IVCA Feature: Highlights of Educational Luncheon ‘PE and VC Firms Playing in the Sandbox Together’

August 1, 2018

The IVCA Educational Luncheon series is a significant perk of membership for the association, and another vital one took place on July 21st, 2018, at the UBS Conference Room in Chicago. The topic was topical: “PE and VC Firms Playing in the Sandbox Together” and was discussed by a distinguished panel of industry professionals. The event was moderated by Ira Weiss, Founder and Partner at Hyde Park Venture Partners, and included the following panelists...

• Dan Connolly, William Blair, Managing Director (Technology)
• Doug Grissom, Madison Dearborn Partners, Managing Director
• Jim MacDonald, First Analysis, Managing Director
• A.J. Rohde, Thoma Bravo Discover Funds, Partner

The format of the discussion was a topic question or statement and the answer from the panel. The following are the highlights of the luncheon presentation...
 
OVERALL VIEW OF PE/VC ‘WORKING TOGETHER’ MARKET
 
Dan Connolly pointed out that that the shift in the marketplace is towards M&A exits rather than IPOs. Two/thirds of those IPOs are VC backed and this has been a down year for IPOs. Valuations are on the rise, as are costs to IPO. For sellers, a private equity fund can be a better exit than to a strategic buyer because there is an opportunity to take some money off the table but to also rollover some equity and continue to participate on the upside. On the VC side, an exit to Private Equity is also clean and quick, as opposed to an IPO or a sale to a strategic which can be more burdensome in terms of time and complexity.
 
EXAMPLES OF PE & VC TOGETHER, IN WORKING WITH MANAGEMENT
 
Doug Grissom gave the example of Fieldglass, a $35 million dollar Chicago company, which had taken 12 years to get to that value. Madison Dearborn cashed out six VC investors in the company with their acquisition. Fieldglass tripled the valuation in three years, and MDP sold it. It was an example of a well-resourced PE firm being able to do more, quickly, to help a company scale.  
 
Grissom also talked about leveraging VC investors on these deals. Some VCs are high value, and have worked closely with the management teams in their investments, and some have been less engaged. It comes down to the board member... are they adding value or not?
 
A.J. Rohde added that Thoma Bravo bought a company called Tripwire, with seven VC firms and 12 years of investments, with $90 million in revenue, and an 18% growth rate. They maintained the management team. They restructured the company, and used EBITDA to fund acquisitions off the balance sheet. They bought competitors, and was able to sell for five times the purchase price. It was about finding a team willing to do a 180 degree turn on creating value.
 
A.J. continued on the process when dealing with management teams... they have to be willing to be a platform for other acquisitions, and to be able to absorb them in transition.  Next, they have to prove – especially for the next owner – that they can sustain these changes. Quality of revenue is important, whether its retention rates or adding revenue through sales.
 
ANOTHER EXAMPLE WITH YELLO
 
Jim Macdonald was asked about YELLO, which specializes in talent acquisition software. He spoke about the First Analysis initial VC investment, when the company was valued at $3 million and grew from there. They also raised growth equity funds, but some of the minimum potential buy-ins of PE firms was too much funding. PE firms would want to come in at a certain amount, but it didn’t make a difference in the percentage of the company they wanted.  
 
FINANCING PE ACQUISITIONS
 
Jim Macdonald brought up the example of investment banks, in providing a multiple of revenue in debt for a VC backed SaaS company, usually it’s about three or four months. When bringing in a PE investment, he can get 12 months of revenue as debt. A.J. Rohde talked about it being two years presently, but felt that was a bit too reckless. Doug Grissom then added the banks will do these deals with at least some EBITDA, and some revenue returns. In a competitive market, it’s a way to increase value.
 
WOULD YOU RATHER BUY A COMPANY FROM A VC or PE-BACKED FIRM?
 
Dan Connolly first talked about a dynamic that has changed in the length of his career... there are more outside PE buy-ins to Private Equity acquisitions then when he started. Factors include the maturation of the PE industry... there are funds for growth equity, buyouts and mega-funds, for example.  For almost any segment of the market there is a different category of buyer to fit any investment out there.
 
Doug Grissom added that one of the benefits Madison Dearborn Partners is providing their PE accounts is introductions to other funds that could be good investments for their larger funds, something that is now accepted.
 
A.J. Rohde concurred with what the other two panelists were saying, and said that buying 50% of a company from another PE firm is more common. Instead of an outright buy of a company, there are more percentage deals. There is a lot more partnering between firms than five or ten years ago. He also added that acquiring companies from certain VC firms has advantages, especially if they’ve institutionalized systems and processes within a company, which is much more advantageous than an acquisition from a founder.
 
Jim Macdonald brought in the VC viewpoint regarding PE firms wanting to acquire a VC-backed company.  The highest price is not necessarily the issue so it’s important to understand the VC’s motivation.  Are fund life pressures forcing them to sell?  Valuation, and exit potential, are important to PE acquisitions, and sometimes the VC position is how long will that take to multiply an exit value, and is that the VC strategy? And what if an outside strategic fund comes in and offers an attractive buyout, and the VC who has held the company for a while is ripe for it but their PE partners, who are newer to the deal, are not?  Usually growth equity is in the minority stake realm as well. Stakes, structure (preferences et al) and strategies are also factors.
 
