It’s easy to make a deal look great on a spreadsheet, especially in an investing environment swamped with cheap debt. Reality is far more complicated.

While high stakes negotiations make for great movies, the reality of private equity negotiations is closer to an exercise in collaborative problem solving. Investors seek to deploy capital in an industry on terms that will meet their target return, with an acceptable risk level. Sellers have a deep understanding of the risks involved in running the business and are comparing an investor’s bid against their next best alternative, either holding the asset and/or continuing to shop the deal. Reconciling the two comes down to creatively identifying and addressing the gaps separating the parties from saying “yes”.

Viewed in that light, nearly every private business is immediately available for sale to a financial buyer. All you have to do is offer the owner more than they think the business is currently worth. Most owners are sufficiently rational that you will quickly find yourself owning many companies, bought at full price. Unfortunately, paying high prices makes it hard for you to deliver impressive returns to your investors.

The inverse doesn’t work very well either. While the seller’s desired price may look like a bargain in your valuation model, remember you’re generally bidding against a knowledgeable insider. They likely know something you’re not aware of. That insight, an example of asymmetric information, means one of the assumptions in your financial model is incorrect. This is also not a path to earning exceptional returns.

So what does work?

Getting close to the business is a good start, investing the time to understand the industry’s risk and value creation opportunities. This is ultimately about building up the PE firm’s ability to serve as an effective strategic advisor, capable of creating value within their portfolio companies by offering relevant perspective and access to the resources to implement it. It also improves your ability to assess a company’s existing management team, the future champions of your improvement efforts. Both of these are solid paths to increasing the value of the company after the deal is signed.

The same principles work pre-deal as well, taking the time to understand and address any unique issues which may be compelling the seller to liquidate sooner vs. later. This could include helping a founding family manage a succession issue, stepping in to provide liquidity and operating expertise to a troubled firm, or helping the current owner prune their portfolio to address pressure from outside stakeholders. It’s a bit like the real estate business: sometimes people need to sell a house NOW. A good PE firm can adjust their approach to support a rush seller, for an appropriate accommodation in valuation. This is a recipe for improving your fund’s overall returns. Pulling this off requires deal expertise, a strong portfolio of capabilities, and a reputation in your market for getting deals done quickly and reliably.

Lincolnshire Management: Putting Theory into Practice

One good example of a private equity firm which has built a robust deal sourcing process is Lincolnshire Management, a middle market private equity firm based in New York City. Lincolnshire is a generalist firm, operating across many industries. As a self-described value investor, their approach to portfolio management includes a strong focus on operational improvement expertise and financial controllership.

In an interview with Privcap, TJ Maloney, the firm’s CEO, credited several factors with their success.

The first of these was investing in the necessary resources to have a presence where the deals are. Within the middle market, a lot of deal flow is fulfilled regionally, with sellers pairing off with local buyers. While New York is a powerhouse in the financial community, the firm casts a wide net for value among regional sellers by operating offices in LA, Chicago, and Atlanta.

Part of the challenge is cultural: each set of prospective sellers has preferences with regards to the type of buyers they want to deal with. New York provides an excellent platform for dealing with the financial community and a good gateway for sourcing European deals, between providing good access to talent and tapping into banking relationships. Sellers in other US regions can be deterred by the prospect of taking a deal to New York; operating other regional offices positions you to get a look at these deals. This investment in catering to the preferences of different buyer types pays off in higher deal flow.

Second, memories are short in this business and the path to a deal can be very non-linear. You need to be constantly in front of prospective sellers to maximize the odds of getting a look at a new opportunity. This is another good reason to operate local offices: it allows you to join the local financial community, building trust and presence in front of prospective regional sellers. This type of low-cost, always active outreach is a competitive advantage in generating deal flow.

Third, the volume of deals itself can create a competitive advantage. The firm looks at between 700 and 1000 opportunities per year. When you’re scanning that kind of volume, you start to build perspective on the overall market. This also provides an excellent basis to start ranking and comparing deals. More importantly, you can spot warning signs of change: if a large share of the industry suddenly goes up for sale at attractive pricing, there’s an underlying trend outsiders haven’t spotted. This volume also gives you the room to choose the best deals, rather than chasing what is merely available.

Does it work? In 2012, a professor of management strategy at HEC Paris teamed up with Dow Jones to rate and rank private equity firms based on their long term performance (over the prior 5 years). In an effort to seek consistency and scale, this study was focused on firms that had raised at least two funds during that period with at least $500 MM committed to the fund.

Within this ranking, Lincolnshire Management placed fifth. A good sign.