Investment bankers (IB), venture capitalists (VC), family offices, and of course, private equity (PE) firms all play key roles in the M&A industry. And while PE firms often get the most time in the spotlight, they accounted for only a little over a third (34%) of the total number of M&A deals in 2023.
Even with private equity, different organizations may choose to focus their efforts on finding different types of investment opportunities. However, most choose to buy and sell companies. Let's dive in and discuss why — and how — private equity companies find companies to buy.
In finance, there are many different types of investment fund structures. Some involve purchasing real estate to either turn a profit from selling the properties or collect rent on them. Others depend on operating within the financial world and trade mutual funds or offer financing. Then there are the private equity firms that buy private companies.
To understand why, first consider that there are approximately 376 million companies in the world, according to Statista. Of those with $100 million or more in revenue, 87% of those are private, according to CapitalIQ.
With so many companies available — and, as we'll discuss, in varying stages of success and profitability — it makes good sense to tap into such a large market. Private equity firms that buy companies often make a return on their investment by growing that company, recovering a distressed one, or augmenting a company already in their portfolio.
The type of company is usually chosen with a particular exit strategy in mind, which generally falls into one of two categories:
There are, of course, firms that choose to hold onto companies within their portfolio if they believe they can make more money simply operating them. In this case, sometimes the company in question may become a buy-side entity vs. a sell-side, leading the PE firm controlling the portfolio company to find more, smaller companies to buy, and continue to build on their initial M&A success.
Before firms can find a deal, they have to know what they're looking for. Usually codified into an investment thesis, dealmaking begins by understanding and identifying the ideal type of company the firm wants to buy.
With the plethora of companies in operation across the world, there is plenty of choice for PE firms wanting to find a company to buy. The key is to choose the right one for their goals and expertise. Here are a few types of companies that firms may invest in:
Private Companies
As we stated earlier, private companies — those not listed on a public stock market (e.g., NASDAQ, NYSE) — vastly outnumber public companies. But within the general distinction of "private," there are many different types of ownership structures. They could be bootstrapped (i.e., have never had investors other than the founders), angel-invested (i.e., an initial investment by wealthy individuals), VC-backed, or employee-owned.
Public Companies
Few private equity firms focus on companies in the public market, but those that do often re-privatize them. This involves purchasing all the public shares of the company from the market, delisting it, and changing its ownership back to a private structure.
When deals like this happen, they're often very large and generate a lot of publicity, both for the company and firm(s) involved. However, these types of deals are few and far between.
Startups & Venture-Backed Companies
When it comes to company size, startups are the newest and smallest — sometimes existing without even having launched a product. Startups are the preferred type of company for venture capitalists, who are usually on the hunt for "unicorns:" startups that will grow into an entity that generates $1 billion in annual revenue.
In contrast to most private equity firms, VCs generally only claim a minority stake (under 50% of total equity) in a company in exchange for their invested capital. However, VC-backed companies are often prime opportunities for PE organizations, and many VC and PE firms have symbiotic partnerships and help each other with deal sourcing.
Small Companies
Just above startups in terms of size, small companies have relatively low annual revenue (under $50 million), but they may have been in operation for many years. Small businesses generally have a very small share of the market and can be family-owned or otherwise long-standing companies that have experienced little growth.
The key for PE firms looking for a small company to buy, though, is its growth potential. Perhaps it just needs the right investment, leadership, or direction — e.g., to undergo digital transformation. Identifying these opportunities and then capitalizing on them is one reason why private equity firms buy companies.
Middle-Market Companies
Larger still are middle-market companies, usually categorized by number of employees (generally 500 - 2500 total) or annual revenue (between $50 million and $1 billion). That said, definitions can vary, though middle-market companies are considered a "sweet spot" for PE organizations.
With such a large variety in the middle market, it's particularly important to define an investment thesis and determine the preferred middle-market company profile before a private equity firm finds a company to buy. And while middle-market companies aren't nearly as populous as startups and small companies, they may have higher success rates since they've already proven they can generate revenue.
Distressed Companies
Taking an existing company that is already successful and helping it grow is only one type of investment strategy. Private equity firms will also find distressed companies to buy and seek to fix what is causing the organization to flounder, which could be for many different reasons.
Sometimes leadership has steered the company in the wrong direction. Perhaps there are market or economic trends that are affecting demand for that company's product (e.g., during a recession, people generally travel less and make fewer expensive purchases). Or, world events such as war or natural disasters can impede or even prevent business.
