Buyout Funds

Buyouts are not new. The origins go back to the 1800s with the emergence of the Industrial Revolution. Some of the notable dealmakers included Jay Gould and JP Morgan.

But the modern approach to buyouts came in the 1970s. This is when the first fund came about. The partners included Wall Street veterans Jerome Kohlberg, Henry Kravis, and George Roberts, who started KKR, and the first fund was set at $25 million. Their strategy for buyouts has actually remained quite similar to the deals structured today.

For example, suppose ABC Corp. is publicly traded but the stock price has lagged. The CEO of the firm contacts KKR to take the company private. With this, the firm will buy all the shares and ABC Corp. will return to being a privately held company.

Why do this? This can help management focus more on long-term initiatives, not the quarterly expectations of Wall Street. Another reason is that the company’s stock is usually undervalued.

Being private will not usually be the end game. After all, KKR’s investors want to make money. This comes by taking the company public again or selling it to another firm.

A key to this is for KKR to implement restructuring plans to improve operations and margins. This could mean layoffs and sell-offs of non-core divisions. There may also be a focus on acquisitions to bolster the business. Since a private equity firm will have majority control, it is much easier to take these types of actions.

Another important aspect of a buyout is to provide incentives for management to focus on improving shareholder value. This involves allocating large equity stakes for them. In other words, the management team could become wealthy if the performance of the company is strong.

In terms of the valuations on buyout deals, they are generally based on a multiple of EBITDA. This is a company’s earnings before interest, taxes, depreciation, and amortization. For the most part, it is a way to measure the underlying cash flow of a company.

OK then, to continue with our example, let’s suppose ABC Corp. and KKR agree to a deal for $1 billion. The company has EBITDA of $200 million.

However, KKR will not put up all the money. Instead, it will write a check for, say, $100 million of the equity and borrow the rest (this is why a buyout is often called a leveraged buyout or LBO).

The valuation of the deal is actually $1.9 billion, which is known as the enterprise value. This is the equity value of $1 billion plus the debt of $900 million. As for the EBITDA multiple, it is the enterprise value divided by the EBITDA or 9.5X.

In terms of the funding for the deal, part of it will come from banks, which will provide secured loans. Then there will be another level of debt that is riskier but has higher returns. This is often high yield or junk bonds. During the 1970s and 1980s, the biggest player in this market was Mike Milken.

The leveraged structure is a way to juice up the return. For example, suppose ABC Corp. comes public again four years later and the valuation is $2 billion, or $1.1 billion after netting out the debt. This would mean that the return on the $100 million for KKR would be 11X or $1.1 billion divided by $100 million.

In light of these returns, buyout funds became one of the hottest investments during the 1980s. But this also attracted lots of other competitors. As valuations and debt levels got higher, it became more difficult to make money on the deals.

The peak in the buyout market came in 1988. This is when KKR sought a mega deal for RJR Nabisco, which erupted into a bidding war. But the firm would win the deal for a hefty $25 billion (this would stand as the biggest buyout until the $33 billion transaction for HCA in 2006).

However, the deal would turn out to be one of the worst for KKR. Some of the reasons were the seizing of the junk bond market (which resulted in higher interest costs), discounting on cigarettes from rival Philip Morris, and difficulties with selling off assets.

As a result, KKR’s 1987 vintage fund – which included the RJR deal – would be the lowest performer. Its average annual return was 12% versus 26% for all the rest. If the RJR deal had not been completed, the fund would have had a gain of 25.2%.³

The good news is that private equity firms learned from this experience. Not only would they be more disciplined with valuations, but also be mindful with debt structures, and projections. For the most part, the buyout market has remained a strong source of competitive returns.

Keep in mind that buyout funds tend to focus on traditional businesses like consumer goods, financial services, energy, healthcare, and so on. After all, to pay for the debt, there needs to be stable cash flows.

But during the past decade, buyout funds have been getting more aggressive with technology deals. The focus has generally been on companies with durable revenue streams and large customer bases. For example, in 2021, KKR and Global Infrastructure Partners agreed to pay close to $12 billion for CyrusOne, which operates data centers. Then there was $12 billion buyout of McAfee, a top developer of security software. The buyers included Advent International and Permira.⁴

Venture Capital Funds

In the summer of 2012, data warehousing veterans Benoit Dageville, Thierry Cruanes, and Marcin Żukowski founded Snowflake. Their vision was to create a native-cloud database platform.

