September 2009

LEGAL EASE: buyout versus venture

Converging on similar sectors and forced by economic imperatives to seek out companies at a similar stage of development, buyout and venture capital...

charles_fletcher.jpgBuyout and venture are generally viewed as two distinct and separate disciplines. There has historically been something of an overlap between later stage venture and buyouts: not only could returns be earned more uniformly across a later stage venture portfolio than in  earlier stage venture, but later stage venture transactions were also more likely to feature an element of debt. However, it has been extremely rare for any given house to conduct both venture and buyout transactions within the same fund: there has always been a tacit understanding as to the dividing lines between the two.

However, the downturn has had a dramatic impact, with players in both disciplines needing to realign their priorities in order to survive. One feature of this has been the emerging trend of traditional buyout houses and venture capital (VC) to invest in late-stage venture deals.

The typical target for VC investment has traditionally been an early-stage company with the potential for significant growth, but where revenues (insofar as they exist) are insufficient to support working capital needs. By dropping in the required working capital (typically £15-20m (€17-23m) over a number of rounds) from an early stage, and thereby benefiting from relatively low valuations, VC funds seek to pick winners that will deliver both binary growth over a short period of time and a good money multiple on exit. Therefore, VC investments have tended to be concentrated in the technology or life sciences and, more recently, cleantech sectors – the areas with the most potential for ‘home run’ returns.

By contrast, buyout investment focused on tried-and-tested businesses. The buyout model, typically investing over £25m for majority control, relies on the availability of large amounts of debt finance that can be loaded onto the target. The importance of these high levels of leverage means that buyout targets have to be mature operating companies with solid trading histories, strong cash flows and sufficient collateral assets or cash reserves to persuade a bank to lend. Therefore, there has generally been minimal focus among funds on developing technology or life science companies: the relative focus has been less on the ability to grow exponentially and more on the ability to carry debt.

Recently the VC community has been gravitating towards a preference for late, or at least later, stage deals, where it is felt that the risk/reward ratio is more attractive. Compared to a start-up company that, despite its potential for growth in the long run, could be generating little or no revenue, operationally mature businesses with strong revenue growth are perceived to be much lower risk. Hence, even though a higher initial investment is required to back more mature companies, and they may not have the same potential to produce ‘home runs’, this lower risk is appealing.

Simultaneously, barriers that have traditionally discouraged buyout houses 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 already generating good revenues that still offer room for significant growth. Given current limitations on the availability of debt, these companies may offer the potential for generating returns that may no longer be available from traditional buyout industry sectors. In fact, the technology sector is now seen by many as a defensive play in comparison with, for instance, financial institutions, which have proven volatile of late.

Converging on similar sectors and forced by economic imperatives to seek out companies at a similar stage of development, buyout and VC funds could now find themselves either competing or collaborating on the same transactions.

The convergence of the buyout and later stage venture business models is likely to give rise to a range of new issues. Both will need to get comfortable with different transaction structures, management incentives and levels of control as they learn to compete or collaborate with each other in a much more crowded market. While the rapprochement remains in the early stages, there is no doubt that the old boundaries are being challenged. It remains to be seen how this might lead to friction and/or new allegiances between the venture and buyout communities.

• Charles Fletcher is an associate, Venture Capital Group, Taylor Wessing LLP

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