Reaction Wheel

An anecdote.

A few years ago a private equity firm asked me to help them look at some lead-gen companies. One of the target companies had a network of many thousands of small lead buyers and were known to produce high-quality leads. They had worked years to build this reputation. They got good prices for their leads. But high quality leads are expensive to generate–and there aren’t as many of them out there–and building and maintaining a large distribution network is also expensive so while they had historically made OK margins, they weren’t blowing the doors off and their growth was steady but slow.

Then the founders started thinking about selling. They hired an investment banker a few months before the PE firm started looking at them. In that time, revenue had started to grow faster and margins had started increasing. The lead-gen company credited improved technology.

The PE buyer was enthusiastic. They asked me what I thought. I called a couple of people who were in the same lead sector. This is what I heard: “they’re stuffing the channel, everybody knows that.” Maybe everybody in the lead-gen business, but obviously no one in the PE business.

The company had decided that, to boost their valuation, they were going to generate lower-quality leads, and more of them. Since their customers generally bought a few dozen leads at most, they did not in the few months after the change notice when the average conversion went from about 5%-10% to something much lower*. This allowed the lead generator to raise revenue and margins. I warned the PE company that the buyers of these leads would not be fooled for much longer, that this way of doing business would come back to bite them**. And that is what eventually happened; the lead-gen company lost half its customers over the next six months, as the customers became aware that they were paying for high-quality leads and getting low-quality leads.

Any smart buyer knows that uncertainty exists: quality changes over time, for many reasons. The natural response to this is a concentration of buying. Larger buyers have more information, so will notice and respond to changes in quality much more quickly. Any market where quality information is not available will favor large buyers over small, causing the exit of small buyers. This will then cause the marketplace itself to suffer: a large buyer does not need an external marketplace, sellers will come to them. Without a competitive marketplace, the sellers suffer, both from lack of pricing power and lack of information about what is working for the buyers (reflected in varying price levels.) This then causes inefficiencies in production, leading to higher production costs.

This decline in overall efficiency of the ecosystem affects the sellers first, but also eventually affects the buyers. The process, though, can not be avoided by the buyers, even if they are aware of it: they are stuck in a prisoner’s dilemma. The only solution is to have more open and robust quality information available.

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* Junior year I took a semester abroad. My alma mater did not believe that any other university, anywhere in the world, could possibly educate me nearly as well as they. As such, they would not allow me to include any class I took anywhere else on my transcript. The most they would do was allow me to take a test and place out of classes I took abroad. Because of this dynamic, I spent my time in London doing anthropological studies of the pub culture. When I got back I did pass the required tests and so placed out of statistics and a year of German. I now find that I can neither speak German nor do statistics unless I have had several pints of bitter. I was going to tell you how many leads a lead buyer would have to buy before they would have a good idea that quality levels have changed, but I wrote this post Sunday morning and I couldn’t get my hands on a sufficient supply of ale.

** Oddly, they did not believe me. This turned out badly for them.