The founders got a $5 million Series A round of financing from Sutter Hill, a top venture capital firm in Silicon Valley. They initially used the VC’s offices and one of the partners of the VC fund became the temporary CEO.

It took several years to build the product. But once it was launched, it saw strong growth.

In September 2020, Snowflake pulled off its IPO and raised $3.4 billion, making it the largest software offering ever.⁵ Investors in the IPO included Salesforce.com and Warren Buffett's Berkshire Hathaway.

As for Sutter Hill, the firm snagged one of the biggest hauls for VCs. The firm had invested roughly $190 million and generated a profit of $12 billion.⁶

Consider that this was not necessarily a rare event. Take a look at Sequoia. It invested a total of $235 million in Airbnb and the shares soared to $14 billion when the company came public in December 2020. Then the firm profited $8.4 billion on its $240 million investment in DoorDash.

Amazing, right? Definitely. But when it comes to investing, whenever there are staggering returns, there are substantial risks. This is no different with VCs. Even the elite firms have made terrible investments.

But this is part of the strategy, actually. The fact is that startups often fail. A general rule of thumb is that half of the portfolio of a VC will have deals that decline in value or go to zero. Then there will be 20% to 30% that will be singles or doubles. And finally, there will be a handful of deals that have standout returns. Basically, the overall performance really hinges on just a few transactions. If they are not good enough, then the VC fund will probably greatly underperform the S&P 500.

Burgiss Group LLC conducted a study on the performance of venture capital funds from 2010 to 2015 and the average return was close to 16%.⁷ However, the top 5% of the funds posted returns of more than 42%.

Unlike buyout funds, VCs will take minority positions in their investments, say 10% to 20% of the equity. This is to provide significant incentives for the team to achieve stretch goals.

There will also likely be several rounds of financing for these startups. They will be burning money so as to hire employees, expand the products, and spend money on sales and marketing. There will also be low levels of revenues, at least in the early years. Successful VC-backed companies usually raise hundreds of millions in capital before they go public.

Venture capitalists will get preferred stock. This will mean that they will get priority whenever there is a liquidity event, such as a buyout, IPO, or even bankruptcy. This is expressed in a liquidation preference.

For example, suppose Sequoia invests $50 million in ABC Corp. For this, they receive preferred shares that have a 1X liquidation preference. Thus, if there is a buyout, Sequoia will get its $50 million back before any other investors. Then the amounts above this will be allocated based on the ownership positions. In some cases, a VC can negotiate 2X or even 3X liquidation preferences. Although, these are fairly rare.

It’s true that some VCs will invest at the founding of a company. But typically, a firm wants to see some proof-of-concept, such as with a prototype or initial traction with customers.

No doubt, the valuation of these deals can be extremely difficult. Given that there may be minimal revenues, VCs will need to look at alternative approaches. One is to use the valuations in comparable deals.

Regardless, VCs will want to focus on those startups that have the potential for huge returns. This means that the total addressable market (TAM) must be large, say over $1 billion.

Another important factor that VCs look for is that the product or service solves a tough problem – and is done much better than the alternatives. If this is not the case, the startup will likely not succeed.

Some VC funds will focus on growth equity opportunities. This means that the companies are in later stages of development. For example, the revenues may be in excess of $100 million. Often these deals are known as unicorns because the valuations are over $1 billion. Many of these companies will either attempt to go public soon or sell to a larger company.

Rethinking the Venture Capital Model

VCs are always on the hunt for finding disruptive companies. These types of startups can achieve huge returns, as seen with companies like Uber and Airbnb.

But the irony is that the venture capital industry has seen little change since the early days of the 1970s. According to a blog post from Sequoia partner Roelof Botha: “As chips shrank and software flew to the cloud, venture capital kept operating on the business equivalent of floppy disks.”⁹

But some of the leading firms, like Sequoia and Andressen Horowitz, are rethinking their approaches. A big reason for this is the increased competition. VC firms have to contend with family offices and even institutions that make direct investments into private companies.

To evolve, more VCs have elected to become Registered Investment Advisors, which requires getting registered with the Securities and Exchange Commission. While this is expensive and results in more regulation, the RIA allows much more flexibility. A firm can own larger amounts of publicly traded shares, but also digital assets like crypto currencies and NFTs (non-fungible tokens).

