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We've pointed out, here and there, that the private equity and venture capital industry is changing. For this newsletter, we collected some evidence of that. The media hasn't been paying enough attention to this topic yet, that is why we decided to draw your attention to it before it's too late.
- An unprecedented 2,974 private equity funds last month were seeking a record $945 billion of capital, according to Preqin. The intense competition has continued even after the industry’s dry powder — or the uninvested capital committed by investors — rose to a new high of $1.09 trillion in March.
- Private equity firms have returned almost $2 trillion since 2013, with distributions exceeding capital calls for deal-making for at least six straight years, according to a June report from Preqin. The trend became pronounced in 2014, as investors sought to reinvest the gains to maintain their allocations or satisfy their increased exposure to the asset class.
The word on the street:
- An investment banker in the Midwest said that “crappy little companies” are being sold for 12 times cash flow, when they should be valued at seven times. The debt used to finance these deals could spell trouble down the road. Higher interest payments can eat into cash flow over time, leading to a large drop in a company’s valuation.
- Institutional investors are interested in a better deal on fees and consider managers who aren’t running “monster funds.” The 2-and-20 model in the industry was created when funds were $100 million. Now, many PE and some VC funds are above $1 billion in AUM, and the pricing has changed only a little. There are some funds out there that are willing to pay 2-and-20, but others are not. For example, Texas ERS pays management fees averaging about 1.1 percent, while its cost on carried interest is about 12.4 percent.
- Private equity firms started offering a discount in fees to early and large investors in a new fund, or giving them the opportunity to sidestep fees in a co-investment pool offered as a sidecar to the main fund being raised. The biggest pension fund in the U.S., the California Public Employees’ Retirement System, is exploring another private equity avenue that would avoid fees: it’s reviewing a plan to begin doing its own deals next year.
- First-time fund managers have been leaving large, global private equity firms to run their own show. Some of these managers prefer working on smaller deals because they believe they can add more value by leveraging their experience from larger firms to help build businesses in the middle market. They also feel like there’s more opportunity to generate strong returns in the smaller end of the market.
- Institutional investors are now seeking to work with managers willing to give the fund more co-investment opportunities, as well as those that provide more geographic diversification.
The private equity capital-raising bonanza has at least one clear implication: inflated prices. Buyout multiples last year climbed to a record 10.2 times earnings before interest, taxes, depreciation, and amortization, according to S&P Global Market Intelligence. This year they remained elevated at an average of 9.5 times EBITDA through May, a level surpassing the 2007 peak of the pre-crisis buyout boom.
Along with all this, entrepreneurs have started dumping the grow-at-all-costs model, and now prefer buying out their investors to gain full control of their companies, and take the path less traveled in the tech industry.
Wistia, a video platform for business, turned down the offer to sell the company and instead took on $17.3M in debt to return the investments to early investors and employees. More details on their blog.
In Other News
If you’re a US VC with a foreign LP or have foreign co-investors, then youshould know the law is about to change. Congress is expected to pass legislation that will impact foreign investment into the venture and startup ecosystem in new ways. The purpose of the Foreign Investment Risk Review Modernization Act (FIRRMA) is to expand the power of the Committee on Foreign Investment in the U.S. (CFIUS) to scrutinize foreign investments into ‘critical technology’ for national security implications. FIRRMA was born out of U.S. government concerns that China is leveraging minority investments into startups to obtain sensitive information, like intellectual property, source code, and know-how. Under the final bill, CFIUS will have jurisdiction over any investment by a foreign entity in a critical technology company that gives the foreign entity:
- access to any material nonpublic technical information of the company;
- membership or observer rights on the company’s board or equivalent governing body; or
- any involvement in substantive decision-making of the company, other than through voting of shares
VCs, LPs, and startups raising capital should be cognizant of these three factors because if any of these factors is triggered then a CFIUS filing is very likely necessary.
Recent Industry Reports And Studies (free instant access):
Remember Tim Draper's effort to split up California into three separate states? It might not have worked out, but the tech sector has started to build its own distinct political platform for sure.