PRIVATE EQUITY & VENTURE CAPITAL

LECTURE 2

Theodosios Dimopoulos
HEC Lausanne,
Swiss Finance Institute
 Outline

1. Deal sourcing and evaluation

2. Fund raising
3. Cyclicality in PE investing

Readings: Mostly stick to the notes

1. Deal Sourcing and Evaluation
Private Equity Financing

Source: Bain & Company, Global Private Equity Report 2022

Specialization vs. Diversification

❑ Finding the Deal

✓ Where to Look—Specialization vs. Diversification

✓ Attracting vs. Finding Deals
✓ The Entrepreneur’s Perspective
 Specialization vs. Diversification

❑ Early stage VC firms focus on areas undergoing structural change (e.g. IT, life sciences)
❑ Buyouts target firms seeking generational transition or major reorganization
❑ Should PE firms specialize in sectors, locations etc?
❑ LPs like specialization. Changing investment focus is a bad sign for them
❑ Some would think that diversification is good for reducing idiosyncratic risk
❑ However this can also be done by individual investors
 Specialization vs. Diversification: Information

❑ VCs that finance early stage firms tend to specialize in order to share info with other VCs
❑ That means that VC firms often form networks and pool information in order to better
identify potentially good deals

❑ Specialization occurs both in terms of the sector of the funded firms and their location

❑ Reputation building as a specialist in a sector or location is key to attracting LPs and

financing
 Specialization vs. Diversification: Time

❑ Specialization allows economies of time in evaluating deals

❑ Time is often the scarcest of resources in PE firms, which rely on limited personnel
❑ However too much exposure in a sector makes a firm vulnerable to market fluctuations (e.g.
Internet bubble)
❑ Since deals come in waves which differ by sector, a PE firm must look for opportunities in
new areas, before investment in its current sectors dries up
❑ Indeed large VC firms prefer to diversify
 Attracting vs. Finding Deals

❑ After deciding the sector, stage and geography of investing, a PE firms needs to find deals
and evaluate them
❑ Top PE firms get contacted by top entrepreneurs, so those firms have ample choice (e.g.
KPCB, Sprout, NEA)
❑ Smaller firms can hope for deals in niche markets (e.g. Montagu PE specializes in European
family owned businesses)
❑ What if not many entrepreneurs contact a PE firm?
❑ It will have to find deals by itself
 Deal Formats

❑ Auctions
✓ Bidders compete to acquire the target firm
✓ Especially relevant for buyout funds

❑ Private Deals
✓ Proprietary Deals: The entrepreneur approaches the PE firm
✓ Proactive Deal Searching: The PE firm approaches the entrepreneur
 Private Deals vs Auctions

For entrepreneurs:

❑ Auctions
✓ generate high price competition
✓ make firm info available to competitors. Solution: Tiered auctions

❑ Proprietary private deals

✓ give the entrepreneur the right to choose a specialist GP to lead the deal
 Proprietary Deals

❑ In a proprietary deal, the entrepreneur approaches directly the GP

❑ To attract the GP’s interest, the entrepreneur is more comfortable with releasing private
information on its firm’s prospects
❑ Usually such deals are not contested and take less time for the GP to process
❑ Often PE firms cooperate by inviting each other in proprietary deals
❑ However, the reputation risk to GPs is higher
 Private Deals vs Auctions
For GPs:
❑ Auctions
✓ Are easy deals to find and participate
✓ Are time consuming
✓ Involve high price competition

❑ Private deals
✓ Are not often contested
✓ Facilitate reciprocal invitations to deals among GPs
✓ Protect the GP’s due diligence investment
✓ Involve more reputational risk to the GP
 Proprietary Deals vs Proactive Searching

❑ Proprietary deals involve easier disclosure of info to the GP, as the entrepreneur tries to
impress the GP
❑ However, GPs need to be vigilant against overconfident entrepreneurs

❑ In addition they are not always available, especially to non-specialist PE firms

❑ Proactive searching then becomes a necessary tool for PE firms looking to allocate their
portfolio
❑ Searching for deals though requires more time and money
 Searching for deals

❑ Decide sectors and locations to invest in

❑ Make a preliminary deal search

✓ Roadshows
✓ Industry journals
✓ Personal relationships
❑ Active deal making:
✓ Dial for deals
✓ Intermediaries
Intermediaries for PE Information

❑ Friends
❑ Angels
❑ Commercial bankers
❑ Investment bankers
❑ Stock brokers
❑ Accountants, lawyers
❑ Business development officers

Warning: Each has its own incentives to lie!!

2. Fund Raising
 Fund Raising

❑ Let’s look now at the other side of the table

❑ How should an entrepreneur approach a PE firm to obtain financing?

✓ Select GP partner
✓ Attract preliminary interest
✓ Make a presentation of the firm
✓ Negotiate a deal
 Questions entrepreneurs should ask when choosing GP
1 Does this firm/partner have expertise in my sector?
CHOOSING GPS
2 Where is the firm located?
➢ VC tends to be local; LBO less so, but still proximity is useful

3 Has it backed companies similar to mine? Similar to those of my customers or acquirers?

➢ Knowledge of the business ecosystem means better ability to give better advice

4 How many companies has the firm taken public?

➢ Recent placements imply better networking with investors/investment banks

5 How recently did it raise a fund?

➢ Recent fundraising implies less pressure from the VC to show immediate results

6 What do other entrepreneurs say?

➢ Sources: Networking or databases (Capital IQ, VentureXpert, SDC etc.)

