Attractive Late-stage Firms Grow Scarce for Venture Capital

Mention venture capital and most people will think of a firm that invests in start-ups — companies that may be little more than an idea, some software on a hard drive or a few prototypes in someone’s garage. But some VC firms specialize in late-stage investing.

What is that, exactly?

While it clearly involves buying into companies that are no longer newborns, each fund sees this niche a bit differently, according to speakers on the “Late Stage Capital Investing” panel at the recent Wharton Private Equity & Venture Capital Conference 2014.

Insight Venture Partners defines a late-stage firm as one that has proven its product’s viability, has begun to grow and is focused on marketing and sales, said managing director Ryan Hinkle. And after the late stage comes the very late stage, when cash flow is dependable, the firm is past the initial hyper-growth period and it is ready for sale.

At Polaris Partners, the key distinction between stages is profitability, noted partner Jason Trevisan. A seed-stage firm generally has no revenue and perhaps not even a working product. An early stage company has a product, or at least a version of one, and although it may have some revenue it is generally still burning money. A late-stage firm is growing nicely — though it is perhaps still burning some money — and it needs investor capital for growth.

And at Bain Capital Investors, people issues, rather than concerns over things like revenue and profitability, characterize the early stage. In selecting an early stage investment, Bain focuses on whether those people can deliver, said principal Weston Gaddy. In the later stages, fundamentals like the company’s value on the market become more important. But the stages are not always so distinct in investors’ minds, as over time limited partners have focused more on the big rewards that can be realized by getting in on the ground floor.

In fact, added Cara Nakamura, principal of the Princeton University Investment Company, which invests portions of Princeton’s endowment into VC funds, today’s limited partners are more likely than in the past to be drawn to VC firms large enough to buy into firms at various stages “to go where the opportunities are.”

Finding opportunities is an ever-changing process. In the period from around 2004 to 2008, Polaris found plenty of middle-market companies, with revenues of $10 million to $50 million, that could deliver annual growth of 60% to 70%, said Trevisan. But prices for such firms have soared, so that a firm that once could have returned six to seven times the investment may now bring just one or two times. Firms like this, he noted, have been “priced to perfection,” and the investor might as well buy stocks.

So today, he added, Polaris is looking for businesses with more modest growth, in the 10% to 25% range, that need work to do better. The goal is to buy at eight to 10 times EBITDA. The key, he stated, is to find a firm with plenty of room for improvement.

Before 2001, Insight viewed a late-stage firm as one that had merely reached the point of actually having a business plan, Hinkle said, describing easier times for VC funds. But after the Enron scandal of 2001 the markets became more skeptical of Internet firms, and then money got tighter after the financial crisis. Now, he noted, it’s tougher to take companies public, and for a successful IPO, a company must typically be larger than in the go-go years. Prices of target firms have gone up significantly in recent years, probably because hedge funds, private equity funds and institutional investors have poured money into IPOs, Gaddy added.

Looking ahead, two of the panelists saw opportunities in subscription-based software. But it’s a risky area, Trevisan said, noting that acquisition prices can be scary. One reason for that, noted Hinkle, is investors’ assumption that a subscription software firm will retain most of its customers from year to year, as well as adding new ones. In contrast, a traditional company — like a restaurant chain — starts each year with zero customers. Prices of subscription software firms thus reflect investors’ belief in “a certain inevitability” of growth. Investors, he said, “are a bit intoxicated by that.”

What do LPs Want?

Given all of today’s risks of investing in VC funds, what do limited partners look for?

Princeton’s Nakamura said that, overall, the VC industry’s returns are “terrible,” so Princeton is very choosy. “From the LP side, our perspective is there is a top tier of firms that you should be invested with.” The rest, she added, should be avoided. The best VC funds have done very well, returning $5 for every $1 invested, she noted, and they’ve been able to do it over and over. But “there aren’t a whole lot of names that have been able to do that on a repeat basis over decades.” Princeton, she stated, likes early rather than late-stage investments because there is more chance of hitting home runs.

“Some firms have been priced to perfection and the investor might as well buy stocks.”

Of course, for VC funds, finding a target that needs a helping hand is not enough; the firm must have some promising features to begin with. Gaddy said that in a venture capital investment, in contrast to many private equity deals, the founders and existing management are usually retained. Bain therefore prefers a company that already has a good team — people with the right mix of background, experience and skills to move the company forward. Bain also prefers a firm that serves a big market rather than a small one. “For the most part, it’s a market that starts with a “b” [billions], not an “m” [millions],” Gaddy noted. Bain also likes a market “with some disruption” that leaves room for a new player — mobile marketing to phones and tablets fits the bill today. Ideally, he added, the company should also have a moat i.e. that “there is a reason it’s going to be hard for somebody else to come in and play in that market.”

Though few companies make the grade, it’s often clear which ones do, added Trevisan, suggesting that if 100 companies were presented to the four panelists, all four would identify the same 10 as the most attractive. Many targets, however, look good at first glance but reveal flaws upon closer inspection. Are there common traits among those that, despite their initial appeal, just don’t make the grade?

Deals die for many reasons, Trevisan noted, but often because the target’s owners and the VC executives view the prospects too differently. “They view the world in a far more optimistic light than you do.” Hinkle recalled deals that had died after the VC staff talked to the target’s customers and found “that they hate the product.”  An outwardly attractive acquisition may be rejected if it competes with an existing holding, Gaddy added.

And, he said, his firm is sure to pull the plug if the target’s executives have lied or “if, for any reason, there is just a categorical mistrust.”

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