In the end, it’s all about the exit. When a VC firm invests in a company, it’s looking down the road to see where it can reap the best possible exit multiple; and lately, more and more VC firms have found PE to be their way out, averaging 89 exits a year from 2010 to 2013 compared to the 60 each in 2007 and 2008. What is driving the increase in VC exits to PE firms or PE-backed companies?
The short answer is that it’s not a shift in VC or PE investment strategies, but PE taking advantage of an open market segment. Let’s get some context first.
VC exits that dominate news cycles are primarily strategic acquisitions, like Facebook’s $19 billion purchase of WhatsApp. Corporations can proffer huge sums with ease as they have not only deep pockets but also shares to barter. They usually have the financial upper hand over PE firms in this scenario, and can also entice management and VC investors with Board seats. But corporate buyers often focus on the rockstars of the VC world, targeting companies with skyrocketing valuations, customer/user bases and hype. And while numerous VC-backed companies in the lower-middle-market boast stable revenues, strategics don’t often look there, and smaller IPOs are difficult to pull off. That’s where PE firms and platforms come in.
They have ramped up investing in that arena, with a little more than half of all buys in the space coming under or at $100 million. Activity has grown particularly in the software sector, wherein 37 of last year’s 102 exits occurred. LiveVox, bought by Golden Gate Capital for $79 million a few months ago, is a solid example: a provider of cloud contact center solutions, it operates a burstable platform that rakes in steady revenues, with a variety of opportunities for scaling.
The surge in activity can be attributed to a few factors. Buying out VC investors doesn’t have to be very expensive relatively speaking, as VC firms’ stakes aren’t usually as sizable as other PE firms’ would be. PE investors are perfectly willing to offer amounts that range within normal PE deal multiples but represent solid exits by VC standards. They’ll outbid strategics up to a point (hence the focus on the lower-middle-market range), utilizing increasingly accessible debt. Plus, the prices PE firms are willing to pay are usually a better prospect for VC firms than pulling off a successful IPO. Essentially, PE firms are now, more than ever, offering a third exit option to venture capitalists.
The likeliest factor causing the increase in PE purchases of VC-backed companies, however, is buy-and-build’s popularity. Add-ons comprise most of the deals in the space, accounting for no less than 62% of 2013’s activity. As PE firms focus more on the middle market as a whole with an eye toward building, it makes sense that they’re going to find more and more VC-backed companies. Of course, deal multiples are on the rise, as PitchBook noted recently, so PE firms may have to pay more not only to best strategic buyers but also to match higher valuations. This trend is what has probably contributed to the slight slowdown in PE firms’ acquisitive enthusiasm in 2014 so far.
So will the trend continue? 2014’s pace is a little down compared to 2013’s, more in line with 2010’s total of 85; yet the 46 VC-backed exits to PE buyers completed so far this year still reflect a continuation of the trend. Unless deal multiples grow even higher across the board, PE firms will likely continue taking advantage of the lower-middle-market, and as a result, will keep finding VC-backed companies ripe for the plucking. Platform add-ons are cheap and safe; why not rack up some singles while waiting for the home run?