WHAT ARE THE OBSTACLES OF VC and PE COMING TOGETHER?
 
A.J. Rohde talked about how in later rounds of funding, an acquisition or buyout is most likely, because the boards are usually focused on liquidity, and that process usually has to work itself out. In his view, it can become a timing and valuation mismatch.
 
Doug Grissom brought up the recent industries of cyber security. It’s a hot-product-to-flatline cycle. When the flatline hits, that’s when valuation problems start. VC funds come in to finance, but they want 2-3x return guarantees, and that can take five years to unwind. The view on that is be careful about layering rounds in some products, it causes boards to stagnate in decision making. Jim Macdonald weighed in on that thought... is there anything left for the company’s management when these layers of funding happen?
 
Dan Connolly talked about misalignment... different holders and different levels of partnerships... the challenge for VCs is getting deals done, when PE firms are asking what can they get done. If you cannot articulate what you want an investor to solve, you don’t give the investor a chance. Deals are sticky that way, and shareholders also are sometimes negotiating against themselves, and that can be difficult. The risk of nothing getting done is very high. The management can get resentful in that strain.
 
HOW DO VCs and PEs HANDLE A ROLLOVER VS. NO ROLLOVER SCENARIO?
 
A.J. Rohde related that it is a different mindset on the board... a PE sits as an owner, and a VC is an investor, and several factors come into that decision. But at the end of the day, the rollover could solve some key questions regarding the end value of a company.
 
Doug Grissom talked about control... having at least a 51% control. VCs are sometimes not on board with that, but that is a way to go for a cleaner decision making process. Dan Connolly added that PE growth equity funds are willing to solve what the owner wants.
 
HOW ABOUT HAVING VC FIRMS ON THE BOARD?
 
Doug Grissom thinks it’s a question for the CEO. Are they adding value? The PE stake is paying the highest price, so they get to set the table the way they want it set. Jim Macdonald added its about knowledge... the general VC who is on the board versus someone with the particular industry knowledge. For example, on HR and tech, most of the time a VC would have more knowledge than a PE stakeholder.
 
HOW DOES PRE-EMPTION IN PRIVATE EQUITY CHANGE THE BUY OUT OUTCOMES?
 
Dan Connolly said in a competitive market, if a PE firm wants a “commitment to win,” they want to turn that dynamic in their favor... it’s possible to pre-empt to win. So he’s seen two-thirds of transactions have some form of pre-emption. Buyers will use any tools to create opportunity, including pre-emptive speed and funding promises, and contracts can be extraordinarily seller friendly. That results in the “first bid” being the more thoughtful and highly due diligenced bid.
 
IN A BUYOUT OF A VC-BACKED COMPANY, HOW DO YOU MAKE THE DECISION ON ‘WINNING THE OUTCOME’ VS. NOT EVEN ATTEMPTING IT?
 
Doug Grissom brought up the software industry, grueling in its competition right now, and every PE firm in the country has a software team. It puts a premium on picking your spots wisely... for example, what’s our angle? Do we know someone on the board? Do we know some of their VC investors or the CEO? Otherwise, there is a waste of due diligence funds with nothing to show for it. So when the decision is made to dig in, it’s all in, and it has to be done fast in this super competitive environment.
 
A.J. Rohde chimed in that when it’s VC, he assumes it’s only about price. And he also assumes that in those situations, the single commonality is the CEO. They will drive the proprietary outcome. We have to win over the CEO, because they can get us up front in any decisions to be made. If a VC-backed company is up for sale, it will be about price and that decision making associated with it will be on the CEO. Doug Grissom added that the firms compete to “break the tie,” because they all end up in the same place around a bid for acquisition. That tie-breaker lies with the CEO.
 
POST ACQUISITION, HOW DO YOU GET A MANAGEMENT TEAM ALIGNED, AND HOW DO YOU MAKE DECISIONS ON WHO REMAINS WITH YOU?
 
A.J. Rohde said it starts with a financial plan with his firm, and it’s based a four year EBITDA strategy, with half of their equity based on that timing and the other half on performance. Doug Grissom added that the team that got them to where they are at is often NOT the team that will get you where you need to go. Grissom said they will bring in an “organizational assessment” that will overview on everyone, and use it as a tool for the CEO to get the right team in place.
 
AUDIENCE QUESTION: HOW DOES THIS DISCUSSION APPLY TO LOWER VALUATION COMPANIES ($5-20 MILLION)?
 
A.J. Rohde observes that the level has become one of the fastest “arcs” in PE investing. This niche competition has made exit potentials harder to predict. Doug Grissom opined investment at those levels are a way to compare life-cycle-of-the-company results.
 
AUDIENCE QUESTION: WHAT ARE SPECIFIC MANAGEMENT EXPECTATIONS DURING AN ACQUISITION PROCESS?
 
Doug Grissom re-emphasized that the person that matters is the CEO, they know most of the options, so the senior team is not as much of a concern. Also with the CEO it’s more important than ever to have a partnership, so their stake is as important. A.J. Rohde concluded by talking about creating deadline incentives, which will make a tired management team more focused.