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CircleUp November.03.2016 11 min read

Innovation In Consumer And Retail: Where Investors Look For Innovation

How many of these ring a bell? SuperZoo, Cosmoprof, HBA, Natural Products Expo West, Natural Products Expo East, Fancy Food Show, Global Pet Expo, Outdoor Retailer.

Unless you’re a consumer investor, entrepreneur or retailer, you’re likely spared from these consumer products tradeshows, which are the biggest and best in the industry. These tradeshows are where consumer products companies live and breathe. These shows are where young, innovative consumer brands get in front of retailers, and where retailers are on the hunt to pick up interesting new products.

Recently, there’s been a third participant at tradeshows: private equity investors. Tradeshows are one of the inefficient sourcing channels for private equity investors in the consumer and retail space.

In my previous post in this series, I analyzed the explosive growth occurring in consumer and retail. That surge in innovation and potential for rapid growth has led to a boom in exit opportunities. In 2015 alone, consumer M&A was $238 billion, an all time high following the $195 billion in 2014, and the $124 billion in 2013.

These market dynamics are attracting more and more smart investors. But early-stage consumer investing isn’t easy, not because of lack of talent and opportunity, but because of a lack of financial infrastructure supporting this asset class. Early-stage consumer is notoriously difficult to access, leaving investors with antiquated, laborious methods for sourcing.

Why Early-Stage Consumer Investing is Rare

The mandate for almost all private equity investors is to raise a fund, deploy the capital and generate returns. For funds with hundreds of millions of dollars, it is impractical to spend time on small deals that do not make a dent in the capital deployment. In consumer, smaller deals mean extensive time spent finding and diligencing deals. Since investors have to deploy their funds in a certain time frame to satisfy limited partners, it’s nearly impossible to allocate too much time to early-stage deals. The clock is ticking.

In tech, it’s a different story, because the cost to find great early-stage deals is low. There is an established network, startup hubs in Silicon Valley and New York, and media celebrating the early innovators. Consider Y Combinator, 500 Startups and TechCrunch. Early-stage consumer doesn’t have an equivalent of Silicon Valley. Investors neglect smaller consumer deals because the diligence time is too expensive and time-consuming to justify a smaller check size, not because they aren’t compelling. That’s why they wait a few years and write a $10M+ check for a mid-size company, while search costs are basically the same.

Sourcing is Painful

Despite the obstacles, there are some investors in early-stage consumer and retail. But it’s not easy or glamorous. Consumer companies are geographically dispersed with no centralized network surfacing the most promising deals. It’s a slog to source. How exactly is it done?

Tradeshows: Superzoo, Fancy Food Show, and other tradeshows are the lifeblood of any good consumer private equity investor. The largest tradeshow, Natural Products Expo West, features thousands of exhibiting brands and more than 75,000 attendees. For perspective, that’s the size of many small cities. The show is spread over multiple days, across multiple levels of multiple buildings. There are bankers and investors that have been attending literally for decades.

Those in private equity that attend are flat out overwhelmed but put on a good face to show they have a leg up on other investors. Some investors do have a leg up. The heads of successful firms, such as Encore Consumer Capital, TSG Consumer Partners, Catterton Partners, Swander Pace Capital, Castanea Partners, and a few others, have spent thousands of hours evaluating tens of thousands of consumer companies.

The problem? Gaining that expertise is very expensive, due to time and search costs. To recoup these costs, they have to concentrate on larger companies, where they can invest more, and thus amortize their costs and time to make more money. You’ll be hard pressed to get the heads of those firms to sit down for an hour at Expo West to hear about your great company with less than $10 million in revenue. They would rather spend that hour with a much larger company where they can write a larger check.

This creates a painful situation for entrepreneurs. The only investors with the expertise to identify great early-stage consumer companies can’t afford it. This brings us to other sourcing options for consumer and retail investments.

Finders: Tully & Holland. Valufinder. CW Downer. HT Capital. Castle Crow. Harvey & Company Private Capital Research. Hunter Wise. The Spartan Group. CMF.

These names may sound as foreign as the tradeshows I listed. Some don’t even have websites. But, I guarantee you, there are more than a few private equity professionals at the top five firms who are upset I just listed these groups by name. They are unknown finders and brokers that generate as much as 50-90% of the dealflow for some firms. For that dealflow, firms pay a steep price, often a retainer of $10,000-$25,000 per month and a commission. A finder who really hustles might deliver a firm one deal a year, but one every three years is more common. So firms have dozens of such relationships with finders to get the required dealflow.

The problem? If finders work on commission, they are incentivized to find larger deals. So, once again, the system is stacked against smaller companies. Consumer companies with less than $10 million in annual revenues are barely in the consideration set.

Retail level sales data: The consumer industry has tons of data on company and industry performance. In particular, retail level sales data shows how any given product is selling at the store level. This is more valuable than a company’s wholesale revenue figures, which reflect revenue selling to the retailer but doesn’t inform whether end-user consumers are actually buying the products. The leaders in retail level sales data are IRI and Nielsen. SPINs covers the natural channel, though Nielsen may be getting into that space as well. (Disclosure: Nielsen and SPINs are our partners.)

Private equity firms often pay hundreds of thousands a year for this data. The fundamental value of this data is to see which companies have the highest retail level sales velocity combined with the lowest distribution. The thesis is that this profile presents a huge opportunity for investors to get into the company, blow out the distribution and see hockey-stick revenue growth.

Once again, the high cost of this data disadvantages smaller companies. If you are spending $1 million a year for data just to find a company, it’s difficult, if not impossible, to justify a $1 million investment into a <$10 million revenue company. So, the data tends to be used to research and focus investments on mid-size or larger investments.

NAICS/SEC Code Searches, Trade Magazines: Larger firms with more than $150 million in assets under management often hire associates to “pound the pavement,” sending out sourcing letters or cold calling. One firm I know sends the letter by FedEx just so it stands out. Another sends gift baskets of the products they’ve already invested into. The cold calling starts with developing lists of companies to go after. Usually, associates are looking for long lists that help them hit big quotas. It is not uncommon to talk to 100 companies per week. Two sources are industry lists from trade publications and large government databases, including the widely-used North American Industry Classification System (NAICS) or the Standard Industrial Classification (SIC).

The problem? Companies with less than $10 million in revenue often are not captured in government lists and industry publications. Trade publications tend to focus on larger companies that their readers have heard of and that advertise with them.

So, that’s the landscape. There are opportunities for great returns in early-stage consumer, but all the processes for sourcing dealflow are biased toward larger companies. The structure makes it nearly impossible for investors to find and invest in small, innovative consumer companies.

That’s why consumer and retail sees under 5% of early-stage funding, despite all of consumer and retail accounting for 20% of the U.S. economy, according to Bureau of Economic Activity. It is very hard for consumer startups to thrive, and just look where it’s left our industry. We still have products like Twix bars and Clorox, which haven’t changed in decades, and are still present throughout America. Just imagine if there wasn’t a well-served early-stage VC market for tech. New companies like Facebook and Uber might never exist, and legacy companies like Apple never innovate, simply because they wouldn’t feel any competitive pressure bubbling up from the bottom. We could still be working with MS-DOS and the Newton.

Given how underserved early-stage consumer is, multiplied with consumer demand for better product offerings, there’s now a huge opportunity for investors to capitalize. How will they do it and overcome the notorious inefficiencies of this asset class? That will be explained in another part of this series.

This originally appeared in Forbes.