The Lies Our Industry Tells Itself: Private Equity

It’s always easier to see others more clearly than ourselves. Axial has a unique vantage point sitting across the lower middle market, and sometimes the biases and conventional beliefs of this industry really jump out at us. This is a three-part op-ed from Axial’s VP of Product on the self-deceptions of our industry. This installment aims at PE firms. Part 2 will talk to bankers/advisors, and Part 3, CEOs.

In this first installment of “The Lies Our Industry Tells Itself,” I’m going to challenge three conventions that seem to be common across private equity firms.

PE Self-Deception #1: “Here’s how our firm is different and unique”

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When you ask a private equity firm for their differentiating value proposition, the most common answer is almost identical: “We partner closely with our portfolio companies, have great operating partners/advisors, invest in better data/systems, and unlock growth strategies.” And if you then ask about investing strategy, you hear, “We are industry agnostic and target growing recurring revenue businesses in non-cyclical industries with low customer concentration.”

I have two reactions to this. First, I acknowledge that these claims are usually true. There are now thousands of PE funds staffed by smart, experienced investors who are connected to very capable operating execs. But this “unique value proposition” is really the exact opposite. It is so completely commoditized that bankers roll their eyes every time they hear it.

You might argue that the differentiation lies in the details. Some funds have operating partners on staff while others have a network. Some get very involved and some coach from afar. Some pull in executives from Fortune 500 companies, while others think the brand names backfire and instead involve execs who have lived the lower middle market. You hear similar things around investing in technology or helping a company integrate add-ons — everyone says they do it, but not everyone will do it equally well.

Here’s the tricky part — it’s relatively easy to make your case for the nuances of your special sauce once you are deep in the conversation, but first you need to get access to the deal. How do you differentiate at the top of the funnel when the seller is trying to figure out which of the thousands of PE firms / family offices / independent sponsors they should include in their deal process?

So what should a PE firm do?

Since commoditized markets typically compete solely on price, you could build a reputation as a big spender. In the world of venture capital, Andreessen Horowitz made a splash because they concluded that valuation mattered less than getting into the right “unicorn” deals. But this high-risk, high-return model doesn’t lend itself as well to PE.

The more interesting strategies we are seeing include:

• Focusing on specific industries, increasing credibility and visibility.
• Specializing on deal types (for example, divestitures / carve-outs / dedicated add-on programs).
• Building a competency in problems that scare others PE firms away, but where you can build expertise in fixing.
• Developing a strong narrative (i.e., storytelling) around the background and experiences of both the PE team and CEOs who have sold to the PE firm.

Self-Deception #2: “We see all the deals we want to see”

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We hear this claim all the time, but all the evidence (both our data and that from Sutton Place) reveals that only a few top-tier firms can truly back this up. Yes, PE firms get enough deal flow to fill up the day, but that isn’t the same as the seeing the right deal flow. A longtime buyout investor said to me the other week, “There’s no such thing as too much good deal flow.” After all, if the “value add” you provide a portfolio company is consistent across your portfolio, then the IRR on a deal is based on which deals you close, which in turn is based on which deals you got to see.

The following two examples are more the rule than the exception:

• Example 1: We worked with an established PE firm who looks at over 3,500 deals a year, of which they close 3 or 4. They thought they had “coverage” of a particular lower-middle market advisor, but they were going to be left off the buyer list for a fast-growing consumer products company until the advisor turned to Axial for recommendations. This ended up being one of the 3 deals the fund closed that year. Why did the advisor come to Axial? Because the buy-side has become both fragmented and commoditized, and the advisor wanted to use technology to winnow down the thousands of options.
• Example 2: We were talking to a midwest PE firm and asked if they knew the boutique bank Capstone. “Sure, we know Capstone — they are in our CRM,” was the response. It turned out the last conversation they had was in 2013 and their contact was no longer at the firm. If this was the case for a major boutique like Capstone Headwaters, what do you think their coverage was like for smaller shops?

Here’s the truth: there are so many PE funds (let alone family offices, independent sponsors, and now PE-backed corporates) that bankers running a controlled process are looking for excuses to *not* send you the deal. On Axial, the average investment banker privately shares their deal with only 20 to 30 targets.

Still don’t buy it? A few days ago, I spoke to a banker about one of their new clients coming to market. I highlighted a PE firm that had a platform in the same industry actively looking to do deals. “We think that platform isn’t quite big enough,” was the response. From one perspective, that’s a crazy assumption to make in this era of dry powder. But put yourself in the banker and their client’s shoes: they don’t want it broadly known that the business is for sale, nor do they want to have to talk to hundreds of people. In lieu of better information to help them understand the true hunger and motivations of the buy-side, they made assumptions. The PE firm I mentioned really should get the deal, but won’t. It had nothing to do with whether they were in each other’s CRM systems.

Where does this misplaced confidence on the side of PEs come from? Partially, they want it to be true, but I think a big root cause is how GPs pitch their LPs on their fantastic, unique deal flow. But the bottom line is that no PE firm sees all the deals they “want” to see — and this will always be the case. We’re never moving to a market where everyone sees everything.

If you want to compete in the lower middle market, you can’t assume that there is a “sponsor coverage” banker to make your life easier. It’s also hard to “network” your way to complete coverage, not least because bankers and CEOs have other, better ways they want to use their time. This is an information efficiency problem, pure and simple, which means it needs to be solved through technology.

Self-Deception #3: “We don’t spend money on deal flow”

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I’ll be brief with this one. Everyone pays for deal flow. They just think that they are paying for other things, like people or travel.

Calculating your spend on deal flow is no different from trying to estimate the total sales and marketing costs of any of your portfolio companies — you need to add up both the direct expenses and the human labor involved. In this case, there are countless hours (and thus salaries and sometimes commissions) that go towards networking, building relationships, and staying “top of mind” with the sell-side, whether from investing partners or dedicated BD professionals. There are also expenses towards conferences, travel, data tools, and entertainment.

Based on what we’ve seen, if you really add that up, many firms are spending at minimum a million dollars a year. If you take a middle-of-the-road assumption that they are sourcing 1,500 deals, you’re already over $600 per deal seen. For many, it’s over $1,000 per deal seen. Interestingly enough, few firms analyze their top-of-the-funnel unit economics.

However, of all the self-deceptions tackled here, I believe that this one is disappearing the fastest. PE firms are increasingly professionalizing their BD operations, which will entail clearer understanding of total spend, cycle times through stages, win rates, and ultimately ROI.

Next week, stay tuned for part 2: the lies investment bankers tell themselves [link]…

About the author: Giff Constable is the VP of Product at Axial. Previously, he sold 3 lower-middle-market software and business services companies as CEO, and was an investment banker at Broadview/Jefferies. Admittedly, he’s never been a private equity investor.