Next, VCs have been getting more innovative in how they source new deals and help entrepreneurs. Some of the initiatives include hiring scouts to find interesting startups and creating educational programs.

Another change for VCs is to abandon the 10-year fund cycle. A reason for this is that – even after a company goes public – they can continue to generate significant returns. This has certainly been the case with companies like Google, Apple, Facebook, Square, and so on.

VC firms are even looking at ways to expand into other parts of the traditional financial services market. Again, Sequoia is a firm that has been at the leading edge of this trend. With a large network of entrepreneurs and employees that has become wealthy, the firm has set up its own wealth management firm, called Heritage.

It has about $14 billion in assets under management and invests in categories outside of venture investments.¹¹ The firm also manages money for institutional investors.

Angel Investing

In 2010, Travis Kalanick raised $1.6 million for his startup, which was called UberCab (the company would eventually be renamed Uber). At the time, the focus was on providing an app for a ride-hailing service with luxury black cars. The valuation of the startup was $5.4 million.¹²

Among the investors in the round was Alfred Lin. He was the chairman and operating officer of Zappos, the online shoe e-tailer. He invested $30,000. When he later joined Sequoia, he brought the deal to the partners. But they passed on it. As for Lin’s investment, it would be worth $149 million when Uber came public in 2019.

Basically, Lin was an angel investor. That is, he was investing his own money in an early-stage startup. Such a person is an accredited investor. They may also be working full-time, such as a lawyer, doctor, real estate developer, corporate executive, founder, and so on.

And yes, the returns on angel investments can be huge. But there are considerable risks as well. The reality is that most angel investments wind up being losers. Moreover, when a deal does well, it will usually take years until you can monetize it – say five to ten years. This is why it is a good idea to invest in, say, 10 or more deals. This will help to reduce the risks of the portfolio. Keep in mind that angel investments follow the J-Curve.

An angel round usually comes after a friend-and-family funding and the amount ranges from $25,000 to $500,000. This is known as a seed or pre-seed round.

There are “super angels” – who are very wealthy individuals – who may write a check for the whole amount. But the usual case is for a group of angels to participate in a round and one or two of them will lead it.

There may be additional rounds so as to lessen the dilution. But it is more common for the next funding to be from venture capitalists. This would be a Series A round, which may be $5 million to $15 million or so.

Before making an investment, angels will usually have the entrepreneurs make a presentation. But evaluating the potential for the investment is far from easy. Because the startup is in the early phases, there will be minimal or no revenues. The company may actually be more of an idea or concept. Because of this, angels will look at the leadership skills, passion, and vision of the founders. It can really be a “gut decision.”

Consider the story of Andy Bechtolsheim, who founded Sun Microsystems. In 1998, he met two students at Stanford – Sergey Brin and Larry Page. He saw the prototype of their search engine and invested $100,000 in Google. It was the company’s first outside investment. According to Bechtolsheim: “So I really invested in the company to solve my own problem which was how to find information on the internet which in 1998 was actually a very difficult thing to do.”¹³

Then what about the valuation of the startup? As we saw with VC deals, it can be a blend of art and science. But ultimately, it will come down to a negotiation between the parties.

There will be a pre-and-post money valuation. Let’s take an example. Suppose you agree to invest in ABC Corp. at a valuation of $1 million. This is the pre-money valuation. For the investment, you write a check for $200,000. This puts the post-money valuation at $1.2 million, which is the $1 million pre-money valuation plus the $200,000 investment.

When an investor wants to make an investment, they will put together a term sheet and provide it to the startup. The document is not long, say under ten pages. But it sets forth the key terms of the deal like the valuation, the amount of the capital, the type of equity or debt involved, and the conditions. For example, it is common that the term sheet is valid so long as there are no material problems found in the due diligence process.

Founders like to use term sheets to shop their deal. They will show them to other investors to gin up more interest – driving up the valuation. As a result, an investor will put a time limit on the term sheet. This can be a few days.

After the signing of the term sheet, there will be the due diligence process and negotiation of the deal documents. A big part of this will be the drafting of the representations and warranties. These essentially mean that the parties stand by their claims.

In this process, if there are problems that emerge, this may not mean the deal is nixed. Rather, it is more common for the parties to renegotiate the terms. This could mean reducing the valuation.

