Deal flow is a common expression used in private equity and venture capital. It refers to the spectrum of investment opportunities from which private equity or venture capital firm can select suitable target companies to invest in. Deal flow marks the beginning of the investment process. Private equity or venture capital firms are faced with the task of identifying the largest possible selection of potential companies that match their investment profile. There are also several private equity books that allow you to learn about the investment process of these firms.
How does it work?
A deal flow can basically take place in three different ways: through a targeted search by management, through referrals by third parties, or through the portfolio companies' own initiative.
In the deal flow phase, initial selection and talks are held with potential companies. Only with a few companies are further negotiations conducted after these initial discussions. These selected companies are subjected to thorough research and valuation in order to determine whether they are investment-worthy.
Types of deal flow
Deal flow will fall upon two main categories:
Private equity and venture capital firms will actively identify companies as investment targets. After identifying potential companies in this pre-selection phase, thorough research will be conducted. During the research, the firm will often consult with the market and industry experts to try and determine how suitable it would be to invest in the company. They will also actively approach the company, and propose an investment.
Active deal flow generation has become widely adopted by venture capital and private equity firms, due to the higher competition the industry faces. It has become one of the primary ways of sourcing high-quality deal flow.
In the passive method, the private equity or venture capital firm refrains from the pre-selecting companies as investment targets. Therefore companies will often contact them seeking capital that could help them achieve their goals. However, this does not mean that the firm will not actively conduct market research. However, their focus will be one marketing activity, as well as a presence at events and affiliation with relevant institutions. Further development takes place through the mediation of third parties, in most cases banks, auditors, law firms, or associations.
If the contact mediation leads to the investment, the mediator receives a commission, the amount of which is determined depending on the transaction volume.
Passive deal flow will also involve companies pitching their business model, as a way to seek capital.
Active vs passive
The active deal flow allows private equity and venture capital firms to narrow down the potential target companies to invest in. They are able to identify trends and choose companies that are appropriate to their investment strategy. However, one of the most significant disadvantages of this method is the valuation. Oftentimes a company seeking capital will often have a lower valuation because of their intent of receiving outside investment.
Another advantage is that companies targeted through active deal flow will often only be in talks with one company. If companies are seeking an investment, which is more common in the passive type. They will often engage with different private equity and venture capital firms, which increases the competition to finalize the deal. Passive deal flow also restricts the target companies to those that reach out seeking an investment. At the same time, valuations tend to be more attractive.
Why high-quality deal flow is essential
High-quality deal flow is perhaps the most essential component of any private equity and venture capital investment process. It determines the quality of the possible investment universe of these firms. Therefore, researching high-quality companies, or having them reach out to you seeking capital is the most crucial part of this business.
Part of the process prior to any of these investments is filled with hours researching and analyzing the company and the industry. If the deals are not high-quality, this ends up being a considerable waste of time and resources. Therefore, it can make a large difference in the returns achieved by the firm.
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