.
Like fundraising, deal sourcing can take months, even years, to complete. If dealmakers maintain relationships with bankers and executives, the deal sourcing process becomes so much smoother and faster when the PE firm is ready to sign a Letter of Intent (LOI).
Valuation and Due Diligence
There’s only so much information dealmakers can glean from outside-in due diligence. A PE firm may think a company is a good fit, but still needs to pop open the hood to know for sure. That’s when they sign a LOI and begin the process of due diligence.
During the due diligence process, the PE firm and their lawyers will evaluate a company’s financial records, tax returns, and other documents to ensure they are correctly valuing the target company.
Once the company has gone through the due diligence process – which takes a significant amount of back and forth between the PE firm, the company, and their lawyers – the final steps in getting the deal done are signing the closing documents. It’s possible, and somewhat common, for a company to go through the due diligence process only to back out at the last minute.
For example, the owner of a family-owned business may be reaching retirement age, considering the option of selling to a private equity firm, but ultimately decides to keep the company for a few more years or sell to a family member instead.
The best case scenario for the PE firm is that when the due diligence process is complete, the final documents are signed and they can begin to operate the business.
Optimizing to Sell
The final stage in private equity deal flow is to sell their portfolio companies – companies they have acquired and run– for more than it cost to acquire them.
The most common way that PE firms accomplish this is through leveraged buyouts (see below for more details).To achieve higher returns and pay back the debt used to purchase the company, PE firms are notoriously ruthless when it comes to cost cutting.
The average holding period for PE acquisitions is approximately 10 years. Once the target is sold, the PE firms will take their management fees and performance fees and the LPs returns are passed along.
Types of Private Equity
Private equity firms target different kinds of companies depending on their thesis and have different methods for financing their investments. The most common type of private equity deal is a leveraged buyout.
Leveraged Buyouts (LBOs)
Leveraged buyouts (LBOs) are when a private equity firm purchases a company with a significant amount of borrowed capital.
One of the best analogies for this type of PE strategy is buying a home. Homes are bought with a bank loan which comes with interest payments. It’s possible for homeowners to rent their property while paying off the loan, use the rent money to pay the interest on the loan, and then sell the house for a profit.
In the case of private equity investment, the house is a company. The firm is responsible for the business decisions of the company before they are ready to sell. The goal: pay off the interest and sell the company for a higher valuation.
There are several creative ways for PE firms to accomplish this goal.
According to EY, PE firms are addressing the opportunities around AI in 2024. “Data leveraged by AI can drive anywhere from 10% to 45% of sales growth so advantageous investors are pushing their portfolio companies to optimize standard business procedures with new technology.
LBOs first became popular during the 2008 financial crisis. During the 2020 COVID lockdown when interest rates were at similar all-time lows, LBOs were a strong bet. When debt is cheap, the interest on borrowed capital can not only be paid back, but give a portfolio company enough runway to create valuable returns for the LPs.
Real Estate
Similar to LBOs, real estate private equity firms raise funds from LPs. In the LBO section above, we used the analogy of buying a home to rent, but in real estate private equity the targets are literally homes and offices — more predictable income—and in some cases speculative development deals with the chance of higher returns.
Growth Equity
Similar to venture capital, growth equity takes risks on smaller companies that may not yet be profitable. Their strategy requires those companies to hit rigorous growth targets within the short timeframe of the fund. Growth equity is not as early stage as VC, but it does not rely on the same valuation factors that a typical private equity firm looks for in their targets.
Special Situations
Special Situations or Distressed private equity funds, target companies that are struggling to maintain their profitability. These kinds of firms lend money to the struggling companies and work with them to optimize their business practices before eventually selling to generate returns for their LPs.
Secondaries
Secondaries are an instance where GPs and their private equity firms raise capital from LPs and use that capital to invest in other PE funds. Unlike public market investing, private market funds have much longer investment timelines. If an investor wants to remove themselves from a private equity fund early, they have no choice but to sell their agreement. Other PE firms may see value in another fund and choose to buy their secondary.
Find the Right Partners, Find the Right Deals
Private equity deal sourcing is more competitive than ever, so it’s important to find the right partners.
If you’re looking for ways to optimize your deal flow, look no further than Falcon River. Falcon River is the best-in-class deal flow service that connects qualified buyers and sellers. We are investing in proprietary IP that connects you with the right targets, fast.
Set up a meeting to learn more.
FAQs
In order to bring in more deals, you have to invest in deal sourcing.
One method PE firms use is building their own internal databases. They incorporate technology, learn from their past deal data, and find the right targets using their own data. This kind of detailed analysis can move the needle but will take a large portion of an IT team’s time.
Alternatively, PE firms partner with advisors and bankers to maximize deal sourcing efforts. Working with experts in your particular industry will ensure that you’re not wasting time talking to companies that are not the right fit.
Another option to optimize your deal sourcing is to use deal sourcing technology. With the right tech, what could take hours of your business development team’s time should be significantly reduced, making sure your time is spent on the highest quality targets.
PE firms raise funds from limited partners (LPs) who typically are pension funds, university endowments, family offices, or high-net worth individuals. Limited partners contribute to the private equity firm’s fund in exchange for a percentage of the fund’s returns.
PE firms drive returns for their stakeholders through purchasing and selling companies. Deal sourcing is the process by which they court and vet potential targets. During the deal sourcing and due diligence stages, PE firms will assess if a company fits their fund’s criteria.
The most common type of PE deals are leveraged buyouts (LBOs). LBOs are when a private equity firm purchases a company with a significant amount of borrowed capital. One of the best analogies for this type of PE strategy is buying a home with a bank loan, renting it for years while you pay off the loan, and then selling the house for a profit.
