Competitive market conditions in middle market private equity necessitate that firms need to review more investment opportunities to deploy capital. Private equity’s voracious appetite for deal flow has led to the rise of a sales force of business development or origination professionals embedded within each firm. Since this function has only recently come to exist, there is a thin talent pipeline to fill these vacancies. Private equity firms are scrambling to staff these positions by repurposing talent from other functions in the transaction ecosystem.
In an effort to gain more insight for our private equity partners, Capstone Headwaters' Managing Director Brendan Burke recently sat down with Erin Carroll and Bill Matthews of BraddockMatthews to discuss the development of and current trends in the private equity business development function. Erin and Bill have great insight into the human capital dynamics behind the PE business development function and have placed more people into this role than any other executive search firm. The following is a summary of Brendan's findings. For a full script of the interview click here.
The Rise of the Deal Finder
By: Brendan Burke, Capstone Headwaters Managing Director
For the first time on record there are more jobs in the US than there are job seekers, and this tight labor market is even more constrained in one particular white-hot niche: business development (BD) professionals working in private equity. These folks move about the world in search of investment opportunities for their funds – they are the deal finders.
For the uninitiated, private equity firms use equity capital raised from institutional investors to buy stakes in privately owned businesses. These firms generally hold on to these investments for several years and often underwrite major expansions in the business during the period of their ownership. If executed successfully, the growth in revenue and profitability in the business will allow the investor to reap a large financial gain on a subsequent sale.
Private equity funds have posted the strongest returns among private market strategies since 2001, with a 15-year IRR of 13.9%, according to Pitchbook. This has caused private equity to become the darling of institutional investors worldwide, with the asset class outperforming other “alternative investment” strategies like venture capital and hedge funds and with lower volatility than public market investing. This success has attracted an ocean of capital from institutional investors in desperate search of yield in a low interest rate environment. So successful private equity firms raised larger and larger funds and young, talented, entrepreneurial investors felt empowered to launch their own firms. According to Pitchbook, as of the end of the third quarter of 2018, buyout funds collectively had $708.5 billion of undeployed equity capital. Funds dedicated to the middle market constitute the vast majority of new fund creation.
These funds are all chasing the same stock of privately-owned businesses to invest in. As competition has increased, this market technical has led to an across-the-board increase in middle market valuations. There are simply not enough great companies and management teams to invest in, so strong performers get bid up to stratospheric valuations. Higher entry prices inevitably depress returns in the long term. In the short term, however, private equity funds have a ticking clock of capital deployment.
These market conditions have forced sponsors to seek “diamond-in-the-rough” investment opportunities, making feeding the top of the investment opportunity funnel more important than ever. That is easier said than done as thousands of transaction advisors flog, on average, over 11,000 middle market deals annually. Finding and evaluating these opportunities is manual and time consuming: enter the deal finder.
With this high demand to source deals, the BD or Origination function has rapidly professionalized in the past decade. The rapid ascent of deal finder has also created a hiring problem for firms, namely, there is no “central casting” or precedent to default to. Unlike the way accounting firms bring up junior auditors or investment banks prepare financial analysts, there is no training program for BD. Instead, private equity firms typically hire mid-career professionals from private equity execution, investment banking, consulting or other sales positions. Firms inevitably must therefore coax workers from other facets of the deal business, ultimately devising creative hiring solutions or offering competitive salaries to find a professional with directly relevant experience. Indeed, BD pros with even two or three years of origination experience in private equity are in hot demand and being poached at high levels of compensation and fund economics. Make no mistake - this is an arms race. Firms that are not invested or underinvested in this function will fall behind, because they simply will not see their share of the relevant deals.
Limited Partners (LP), the institutional investors that fund these private equity firms, are reinforcing the need for these resources. In their manager diligence, LPs have begun to dig in with private equity partners to understand the firm’s access to deal flow and the composition of the BD team.
Know Your Customer
The BD professionals have two core targets: business owners and financial intermediaries like business brokers and investment bankers. These two groups constitute the bulk of the decision-making power in the sale of a privately-owned business. As such, private equity BD professionals need to carry authority in discussions with both audiences. From the business owner’s perspective, BD professionals need to plausibly represent their firm’s investment committee. From the intermediary’s perspective, BD professionals can be key sources of information on portfolio companies and commercial advice and insight about winning advisory business from the fund. BD professionals that don’t have detailed access to portfolio information or are perceived to have no decision-making authority regarding advisory assignments will swiftly lose the interest of their investment banking counterparts.
Rock and a Hard Place
Funds looking to increase or simply maintain their deal flow are caught in this labor market. If they don’t already have a senior BD resource, the pickins are slim and compensation expectations are very high. Bringing junior or mid-level resources up through the organization is a great cultural and firm building exercise, however unleashing junior resources to cover important constituencies can backfire. Further, failure to articulate a successful origination strategy can provoke unwanted scrutiny from LPs during fundraising. If M&A volumes hold up, private equity managers are going to need creative solutions and great recruiting help to patch these holes until this labor pool deepens.
Brendan Burke is an investment banker in the Financial Sponsors Coverage Group at Capstone Headwaters.