Deal sourcing is as critical to financial returns for private equity as sales effectiveness is to a product company, and investors should take an equally rigorous approach to optimizing their strategy.
It’s impossible to develop or implement a new business development strategy without having a firm grasp on the current state of affairs. Understanding your firm’s unit economics — that is, the revenues and costs associated with each sourced deal — is key. But in the private equity community, these metrics aren’t always tracked regularly.
Here are three steps to determining your firm’s total and per-deal business development costs.
In part 2 of this article, we’ll cover how to use this information to optimize your origination strategy.
Step 1: Determine total costs
Human capital is usually the largest cost involved in generating deal flow. Complex transactions require extensive relationship building to generate quality leads. As a result, this is a good place to start when seeking to understand business development costs.
PE has one of the highest average salaries of any industry. According to Prequin, total remuneration for U.S. PE professionals ranges from $110.60K for an analyst to $1,873K for an MD.
To calculate how much of this goes to the firm’s deal sourcing efforts, take the percentage of each investment professional’s time that is allocated to this type of activity, multiplied by their annual compensation. Next calculate the sum of that number across each contributing team member.
Example: If 6 investment professionals spend exactly 30% of their time each on deal sourcing and 2 of them are senior associates, 2 of them are vice principals, and 2 of them are managing directors, the sum of this cost would be roughly $773,000.
Next, take into account additional resource allocation for deal sourcing. Examples include conference attendance fees, travel costs, entertainment/gift costs, marketing software subscriptions, buy-side retainers, and advertisement costs.
For this exercise and to get round numbers, let’s say this cost equals $127,000.
Summing these numbers will give you your total cost of origination. This is commonly referred to as “lead acquisition cost” in the sales community.
Total = $900,000
Step 2: Assign costs
Sort your annual output (deals reviewed) by category so you understand which of the deals are associated with the allocated costs.
For example, you might break down deals into three categories:
1. Deals that came in without any particular spend or activity
Example: The sponsor coverage team at a large investment bank broadly distributed a deal.
2. Deals that can be directly tied to deal sourcing activities/spend
Example: If you saw a deal after a team member held a meeting with Smith Advisors at a Chicago M&A conference, the deal can be linked to the spend on travel, conference tickets, and possibly entertainment.
3. Deals that can be indirectly tied to previous spend or activity
Example: A contact from previous outreach/meetings remembers you and shares a deal.
This approach allows you to, at minimum, exclude a portion of the deals reviewed which are completely unrelated to investments you made in your business development function. The sum of deals directly and indirectly tied to deal sourcing activities/spend (categories 2 and 3) is your total output or return.
For this exercise, let’s say the firm reviewed 500 deals that were directly or indirectly related to sourcing activities.
Step 3: Calculate cost to return on a per deal basis
Once you’ve determined your total costs and how many deals are associated with that output, you can determine how much you’re typically spending on a per deal basis.
Total Cost of Origination ÷ Return or Output
$900,000 / 500 = $1,800 per deal
Now that you’ve calculated the per deal cost of your strategy, you can begin to explore cost-effective ways to improve output. Read Part 2 here for more.