Achieving private equity exits in today’s market

September 2017  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2017 Issue


It is hardly surprising that European technology investment has grown tremendously over the past few years, given the fresh wave of innovative start-ups coming on the scene each month. As a consequence, Europe is now home to a host of mature yet fast-growing technology businesses, such as Auto1, blablacar, Klarna, iZettle and SumUp.

We are in the midst of a technology revolution where sectors such as artificial intelligence, blockchain and cryptocurrencies, enterprise SaaS, online marketplaces and platforms, mobile and broadband telecommunications and electric or autonomous vehicles are at the forefront of new product development.

Yet VC investors are facing an uphill battle to exit their portfolio companies. They have to wait longer and longer before selling, according to research carried out by Dow Jones Venture Source. Holding periods are an average of seven years, yet often investors need to exit earlier than this to return capital to their fund investors.

A key reason behind the delayed exits is that many venture-backed tech firms are finding they need to develop their business models further before an attractive sale is possible; which all takes time. In the past, business angel and venture capital funds would buy and hold investments until the final exit, be it a trade sale, an IPO or liquidation.

However, IPO exits are no longer as straightforward as they might seem. Only companies with substantially higher revenues and sustained profitability can list on a stock market and achieve liquidity. Prospective trade buyers, meanwhile, are also demanding more maturity. Many of the larger technology companies, including Cisco, Google, Oracle, Qualcomm and Salesforce, to name a few highly acquisitive ones, have grown into much bigger businesses themselves, which is the reason they now often want to do bigger deals.

The lack of quick and easy exit options for VC owners in today’s market has paved the way for growth investors and secondary direct players. The secondary direct market, a niche sector that came to Europe from the US in 2003, has rich pickings in today’s market. The fund model involves buying up stakes from shareholders who are keen to sell, yet struggling to do so. It was initially seen as quick-fix solution to institutions affected by the dotcom bust over a decade ago.

When a syndicate of venture capitalists owns stakes in a company, there is usually growing misalignment as to when each investor would prefer to exit. Secondary direct funds come in handy when some shareholders need liquidity, yet others want to continue growing the business. Secondary direct deals allow a speedy exit for investors closer to the end of their fund life or looking to change investment focus.

Typical sellers in these transactions can be more traditional investors, such as corporate investors, venture capital firms or family offices that change their investment focus, reach the end of fund life or simply need to generate liquidity to use in other investments. However, non-traditional investors, such as departed founders or business angels, have benefitted from secondary direct transactions. Increasingly, secondary direct transactions are seen by the seller as a more flexible, sophisticated way of portfolio management, rather than as ‘selling-out’.

Generally speaking, relatively old syndicates are most likely to provide interesting secondary transaction opportunities. Sellers in these situations have valid reasons to exit, even from good quality assets. However, such syndicates also struggle to provide companies the appropriate funding to unlock their often significant remaining growth opportunities. Therefore, experience has shown that the combination of secondary direct and growth capital produces the most attractive investment results.

The secondary part of such a transaction allows willing sellers to exit the syndicate and therefore to take away immediate exit pressure. The growth capital part of the transaction resolves the pent up demand for capital and, if necessary, allows recasting an overly complex liquidation preference stack and suboptimal governance structures. After the transaction, a company is well positioned for another round of strong growth that can translate into a relatively short-term exit.

Experience has shown that secondary transactions can have a positive impact on the companies concerned. Providing a liquidity option for shareholders has enabled some of Europe’s leading technology companies to go for the long-haul and refresh their shareholder syndicates with new, deep-pocketed investors.

In general, there is a dearth of growth capital in Europe. While early stage capital has made great progress, compared to the US the amount of growth stage capital available is much smaller. Large institutional pension funds and insurance funds, for example, hold large pools of wealth but tend to invest their funds rather conservatively.

The emergence of secondary direct and growth capital investors should help in terms of stumping up adequate funding and business know-how in order to take promising companies the extra mile to make them attractive targets in the eyes of industry heavyweights.

 

Roland Dennert and Diana Meyel are managing partners at Cipio Partners. Mr Dennert can be contacted on +49 (89) 550 6960 or by email: rdennert@cipiopartners.com. Ms Meyel can be contacted on +49 (89) 550 6960 or by email: dmeyel@cipiopartners.com.

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