7 What other resources can the firm supply?

➢ Human resouces experts? Marketing, public relations help?
CHOOSING GPS
Roadshows: How to pitch your company when bumping into a VC
1 Start with energy and excitement. Highlight the enormity of the problem to grab attention
➢ “… surgeries are performed every year in poor countries, with little purification means”
2 Explain in easy terms what your company does
➢ We develop an incredibly affordable system of surgical instruments purification

4 Avoid scientific details and jargon

➢ Tech-founders often forget this point and get carried away

5 Establish credibility: Experts involved, any news coverage received etc.

➢ The master-mind behind our product, Prof. … of EPFL, recently spoke to Innovaud regarding our
project
 Presentation of startups to VCs: Structure of slides
1 Front slide: Company name, phone number, email address, what the firm does in one line
CHOOSING GPS
2 Market being addressed: How big is it?
➢ Our VC tries to understand the potential for sales

3 Why is the market in pain?

➢ Would our target customers care about what we are developing?

4 Why are the current solutions inadequate?

5 How does our firm solve the problems? Why is ours a TEN times better solution?
➢ Lots of things go awry for startups. If the ideal scenario is not exciting, the VC is not looking into
our case
6 Who is the team that is going to build this business?

7 What early proof points do we have?

CHOOSING GPS
Presentation of startups to VCs: Structure of slides
8 How are we going to sell it, how are we going to get lead GPs?
9 Potential competition

10 How fast can this grow?

11 Basic financial projections by quarter for three years, including revenues, expenses, cash,
head count

12 How much capital do you need to raise now? What milestones will you hit before you need
to raise more?
3. Cyclicality in PE investing
Cycles of the past: Aggregate funds
Total Invested ($Bln) Number of IPOs

160 250

140
200
120

100 150
80

60 100

40
50
20

0 0
1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019
Cycles of the past: Computer startups
Total Invested ($Bln) Number of IPOs

80 120

70
100
60
80
50

40 60

30
40
20
20
10

0 0
1990 1993 1996 1999 2002 2005 2008 2011 2014 2017
Cycles of the past: Semiconductors
Total Invested ($Bln) Number of IPOs

8 30

7
25
6
20
5

4 15

3
10
2
5
1

0 0

1990 1993 1996 1999 2002 2005 2008 2011 2014 2017
Cycles of the past: Communcation & Media

Total Invested ($Bln) Number of IPOs

35 80

30 70

60
25
50
20
40
15
30
10
20

5 10

0 0
1990 1993 1996 1999 2002 2005 2008 2011 2014 2017
Cycles of the past: Biotechnology
Total Invested ($Bln) Number of IPOs

18 60

16
50
14
12 40

10
30
8
6 20

4
10
2
0 0
1990 1993 1996 1999 2002 2005 2008 2011 2014 2017
Cycles of the past: Life Science

Total Invested ($Bln) Number of IPOs

12 50
45
10 40
35
8
30
6 25
20
4 15
10
2
5
0 0
1990 1993 1996 1999 2002 2005 2008 2011 2014 2017
Venture financing across sectors
 Characteristics of Cycles

❑ Cyclicality is a widespread phenomenon in PE investing

❑ There are certain periods that make fundraising easier

❑ Besides market wide cycles there are those isolated to specific sectors or specific regions

❑ It is not predictable though how long a cycle will last, or when is the new cycle coming
 Why do Cycles Happen?

❑ Normally supply should adjust to meet demand for PE financing

❑ Often however supply is limited by regulatory reasons (e.g. pension funds)
❑ In addition, it takes time to build a reputation as a good PE firm and find LPs
❑ Supply therefore responds sluggishly to demand shocks
❑ This produces cycles
❑ Misjudging a demand shock can also cause overshooting in PE supply
Equilibrium in the PE Market: A sketch
Demand<Supply:
Return PE return
decreases Short term Supply of
PE funds: Fixed,
since funds are closed

Demand of PE funds:
R1 Smaller the lower
entrepreneurs have to
Demand> price their firm to leave
Supply: room for PE returns
Entrepreneurs
sell cheaper, PE
Q1
return increases Quantity of
Funds
Equilibrium in the PE Market: Demand shock
S1 Competition by
Return new funds
SL
drives returns Long term supply of
downwards PE: Increases with
expected return, since
more funds are raised
R2
RL
Positive demand
R1 shock: Funds
D2 demanded increase
for each level of
D1 return required by PE

Q1 QL
Quantity of
Funds
Equilibrium in the PE Market: Overshooting
S3 Too many funds are
Return S1
raised
SL
Investors
overestimate the
future demand for PE

RL D3
Returns are driven
R1 down, leading to exits
D2 of funds from the
D1 industry

Q1 QL Q3
Quantity of
Funds
 Implications for Fund Policy

❑ The quality of financing differs over the cycle

❑ Usually investment made at the peak of a financing cycles yield on average lower returns

❑ Makes sense: When financing is hard, a PE firm only undertakes the best PE projects
available

❑ Implication: PE firms often raise financing with a view to investing later, at more favourable
times (cookie jar approach)