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$$ Left on the Sidewalk – the Hidden Value of Relationship Intelligence

Sidewalk Money
Working through some dimensions where relationship management done well (what we think of as relationship intelligence), creates meaningful value.

Most investors believe their relationship network is an important part of what makes their firm unique.  Those relationships are valuable to the companies they work with, and the limited partners who give them capital to invest. That importance is borne out via the moments of human connection we encounter daily, and reinforced by the tangible ways that business relationships create value.

However, most firms are resource-constrained – both by budget and more importantly by time and bandwidth. So even if your team recognizes the value of a relationship network, there’s often a lingering question.  In short – exactly how valuable is spending more time leveraging it?

Below, we work through some dimensions where relationship management done well (what we think of as relationship intelligence), creates meaningful value. This includes calculating the expected benefits, and showing our work along the way!

Deal Sourcing

The deals you do determine the success of the fund. As a result, most of the relationship management activity within a firm naturally centers around deal sourcing. Your team’s collective network is likely your most valuable engine for surfacing and winning new investment opportunities.

One way to think about the value of your relationship network for deal sourcing purposes is around direct value – given the average returns on deployed capital, if your network generates a new investment for you, how much in value does it generate for the firm?

The Burgiss Group, which collects returns data from a sample of Private Equity funds, found the net MOIC for an upper quartile fund is 1.7x or more.  So for each dollar your fund successfully deploys, you can expect a 70% premium – 20% or so of which comes back to your partnership in the form of carried interest.

Putting rough numbers through that model – the average Private Equity deal size was ~$200M in 2018 (though this is naturally heavily dependent on where in the market you play).  Multiplying that average deal size by the 1.7x MOIC above suggests a return of $340M on exit.  

Treating this as an average return and applying carried interest percentages accordingly – $340M – $200M in initial investment = $140M.  $140M * 20% of carried interest = $28M split amongst the partnership.  The payoff for any single introduction can be quite lucrative.

In the venture universe, though the nature of the investment profile is far more boom or bust, the underlying dynamics are similar.  The upside potential of having an investment go to 10 or 100x may make any given introduction more precious – but also means any given referral is more likely to be a pass or 0x. 

Another way to approach this question is by looking at where completed deals are sourced from – which provides a signal of the quality of those deal sources. A pair of studies conducted in 2016 and 2018 by Harvard and University of Chicago professors indicates that 62% of deals done by VCs and 64% of deals done by Private Equity funds are generated through their professional networks.  While there’s no industry-wide view of the total number of deals seen by source (so we can’t provide a quantitative assessment of the % likelihood of conversion of deals by source), anecdotal evidence also suggests that deals sourced through referrals are also more likely to convert to investments.

Due diligence

One of the common tactics used to get to conviction on a particular investment is conversations with industry experts. These conversations are often sourced by contracting with expert networks like Gerson Lehrman Group (GLG), who either tap into their existing talent pools or search out people who fit your criteria.

For most customers, GLG charges an annual subscription fee of $25,000 – which gets you a certain number of call credits that you exchange for access to their expert pool. Above that number, you need to buy additional call credits. Some estimates suggest the effective rate that customers pay on a per-call basis ranges between $1,000-2,000. Your team may do 4-5 of these calls to get to conviction on a single investment – which translates to close to $10,000.

So another way to think of the ROI on relationship management – for every expert network call saved, you save $1,500 in cold hard cash.

In addition, that cold hard cash actually understates the value you receive from more fully leveraging the relationship network you have for diligence. Another benefit of relying on the people you know for diligence help is speed.

That speed manifests in two ways:

  1. Winning more deals: in a proprietary situation, your speed to convince the management team to work together (before they get a banker) allows to lock down the investment at a lower valuation. Even in a competitive one, less time spent on getting to a base level of conviction allows you to identify ways to create value in more depth – enabling you to potentially bid higher with confidence.
  2. Time savings: On a pure time basis, each call likely costs you $200+ in employee time (given a 1 hr call with an Associate and Analyst).

Talent

One of the most common ways that an investor will seek to add value post-investment is through the identification of talented executives to join the leadership team. To do so, the team will often call upon an executive search firm to help them search for the right fit for the role.

While there are multiple different fee structures, the most common is that the executive search firm is paid a percentage (typically between 20-35%) of that executive’s first year’s compensation. For a typical executive in a later stage, high growth startup, or a private equity-backed company – that amount can easily represent $40,000 or more for a single placement.

Put another way – a single executive found through your team’s network can represent $40,000 in direct savings for your portfolio companies. And across your portfolio, it’s likely there are 10+ of these searches happening over the course of a calendar year.

Similar to the due diligence point, this number likely understates the true value of leveraging your network to help your portfolio companies hire. Why?

  • Performance: Referred employees are 25% more profitable than non-referred employees – and given the critical role executive talent plays in value creation, we’d all take 25% more any day!
  • Time to hire: Referred employees are hired in 30% less time, and typically have a 3x higher likelihood of being hired vs. non-referred employees. And while an open role doesn’t always directly lead to cash leaving the balance sheet, the cost of an unfilled role generally exceeds that of filling it (otherwise you wouldn’t be hiring!).
  • Retention: Referred employees are 2.25x more likely to be still with the company after 2 years. At the least, this enables you to avoid the incurred costs of recruiting and onboarding a replacement, and the lost productivity that comes with those two activities. At best, their retention signals the asset they’ve become to the company and the success they’ve generated over and above their compensation.

Portfolio Revenue Growth

A straightforward way of creating value for your portfolio companies (and hence your investment in them) is helping them get new customers and grow revenue. While the business model and cost structure of the business has a lot to do with how incremental revenue translates into enterprise value – there are few businesses that don’t value growth.

For a Private Equity fund – taking a 15% EBITDA margin as a starting point, and median EV / EBITDA multiples of 12x (as found by Pitchbook) – suggests that every revenue dollar you grow the business by grows the value of your investment by 1.8x. So an introduction to a portfolio company that leads to a $100K ACV deal, turns into $180K in Enterprise value.

For a venture fund – where a fast-growing SaaS business might be valued at 15x ARR, an introduction for a $100K ACV deal could turn into a $1.5M boost in enterprise value. Depending on your level of ownership (let’s say 10%, though firms usually target higher if they’re leading a round), that single introduction could boost the value of your stake by $150K.

Limited Partners

Finding and attracting new Limited Partners is opaque, to say the least. Simply getting on the radar of a prospective investor in your fund often requires an introduction from someone they already know and trust.  Once you’re on their radar, the path to receiving an investment typically includes a multi-year relationship-building process, so they feel excited and comfortable working with you over the course of multiple funds.

One proxy for the work involved is the cost of a placement agent, who has many of these relationships in place and can help you run a process to garner interest from family offices, institutions, and other potential pools of capital.  For the privilege, they charge between 2-2.5% of the new capital raised for the fund.  

Put another way – for every $1M raised through your relationship network (whether directly or through introductions) you save yourself $20,000-$25,000.

Conclusion: Multi-million dollar checks on the sidewalk

There’s an old economics joke that goes something like this: 

Two economists walk down the street and see a $20 bill lying on the sidewalk. The first economist says, “Look at that $20 bill.” The second says, “That can’t really be a $20 bill lying there, because if it were, someone would have picked it up already.” So they walk on, leaving the $20 bill undisturbed.

Private investing and business building is the art and science of picking up those $20 bills.  In your relationship network, there are likely checks on the sidewalk worth orders of magnitude more.  If you’re interested in picking those up – we’re happy to help!

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