How Do Private Markets Work?

When we think about the alternative investment space, we think of prominent names that have dominated over the years. From Amazon to Flipkart, Ola to Uber, the list of startups that have made it big goes on.

But, if we were to consider the list of startups that did not make it bigger, that would be about a hundred times longer at least. After all, nine out of ten startups fail. That means, if you’re investing in a startup in the private markets, the odds are not stacked in your favour.

The trick, as you can imagine, is to pick the right startup to invest in. You need to identify the one startup that will not fold and will, instead, provide multi-fold returns on your investment.

That is easier said than done, though. Fortune-telling, while exciting, is not something you can bank on in this scenario. Instead, investors in the private markets use several methods to source deals and identify investment opportunities.

In this chapter, we’re going to understand the deal-sourcing process in detail.

Imagine you’re a chef, and you’re looking for the freshest ingredients for your new dish. You’d probably visit various markets, talk to suppliers, and maybe even grow some herbs yourself. In the world of private investments, deal sourcing is like scouting for those fresh ingredients – in this case, promising companies to invest in.

It sounds simple enough until you consider the fact that information is not as readily available in the private markets. You cannot navigate to the news channels on your television and expect to hear about suitable investment opportunities. Instead, finding the right investment opportunities requires a bit more detective work.

Well, think about it.

The more visibility you have, the easier it is for you to access the best deals at each stage – that’s the power of effective deal sourcing. It allows GPs to identify high-quality investments at the correct valuations and generate strong returns for the LPs.

After all, it is not possible to get in as early as possible. GPs generally specialise in different rounds and they only stay invested for 1-3 rounds beyond their entry point. For instance, a Seed stage investor might re-up during the pre-A, A or even B-round. But they would probably exit at C or D.

There is no one source of information, in this case. Instead, when it comes to alternative investments, you have to create your own sources.

The emphasis on different sources of deal flow – entrepreneurs, funds investing at earlier stages, incubators, accountants, academia, research into specific sectors, and investment banks – differs between different spaces in the VC and private equity markets. In all cases, the fund manager seeks to develop a strong network of contacts among the groups most relevant to its particular strategy and an intimate knowledge of companies operating in its themes of focus.

There are many instances of deals that have originated not in the boardroom, but at parties. Take the case of Sequoia’s investment in WhatsApp, for instance. Founder Jan Koum met Jim Goetz at a cafe through mutual friends. They bonded over their vision of an ad-free minimalist messenger.

Sequoia invested $8 million in Whatsapp’s Series A funding round in 2011 and even more in the subsequent rounds. By the time Facebook acquired WhatsApp in 2014, Sequoia had invested about $60 million in total. Its stake, however, was worth close to $3 billion!

Let’s take a look at the main methods of sourcing deals in the private markets.

Networking

Just like in most professions, who you know can make a big difference. Investors build strong networks with entrepreneurs and other investors. General Partners frequently attend conferences, seminars and investment summits to meet founders and industry experts.

Apart from that, GPs also leverage alumni networks from their educational institutions and other successful portfolio companies to find potential investment opportunities.

FYI, on average, General Partners go through at least 80 different opportunities before narrowing down on a single investment.

Referrals

Finding a mutual source or point of contact is ideal. Referrals can come from different sources like entrepreneurs, service providers, brokers or investment banks. It could even be as random as a vendor repeating a story they’ve heard before at another office.

In the early stages, networking is the key! GPs network with entrepreneurs, other VCs, individuals from academia and investment banks.

Deal Origination:

It is the process of sourcing investment opportunities for private investors like PE funds, VCs and investment banks.

In the Indian markets, VCs source from their network of founders, their thematic research which identifies companies in their target themes, academic institutions and their network of other VCs. Brokered deals are the minority in this space.

Private equity funds, on the other hand, prefer brokered deals and this is more prevalent in the PE space.

In-house Research

1. Dedicated TeamsMany venture capital and private equity firms have in-house teams that carry out market research to identify promising startups.They constantly map out various sectors, industries and geographical regions to identify growth areas. Once a potential sector or trend is identified, analysts screen startups within that space using certain criteria like revenue growth, profitability, competitive positioning, management quality and more.It is a constant endeavour to stay ahead of the market; and to find the right opportunities at the right time.
2. Proprietary DatabasesPrivate market funds use databases like PitchBook, CB Insights and Crunchbase, among others to identify and track potential targets. They use their own evaluation models.These databases are regularly updated to reflect the latest market trends and company performances. Many private funds also integrate these databases with other in-house analytical tools for deeper analysis.

Cold Outreach

Sometimes, if you’ve got a lead on a company that looks promising, it doesn’t hurt to reach out directly. Proactive GPs sometimes approach companies they’re interested in directly, even if those companies aren’t actively seeking funding.

In fact, most private funds have an in-house team for business development. They focus on outbound deal sourcing. Often, the business development team works with the in-house research team to reach out to the opportunities identified.

Accelerators & Incubators

Picture a school for startups. Much like Xavier’s School for Gifted Youngsters nurture and train the X-Men, accelerators and incubators nurture promising young startups. They provide capital and mentorship, along with resources like office space and workshops.

General Partners often partner with or monitor accelerators and incubators to spot promising startups.

Geographic Focus

Private market funds often open regional offices in specific regions known for innovation or business growth. For instance, a US-based VC might open an office in Bangalore or Mumbai to tap into the local startup ecosystem.

After all, sourcing deals when you’re in the thick of things is much easier!

But hey, it’s not all smooth sailing. These are some of the challenges that fund managers can face in the deal-sourcing process.

Competition

In the early stages, there are a large number of companies and the trick is to sort through it all and identify that hidden gem. In the later stages, however, there can be more competition because of two reasons.

Firstly, this is because the winners from the earlier stages have already been identified. The competition can be intense with many funds chasing a limited number of high-quality deals.

Apart from that, the later stages usually also have more capital available, both local capital and global capital. This can drive up valuations and reduce potential returns.

Take the case of Swiggy, for example. Its valuation grew from $700 million in early 2018 to over $3.3 billion by the end of the same year! It went through several rounds of rapid fundraising as more and more investors like Naspers and Tencent showed keen interest.

Quality over Quantity

Sure, there might be thousands of startups out there. But very few are good opportunities. Sifting through them to find the real potential is where the skill lies. If General Partners make a mistake in this stage, they may lose out on the entire investment!

Consider this as a cautionary tale:

In 2014, Housing.com attracted almost $90 million in investments from SoftBank and other investors. But soon after that, the problems started.

The company spent a lot of money on marketing and advertising campaigns. It did boost the brand’s visibility but that didn’t necessarily translate into an increase in revenue. And because of the focus on aggressive expansion, the core operations suffered. This impacted the platform’s credibility and user trust.

By 2016, it became evident that Housing.com was not going to deliver on its promises. The high growth projections seemed to move further and further away. Eventually, SoftBank had to write off its investment in Housing.com as a loss!