In terms of the security that the investor gets, this can vary. It may be common stock or preferred stock. Although, the typical security is a convertible note. This is an IOU, which converts into the company’s equity.

Why do this? The main reason is that it is much simpler, such as in terms of the legal documents and regulatory issues. In fact, incubators like YCominator have open sourced their own documents for convertible debt (www.ycombinator.com/documents/).

The holder of a convertible note will get a discount that can range from 10% to 30% or so. This means that – when there is another round of funding or an acquisition—the investor will convert the shares at a lower price.

But there is a flaw with this. For example, suppose you invest $50,000 in ABC Corp. when the valuation is at $1 million, and you get a convertible note with a 30% discount. Then a year later, the company gets a Series A round for $30 million at a $100 million valuation. In this case, you will convert your note at a high valuation of $70 million.

To avoid this, you can negotiate for a cap on the convertible note. This is where there will be a maximum valuation. In our example, this could be something like $1 million.

Deal Flow

Super angels like Ron Conway, Peter Theil, and Reid Hoffman have extensive networks. This means that they see many top-notch deals. In a sense, they are gatekeepers.

As you engage in various angel deals, you will start to build a reputation. Other entrepreneurs will talk to their friends and refer you. What’s more, the investors you work with as well as advisors, like lawyers and CPAs, will be a source of deal flow.

Although, one of the best ways to expand your opportunities is to join an angel network. This is an organization that will host presentations from startup founders. For those deals that look interesting, some of the angels will take the lead and bring other investors on board.

Another option is to join an incubator or accelerator. These organizations usually focus on startups at a very early stage. The incubator and accelerator will provide mentoring to improve on the business. Then there will be a Demo Day, which investors will attend. At this stage, the investment levels are usually small – say $25,000 to $100,000.

Equity Crowdfunding

When a company wants to issue equity, the process can be time-consuming and expensive. This is especially the case for an IPO. A company needs to register its securities with the Securities and Exchange Commission.

Consider that private companies can avoid this. How so? Basically, it involves mostly issuing the securities to accredited investors.

However, this may not be a good solution for early-stage startups. The founders may not have access to a network of accredited investors. Or, if they do, it can be tough to convince them to invest in the venture.

This is why Congress passed the Jumpstart Our Business Startups (JOBS) Act in 2012. The legislation greatly reduced the requirements for raising equity capital. It also allowed for a company to use an online portal to sell shares.

A crowdfunding site will have listings of various deals.

You then click on a deal and will get a detailed profile. Some of the materials include the investor presentation, terms of the transaction, investor documents, online forums, updates, and so on.

Even though some crowdfunding platforms will provide due diligence to screen deals, you should still do your own research. You can do Google searchers on the team, analyze the competition, and identify the potential risks.

A crowdfunding deal may have different types of equity, whether common stock, preferred stock, or convertible notes. Although, the most common is convertible notes.

There are different fee arrangements. They range from processing and payments fees to getting a percentage of the amount raised.

After you make an investment, you can track them via a dashboard. You should also get access to annual or quarterly reports.

Publicly Traded Private Equity Firms

The top firms started with buyouts. But over the years, they have branched out into other categories like real estate, credit, and growth equity. In other words, these firms have diversified revenue bases.

However, the performance can be volatile. Part of this is due to the swings in the markets. Next, the valuations of portfolio companies can be unpredictable since they rely on the timing of IPOs and acquisitions. Finally, another key factor is the growth in assets under management. This provides higher management fees as well as the potential for more revenues from the carried interest.

In fact, to boost assets under management, some private equity firms have been acquiring insurance companies. During the past couple years, Apollo Global Management acquired Athene Holding for $11 billion,¹⁴ and KKR purchased Global Atlantic Financial Group for $4.4 billion.¹⁵

Conclusion

Private equity is a big category, and it is becoming more important for finding ways to get higher returns. A key part of this is the active involvement of the portfolio managers. With buyout funds, they own the business and try to find ways to boost value. As for venture capital funds, the partners will help with the business model, getting customers, and recruiting.

Angel investing is another way to participate in private equity. But this is mostly for early-stage deals. While they can be risky, the returns can be significant.

Then there is equity crowdfunding. This is a much easier way to participate in early-stage companies. But again, it’s important to do your own research.

As for the next chapter, we’ll take a look at crypto.