Easily the hardest part of my job is finding exciting investment opportunities.
Great deals are rare, but in times like these, when there is a wall of money looking for a home, it takes ever more resources, application and luck to locate attractive propositions.
Professionals in the private equity world believe that “origination of proprietary deal flow” is the secret of success. What that means is the ability to find decent companies to back that are not being touted everywhere. Typically, a business to be sold or looking to raise development capital employs an adviser, who prepares an investment memorandum that is sent to possible funders. An auction is carried out, usually won by the highest bidder. The belief is that this type of wide marketing secures the best price for the seller.
All venture capital and private equity houses prefer to avoid such processes, because they absorb lots of time, entail an inevitable duplication of effort, and can force investors to pay too much. We probably take part in only a handful of such exercises every year. Instead, we tend to devote more manpower to digging up gems ourselves. This can be a frustrating process, and tends to have a low hit rate. Research suggests private equity firms must look seriously at 80 companies to close one transaction, and that on average more than three investment team members are needed for each deal done per year. It is a labour-intensive activity. Partners need to be persistent and creative in order to put funds to work profitably.
How do investors generate a pipeline of deals? They network ferociously; they cold-call likely candidates; they attend trade shows and conferences; they cultivate connections with intermediaries; and they recruit advisory boards of entrepreneurs to help multiply their contacts. Of course, if private equity firms really want to spend money in a hurry, they can. But that means paying huge prices, and putting at risk the returns they have promised their limited partners.
The very best deals often take years. It is why I believe patient capital is the best form of private equity. I became aware that Pizza Express might be available three years before we could buy it. We backed Gail’s Artisan Bakery well over a year after meeting the proprietors. Developing relationships with management over an extended period allows you to understand them and their businesses better — and should allow you to show that you can add greater value than just money.
We are fairly specialist, in that we tend to focus on consumer sectors such as hospitality, food and drink, retailing and leisure. This helps to differentiate us from the huge array of competitors. It also means we know our chosen industries and markets deeply, and should therefore invest more wisely. Of course, investing in private companies is by no means risk-free: some deals will go wrong, and occasionally firms fail altogether. Such bad bets are an inevitable element of the capitalist system — some capital is misallocated — but creative destruction usually means the assets are recycled, and placed in more productive hands.
I’ve learnt that most opportunities crop up for a limited number of common reasons. Investors need to look out for the typical catalysts — death, disease and divorce among founders are common explanations for a disposal. Other possibilities are an absence of succession, tax changes, partner disputes, impending retirement, or financial distress. Large corporates streamlining their portfolios is another trigger, as is a private equity firm closing a fund and wanting to sell residual holdings. Venture and development capital deals happen exclusively because a business is growing and needs equity finance.
I try not to prejudge presentations from entrepreneurs; often the slickest PowerPoint pitches are the least compelling. I much prefer a somewhat messy business plan, from wholly committed founders with an outstanding project, to a highly polished and rehearsed proposal. The best ventures can sometimes emerge from the least likely sources. I remember seeing the first document from Topps Tiles when it had just 20 stores and thinking it was very dull. Luckily I changed my mind and became one of its largest shareholders. The value rose at least 20-fold and it became a stock market star.
Such endeavours are scarce. The current weight of money means we have to be more imaginative than ever, and seek overlooked, complicated or unloved companies.
I doubt I shall ever lose the thrill of the chase. Finding a truly impressive business and meeting genuine entrepreneurs can be intoxicating; you feel as if you have discovered hidden treasure.
But much more than inanimate bullion, a business is a living entity, providing employment, serving customers, paying tax and providing the backbone of our economy and society. And that is why identifying winners matters so much.