PE firms venture into new territory

It would have been hard to predict 10 years ago, but private equity is becoming a prominent buyer of venture-backed startups. According to our 2017 Annual VC Liquidity Report, buyouts accounted for almost a fifth (18.5%) of all VC-backed exits in North America and Europe in 2017, up from about 14% in 2016 and nearly 10% a decade ago. As the below chart shows, there’s been a shift in strategy for private equity, which seldom ventured into startup acquisitions in years past. Previously, it didn’t make sense to buy VC-backed startups—everything from risk assumptions to capital requirements are typically as different as night and day between the two models. Or at least that used to be the case.

Things are slightly different today, with two popular explanations remaining valid. Startups are wary of going public in a volatile market, and don’t need to IPO anyway, with gobs of private capital floating around. On the buy side, PE dry powder levels are just as strong, and challenging deal flow is forcing PEGs to get creative with their targets. But both of those points have been true since at least 2012, when VC-to-PE acquisitions were much less common. The difference today goes back to the startups themselves, which are selling products and services in big enough numbers to justify PE interest. Late-stage startups, especially unicorns valued at $1 billion or higher, are generating real revenues that can’t be dismissed by institutional investors, including PEGs.

Moreover, many of today’s startups are actually being acquired by PE portfolio companies, which changes the discussion a bit. Add-ons (akin to strategic acquisitions in this case) are popular in the software space as sponsors continue strengthening their platform investments with additional revenue lines. That said, we wouldn’t be surprised to see startups become more popular platform investments in the years ahead, especially late-stage companies that have been private for almost a decade. As PE gains experience in software, the idea of startup buyouts (to coin a phrase) may not sound as crazy as it does today.

This column originally appeared in The Lead Left.