Sourcing a deal through proprietary means can potentially give you a competitive advantage, especially if other private equity firms have not discovered or participated in this niche / sector.
For example, a private equity firm could identify a subsector of an industry that is attractive, which has not seen much private equity activity. There may be an opportunity to roll-up or consolidate this subsector and create a mid-market or large platform, in which they can acquire small companies in the space at cheap multiples. These add-on acquisitions may immediately experience a multiple lift when they integrate with the rest of the platform thanks to efficiencies of scale, best practices, and attracting larger, multi-regional clients.
Proprietary deals tend to deliver higher returns since other private equity firms will not be competing and bidding up the price. However, they may also come with greater risk, and there is more work needed to improve these companies and apply best practices in strategy, finance, and IT. Therefore, the private equity firm needs to have the right experience and people to ensure solid execution, and that additional expenses related to integration, additional hiring (such as hiring a corporate development team), and applying best practices. These deals are also usually much more dependent on management committing and staying with the company, as their expertise may be scarce and difficult to replace.
Sourcing a deal through a competitive auction run by an investment bank may be more expensive initially and could result in lower returns. However, they also tend to have lower tail risks, since the firm has been vetted by an investment bank and it’s less likely that there are inaccuracies in the financial statements. These companies also tend to be more established, and there are less changes to growth strategy, management, and cost structure needed for the investment to be successful. Therefore, the execution risk is lower.