Distressed companies offer a unique opportunity for private equity firms on the hunt for a new investment. Multiples and overall valuations are often lower and the potential for quick profit can be higher than with other types of companies, especially if the firm excels at management and transformation.
How private equity firms find companies to buy not only involves choosing the right type of company, but also evaluating the factors affecting their ideal company's growth. Determining the viability of an investment opportunity is crucial — and often a major part of a firm's "secret sauce". Here are a few of the growth factors that PE organizations must consider:
Market Position
Where a target investment is in its market is a key identifier of potential growth. For instance, a leader in a highly competitive market is likely already doing well and may not have much room for growth. But an underdog in the same industry — unless it has a particularly compelling reason, such as a patent or revolutionary approach to its industry — is probably not worth chasing with a lot of competition.
Having a real understanding of the market and the target company's place within it is one way to separate a good deal from a poor one. Firms will often adopt private company intelligence or deal sourcing platforms to help them create accurate, comprehensive market maps and build industry knowledge quickly.
Financial Performance
No matter if a firm chooses to go after distressed companies or successful ones, financial performance — both past and present — is a key growth indicator. Bad news here can quickly squash a deal in the making. For firms that focus on public companies, this information is easy to come by.
However, finding details on private company financials, including revenue, profitability, cash flow, and overall health, is incredibly difficult. Some dealmakers will try to manually calculate company revenue, but for most, technology is a much better option.
The best tools use data science, artificial intelligence, and sophisticated models to estimate annual revenue — including growth over a few quarters or years — and can make dealmakers' lives considerably easier. Having financial data helps at the start of the deal sourcing process when private equity firms find companies to buy, as well as in later stages, such as during due diligence.
Management Team
Spurring a company's growth (and revenue) to the next level is often why private equity firms buy companies. A strong and experienced leadership team makes that process far easier. Depending on the type of deal a PE firm makes with a company during its merger or acquisition, leadership often changes post-transaction, especially if the company is struggling.
As such, PE firms often hone in on the existing management team when searching for a company to buy and may work with an executive search firm to have replacements in mind once the deal closes. There are even deal sourcing strategies, such as succession planning, that focus entirely on finding certain types of leadership structures.
One reason why private equity firms buy companies over other types of investments is also due to the multitude of deal options and types available. Most often, these deals will be formed as what's called a leveraged buyout (LBO), where the firm outright purchases a company.
However, the size of the company, the foothold a firm already has within a market, and the firm's intentions with the company's product, employees, and leadership all influence the type of deal that occurs. And, of course, LBOs aren't the only option. Here are the three most common types of deals after private equity firms find companies to buy:
Platform Deals
When a private equity organization wants to enter a new industry and start making deals there, they begin with a platform deal. Entering new markets is a major reason why private equity firms buy companies over partial stakes or shares in a company. It gives the PE organization a foothold with which they can start not only influencing the industry but also learn firsthand about it to make more deals — and make more money.
The size of the company the PE firm invests in isn't particularly important and should fit the firm's investment thesis. That said, the target company should be large enough to support the addition of other, smaller add-on acquisitions. This is another reason why PE tends to operate in the middle market: Companies nearer to the top of the market can easily be platform deals while the smaller companies serve as perfect add-ons once the PE organization is cemented in the industry.
Add-on Acquisitions
Add-on acquisitions are just what they sound like: Once a firm has a platform company they wish to grow and make stronger, the org searches for smaller companies to augment the platform. Partnerships with venture capitalists and other intermediaries can be particularly valuable for how private equity firms find companies to buy for add-on acquisitions.
It's important to note that while platform deals are few and far between, add-on acquisitions usually comprise the majority of a firm's M&A deals throughout the year, as the deals require less capital. However, later stages of the deal flow process, such as integration, may take more time and effort, depending on how the company is to be combined with its intended platform company.
Lines of Credit
While not strictly a path for how private equity firms buy companies, providing capital through a line of private credit is an increasingly popular type of deal for private equity organizations. As the M&A market has been quite volatile in recent years, ensuring a return on an investment by providing a loan rather than taking a risk on the purchased company's growth can be an attractive deal type.
However, the deal is one where only money changes hands. Founders often like getting private credit deals since it means they don't give up any equity and still get an injection of capital to spur growth.
Once a firm understands what kind of company they want to buy and how the deal may be structured, the next step is to source it. Firms often approach deal sourcing in their own unique way by using multiple methods to create a bespoke process that fits skill sets and target investments. These methods, however, usually fall into several larger categories:
The most sought-after type of deal, proprietary deals are those where there's only one PE organization at the deal table. Of course, this makes it the most preferred type of deal sourcing since, without competition, deals can more easily be made in favor of the PE firm.
