Historically, the paths of private equity and venture capital investors rarely crossed. They worked in parallel spheres, targeting different companies in different sectors and at different stages in their development.
However, one of the consequences of the global financial crisis for theinvestment community has been private equity starting to look atdeals which are in the more traditional venture capital space. At the same time, some venture capital investors are changing their risk profile to look at mature businesses and are increasingly looking at companies in need of growth capital.
Before the world changed
The typical target for venture capital investment has traditionally been an early-stage or start-up company with the potential for significant growth, but where revenues are not sufficient to support working capital needs. By investing the money (typically over two to three rounds) at an early stage, where the operating company’s valuation is relatively low, VC funds hope that their investments will grow rapidly and deliver large gains on ultimate exit. As a result, VC investments have tended to be concentrated in the technology, clean tech or life sciences sectors – areas with the most potential for dramatic growth.
By contrast, private equity investment has tended to focus on mature companies. The PE business model, typically investing for majority control, had, prior to the crisis, traditionally relied on the availability of large amounts of debt. Greater leverage means a smaller proportion of a fund’s own money is needed to acquire the operating target. The importance of high levels of leverage has meant that PE targets have to be mature operating companies with solid trading histories, regular cash flows and sufficient assets to persuade a bank to lend. As a result, there has generally been minimal focus among PE funds on the technology, clean tech or lifescience sectors to date.
Then and now
Compared to a start-up company that has the potential for growth in the long run, but is currently generating little or no profits during a recession, businesses with strong revenue growth are perceived to be a lot less of a risk. Therefore, even though backing such companies requires a higher initial investment, it is, in a sense, money better employed thanks to the greatly reduced risk.
As a result, the venture capital community has been moving towards a preference for late, or at least later stage deals. On the other hand, barriers that have traditionally stopped PE funds from investing in predominantly VC-backed sectors such as technology, are gradually being removed.
It is increasingly apparent that there are a number of technology companies now maturing beyond their earlier, riskier development stages, generating good revenues, consistent cash flows and delivering on proven business models that still offer room for significant growth. In the light of continuing limitations on the availability of debt, these companies may offer the potential for generating returns that may no longer be available from traditional PE industry sectors.
In fact, a recent report by Grant Thornton found that more than half (58 per cent) of UK private equity and venture capitalists anticipate that the volume of private equity investment in the technology sector is likely to increase over the next two years, with cloud and managed services seen as the most attractive sub sectors.
Converging on similar sectors and forced by economic imperatives to seek out companies at a similar stage of development, VC and PE funds suddenly find themselves in competition with each other. However, VC and PE established business models may differ greatly on a number of fronts: sector focus, transaction structures, management incentives and levels of control – all differences which mean it could be incredibly difficult for them to ever co-invest; competition is far more likely.
For example, the equity structure from a funding perspective on a PE transaction is fundamentally different to that on a VC transaction, but in terms of control, they are not that dissimilar. As a rule, a PE fund acquiring an operating company will almost always require a majority shareholding stake so that it has shareholder control.
By contrast, VC transactions will usually involve several funding rounds, with additional VC investors coming into the deal at later stages. Therefore, although each VC investor will likely only hold a minority stake, cumulatively the investors will hold a majority. Both will typically have the benefit of veto rights over any material decisions by the target company or its management.
The continuing credit squeeze means that there are new opportunities opening up to both VC and PE investors in the growth capital space. For PE funds who would usually rely on bank debt, growth capital deals can offer similar returns without the need for leverage. Equally for VC funds, they can de-risk their portfolio by investing in businesses where there is some cash flow and a proven business model, albeit that there is still room for significant improvement.
The differences between VC and PE investment models are undeniable, yet it is evident that they are converging due to the changes imposed by the on-going recession. As investors are forced to reconsider their strategies to select the safest investments, private equity looks at sectors previously dominated by venture capital, whereas the VC community gravitates towards late-stage deals. A number of funds that worked in parallel realities until recently, now find themselves in direct competition with each other – how they both operate in overlapping markets will be interesting to watch develop.
A recent seminar and debate on the comparative business models and possibility of joint investment co-hosted by Taylor Wessing LLP and Go4 Ventures attracted over 70 delegates from both the VC and PE industries. This demonstrates clearly that key players have already noted this trend for converging business models and interests, and are eager to find ways to adapt to it.
Nick Hazell and Simon Walker are partners at International law firm Taylor Wessing LLP.
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