VC and PE historically have been apples and oranges. Both fruit but obviously different (can’t use oranges to bake an apple pie). But the same data has started to show that VC competition has forced PE into higher and higher multiples and is forcing them to push for more equity appreciation in their assets to produce the return profiles they promised their LPs.
According to a Bain & Co. report, 2020 saw an average 11.4x EBITDA multiple on buyouts in the U.S. This trend was mostly driven by tech which continues to see growth in valuation multiples driven by VC investments. This pressure is being felt in the PE markets as sellers look for those same multiples. The issue for many PE funds is that if our bull market slows or even reverses their portfolio will have overpriced assets. So what is the big deal? VCs keep paying for higher and higher multiples and still hit return targets?
The issue for PE funds is their return profiles don’t work like VC funds, they historically paid lower multiples for less-risky, less-upside businesses. PE funds typically operate by increasing margins, streamlining operations and make the business more profitable, and then flipping it 3–4–5 years down the road for 2–3x what they bought it for. That model works as long as the multiples that you are paying for stay low enough to generate that 2–3x return. As more and more PE firms move into technology, they are getting pressure from founders who want to get the multiples that VC investors are offering. Here is a look at the math and why it compresses the PE firm’s ability to generate their usual return profile.
Typical PE Investment - $10M EBITDA Business x 2.5x EBITDA Purchase Price Multiple = $25M Buyout
Operate for 4 years and increase margins by 50% and earnings 30% - $13M EBITDA x4 Purchase Price Multiple (due to improved profitability) = $56M Sell Price (2.25x Return)
PE Investment at 11x - $10M EBITDA x 10x EBITDA Price Multiple = $100M Buyout
To generate the same 2.25x return in 4 Years this business would need to sell for $225M
If we assume the same 50% margin increase, you would need $25M in EBITDA meaning you need to increase earnings 5x more over the same 4 year period, sounds much more VC than PE to us.
There are a few things we need to consider here as private equity investment evolves. Tech/Software startups have seen the greatest price multiple expansion over the last few decades and PE firms that target this class of companies typically don’t look at them like how traditional PE evaluates businesses. What I think is happening is we are seeing a small subset of PE that has broken off and are targeting software/tech companies that they think they can buy into, help scale up and optimize, then flip.
The interesting thing is from the founder's perspective this has created two very distinct routes that you can take to scale and exit, you just need to find the right fit. You can still go VC, smaller checks, selling minority chunks to investors where you don’t need to be profitable but if you show potential and strong top-line growth you can keep increasing valuation and taking on VC dollars. The other option is the “Tech-PE” route like with Tiny Capital or BloomVP. You can scale up a smaller or niche software business but in a profitable manner. At roughly $1M in ARR you become big enough for these groups to come in, they can make a majority purchase at a health multiple and provide you with capital and operational expertise, just like a traditional PE firm. The founder(s) can keep a minority stake and work with their new partners to scale the business up to the $10MM ARR range, potential improve margins, drop that to the bottom line and really streamline the business over time and then still flip the business again at $10m in revenue at that “tech” multiple of 5–10x generating returns for the “Tech-PE” firm along with a second payday for the founder(s).
It might be time to break PE into two distinct groups or perhaps these “Tech-PE” firms are better categorized as “Major Buyout VCs” (you pick which one you like better).