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Hedge Fund Monthly
 

Meeting in the Middle

Adrian Rainey, Associate
Taylor Wessing

October 2009
 

For so long at opposite ends of the investment spectrum, private equity (PE) and venture capital (VC) are increasingly converging as the hunt for returns forces the adoption of new strategies.

Until recently, the idea that PE funds and VC funds could be looking for returns in the same areas would have seemed as improbable as the collapse of Lehman Brothers.

The divergence of PE and VC as asset classes began so long ago and had become so pronounced that only the more experienced players in the field remembered that the terms were virtually synonymous until the early-1990s. However, the world has changed and we have seen the beginning, at least, of a convergence at the boundary between PE and VC.

Causes

There are three key drivers. Firstly, according to the data released by EVCA and Thomson Reuters, the internal rate of return for VC funds over virtually every investment horizon in the last 20 years has been better for those investing in growth-stage technology companies (companies that are not necessarily profitable but that have developed some traction with their products or services and have started to generate revenue) than those investing in early-stage companies or indeed than those of ‘balanced funds’ investing in both early-stage and growth opportunities.

As a result, there are more VCs focusing on later stage opportunities than there were previously, with the likes of Index, Kennett and NextStage all recently having raised funds focusing on this space. This trend has been highlighted during the current recession – compared to a start-up company that has the potential for growth in the long run but is currently generating little or no profits. More mature businesses with strong revenue growth are perceived by VCs to be much less of a risk.

Secondly, as a result of the global financial crisis, the traditional PE business model of leveraging their investment with large multiples of debt has become significantly harder to implement and so, private equity has been looking at other ways of generating returns.

The global financial crisis has occurred at the same time as the third cause of the convergence – the maturing of the technology sector. It is increasingly apparent that there is a now a large number of technology companies across Europe which are already generating good revenues but still offer room for significant growth.

The PE industry in Europe has traditionally avoided the technology sector because it has not been able to support the high levels of debt employed by PE funds. However, these companies now offer the potential for generating the returns that PE funds are no longer able to make from their traditional business model.

Global PE firm, the Carlyle Group, recently raised a €530 million fund to invest in established TMT companies in Europe with the aim of making investments of ‘expansion’ capital as well as small- and mid-cap buyouts, and it is not alone.

Boundary Blurring

PE and VC firms can now find themselves chasing the same late-stage European technology companies. With more capital chasing the same opportunities – for quality deals at least – competition is driving up prices for entrepreneurs and driving down yields for investors, even in the current economic climate.

Although there are significant differences in transaction structure, levels of control and management incentive arrangements at their boundary, PE and VC deals are also starting to look more like one another.

For example, the competition for deals has resulted in VCs borrowing from PE and doing the unthinkable – using part of their investment to buyout existing backers who require a partial exit rather than investing solely for new equity to fund the company’s working capital needs.

Amadeus Capital recently announced a US$24 million investment in Stockholm-based Episerver, with 40% of its investment being used to buy an existing stake in the company. As a law firm, we are now seeing a significant number of late-stage investments incorporating a secondary acquisition element.

And the borrowing is not all one-way. PE has traditionally employed significant multiples of debt to support its equity investment as a way of generating returns but is now having to employ larger amounts of its own equity to finance deals.

At the same time, mature VC-backed companies with revenue are now more able to look to providers of ‘venture debt’ to support their expansion plans. The business models are not looking as different as they once did.

Benefits

There may be increased competition but there is also the opportunity for co-operation. From a VC perspective, there is an increased appetite for growth investments and a scarcity of European syndicate partners available.

For PE, syndication with VC funds offers the opportunity to spread risk. There is also the prospect of a new exit route for VCs through the sale of more mature portfolio companies to PE firms with the resources to take the company to the next level – particularly given the significant number of European funds sitting on long-dated positions in companies which are not yet ready for exit.

It may be early days but the landscape is changing and bringing new opportunities with it.

 

 

This article first appeared in EVCJ (July/August 2009 issue), www.evcj.com.

 

 

 

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