Time's a-wastin'

Study: PE firms spend hours on investments they’ll avoid

Executives at a median private equity firm review 80 potential investments before they make a single one, according to a new study in the Journal of Private Equity.

This means that the median private equity fund firm “spends 80% of its man hours on deals that do not close,” David Teten, CEO of Teten Advisors LLC, New York, said in an interview. Mr. Teten co-authored the paper with Chris Farmer, a venture partner with Cambridge, Mass.-based General Catalyst Partners.

The study was based on about 150 interviews of global private equity and venture capital executives and deal origination data provided by these executives over 18 months through spring 2010.

The result of all this time spent on potential transactions that never pan out is that not only are returns lower but returns are more volatile, Mr. Teten contends.

“This (time spent) has an impact on returns because they have to spend a lot of time and money to pay people to do this,” Mr. Teten said in an interview. “The pattern was a clear theme in our interviews.

“It's extremely hard to correlate returns rigorously with anything in research on private equity, because return data is not released, and even if it were, it would be hard to compare,” he added.

The study also revealed the median private equity firm held 20 meetings with management, four negotiations and three rounds of due diligence to conclude one transaction.

Messrs. Teten and Farmer also found the median venture capital firm reviewed 87 opportunities for one investment and held 29 meetings with management, four rounds of negotiations and three due diligence efforts for each deal.

The median private equity and venture capital fund needed 3.1 investment executives to close one transaction in one year.

The study found little difference in the median annual pipeline per investment professional between private equity and venture capital firms: 25.7 potential transactions for private equity executives compared with 27.3 for executives at the median venture capital firm. These opportunities resulted in 0.3 closed transactions for each private equity executive and 0.4 deals per venture capital executive.

Forty-four percent of the total potential deals of all the firms studied came directly from in-house sources, including professional relationships. Thirty percent of private equity manager investments and 23% of venture capital manager investments came from sell-side investment bankers, while 11% of private equity deals and 19% of venture capital investments came from other contacts.

In three years, 40% of those surveyed indicated their firms plan to change to use more in-house sources.

Fewer investments came from buy-side intermediaries, syndicate partners and independent intermediaries, which are investors that source deals without any committed capital. Eight percent of private equity and 1% of venture capital deals are from buy-side bankers; 1% of private equity and 9% of venture capital are from syndicate partners; and 5% of private equity and 4% of venture capital investments were from independent intermediaries, the study revealed.

Finding deals has become a core business function, the study found. Some 20.4% of the 5,732 investment professionals in the study are focused primarily on transaction origination and marketing. Private equity firms studied have an average of 38 investment generalists, 6.9 origination specialists and 0.5 marketing professionals. Venture capital firms have an average of 17.4 investment generalists, 3.7 origination specialists and 0.4 marketing professionals.

More than half, 58%, of the private equity executives indicated that once their firms grew to more than 50 professionals, they added specialists.

The authors found seven of 13 late-stage technology venture capital firms that have successfully raised new funds since 2007 targeted deals outside the typical venture capital investment areas of northern California, Massachusetts and New York City, Mr. Teten said. Messrs. Teten and Farmer cite a 2009 Harvard Business School Working Paper that said venture capital firms based in locales outside of venture capital centers outperform those managers in industry hubs.