Getting proprietary deals, though, takes a monumental effort through a wide variety of activities, such as networking, marketing, and Business Development (BD). However, the most effective path to proprietary deals is a deal sourcing platform.
Put simply, deal sourcing platforms are how private equity firms find deals. These platforms have a whole host of benefits, but their main advantage falls into making the deal origination process — and, by effect, the deal flow pipeline — much more efficient. Rather than having to manually comb through websites and conference lists for relevant companies, dealmakers can use these platforms to instantly filter through millions of sources and pinpoint the companies that are the best fit.
More advanced platforms not only integrate with a firm's entire tech stack (CRM, analytics platforms, etc.) but also proactively notify dealmakers of new companies or changes to existing contacts so companies in the pipeline are easily and closely followed.
Whether a firm has a foothold in an industry or not, keeping abreast of its current and potential future state is a key part of how private equity firms find companies to buy. Only with a deep knowledge of the intended market can dealmakers understand the difference between a poor, good, and stellar deal.
With a wealth of market and company information at their disposal, firms can use that market data, industry reports, and competitive analysis to identify potential investments. Firms that have adopted the latest technology stack often outpace their peers, finding more deals and making stronger deals than those without.
Market mapping helps with more than just deal sourcing, too. Later stages of the deal flow process, such as negotiation and due diligence, are much smoother when dealmakers have industry expertise.
As we discussed earlier, private equity firms aren't the only ones searching for companies to buy in the M&A market. However, other organizations, such as investment banks, brokers, and M&A advisors, can actually help identify potential investment targets rather than be considered only as competition.
This is partially why networking is so important for a dealmaker and many firms have intermediaries and brokers in their digital Rolodex. Different firms and organizations are always sourcing their own deals, but the deals they find may not be right for them. Potentially partnering on a deal due to its size or to use another org's industry knowledge can help private equity firms find deals.
Throughout the many stages of the M&A deal flow process, there are several checks to ensure the deal is a good move for the PE organization investing the capital. With millions (or more) of dollars on the line, as exciting as a deal can be, it's often just as daunting since the firm takes on both the benefits and risks of controlling the purchased company.
The inherent risk in dealmaking is one of the many reasons why having as much information as possible is so important for private equity firms when finding deals, especially during the due diligence phase.
The end goal of any deal is to make money for the firm and its Limited Partners (LPs) — the ones who provided the capital to make the deal happen. As such, understanding the financials of the company the private equity firm wants to buy is usually at or near the top of the due diligence list.
If firms have an in-house data scientist or use an advanced deal sourcing platform, they may already have an estimated annual revenue and/or growth rate for the company in the deal. But it's crucial to verify that information in the due diligence stage, understand where and why discrepancies may have happened — private company intelligence is, after all, incredibly difficult to find — and better understand how the company makes its money.
With this information, it's also possible to more accurately analyze past company performance and forecast future growth.
Financials only provide one side of the story of why a company may or may not be a good investment. How it operates is also a key concern. Productivity, employee morale (and turnover), product development processes, and more should all be thoroughly investigated.
By digging into the specifics of the company's operating practices, firms can better understand how to improve it. This may come in the form of cost-cutting, standardizing processes, undertaking digital transformation, or another strategy that makes the investment company more efficient while spurring growth.
Operational due diligence is especially important if the company is in distress. While a valid and potentially very lucrative type of deal, they can be riskier. Understanding just what the firm is getting into, as well as the potential avenues for making a return on the investment, are better to know before the deal is struck.
Mergers are not always successful, even after a transaction is closed. After a merger or acquisition, the financial, operational, and legal responsibilities of the purchased company are now the purchaser's concern. As Bank of America found out with its merger with Countrywide Financial in 2008, the ramifications of poor due diligence can be disastrous.
The original $4 billion deal price tag has since cost Bank of America over $50 billion in legal fees and settlements and serves as a cautionary tale to any firm that doesn't take due diligence seriously enough.
Unfortunately, there's no one answer for how private equity firms find companies to buy. But there's no question the M&A industry is an exciting one, and the many different paths to sourcing and closing a successful deal always keep dealmaking interesting.
Luckily, for those who wish to fast-track deal sourcing, recent advancements in data and technology can help you find more companies to buy much more quickly. Get our 6-step guide to smarter private company deal sourcing here.
