← The Path to Exit
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- [00:02]
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Welcome to the Path to Exit, a podcast to help software and Internet founders understand the process to raise capital or sell their business.
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Hello and welcome everyone. I'm Mike Lyon, Founder and Managing Director at VistaPoint Advisors and this is the Path to Exit. This show is dedicated to helping founders of software and Internet businesses understand what it takes to raise capital or sell their business and how to do it well. My guest today is Mike Greco, managing director at VistaPoint Advisors. Mike has worked in M and a for over 10 years and advised countless founders on M and A and capital raising events. In today's episode, we'll discuss how private equity fund dynamics can impact the quality of their bids, from how serious the bids may be to the structure and closing risk. Please enjoy my discussion with Mike. Mike, so I know in your career you're dealing with all kinds of private equity firms, large PE firms, smaller one first time funds, well established funds. Just give me a little bit of a sense. When you're dealing with a brand new fund, what are some of the dynamics that are different there versus a really established fund who's maybe on fund five, been really successful and been around for 10, 15 years?
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A lot of variability is the simple answer. They can be incredibly aggressive in the right situations, but the level of scrutiny on that transaction tends to be really, really high. And it's really based around the dynamic that this first deal they're going to do in their brand new fund is going to depict success longer term and ultimately the fund driver. And so what you see early on is a lot of either passing quickly or a lot of early diligence being pretty thematic in certain categories and doing a lot of diligence upfront, making sure that's perfect and fits. A lot of those dynamics from a bidding strategy, they can be really aggressive and try to top tick. The market might have greater willingness to move higher if they really like something. But I would say it has to grade out almost to the nth degree. So diligence cycles, one of the cycles is quality of earnings. It's not just doing a kind of fraud check. A week, week and a half long diligence cycle, this is normally like three, four week diligence cycle. They're making sure every T is crossed and I's are dotted. But if those things grade out, it can be a party that gets very aggressive. The question becomes are you going to grade out perfectly in many of those cases? The only additional point I'd add to that is this diligence cycle third party diligence, outside diligence providers to grade out these things cost a lot of money. In some cases, it can cost 500, a million, couple million bucks in some cases even. And that becomes a pretty big driver to almost needing that deal to close at some point, because it is a lot of money. It is their first deal. They don't want to go call their LPs and say, hey, we did a bunch of diligence on this thing and ultimately didn't close. So at a certain point in time, deal certainty actually increases more than the typical because of the necessity for that deal to close. But upfront and through that middle part of the process, diligence can be excruciating, even more so than it typically is.
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And just to talk about a slight difference in terms of the fund versus the person. So all of these new funds, if you will, are generally run by people with a long track record. Right? That's how they're able to raise the fund. So the deal professionals themselves are very experienced. They worked on a bunch of deals, probably at pretty prominent firms, and that's what allowed them to go out and raise their new fund. But since it's a new fund, as Mike said, the bar is really high. They kind of want everything to be perfect, which basically implies a lower probability to close from the very beginning. But we have seen situations where once they spend the money on diligence, I wouldn't say they do irrational things, but I'm thinking of a deal we worked on five or six years ago where some background stuff actually popped up on the founders late in the process, stuff we didn't even know about. And the investor had spent so much money on diligence, you could tell that was a reason why they were able to just get comfortable over some of those issues and close over it. So it's a little bit counterintuitive, but the earlier, I would say, for a new fund, the earlier you are in the process, the more risk there is. But if you get really late with them, sometimes they'll close over some stuff that a more established firm who's not as worried about the expenses or the perception of not being able to get a deal done late in the process, they might just pass on the deal because they have a longer track record. So definitely pay attention to that. I wouldn't say all new funds are bad to deal with, but there's definitely a different set of criteria you want to evaluate them in and then know that your deal is probably going to be under a lot more scrutiny post transaction, because they need that to be a big Win because it's kind of the flagship for that fund, right, Is it's one of the first deals that they've done. I think one other thing that we run up against with smaller fund, and we're talking 500 million to a billion dollar funds, is how they act with their second and third fund. So Mike, maybe talk about how one of these smaller funds, right, when they raise that new fund, their behavior in terms of how they bid and what to look out for there.
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This is even more acute when the check size that that fund is writing starts to get larger and larger. The variability or just understanding of how to price these assets becomes more complicated for them or maybe a little outside of core. And so what you see is they have a lot of dry powder to deploy capital, they're moving up in check size, so maybe expertise is a little bit more blended. So they start to almost bid on everything they come across. And we see this time and time again, assets that you would have historically said probably not a good fit for them, they're putting bids on. And it's not just trying to put in bids to ultimately win, it's more putting in bids to get price discovery on how the market is perceiving things. And it creates a lot of challenges for founders, creates a lot of challenges for us, even in understanding what is real or not. And so when you have conversations with these types of parties, it's really trying to understand how much market diligence, how much conviction they have over the thesis as opposed to just taking that bid. They can get really aggressive, but the challenge is how real is that? How vetted is that at the ic, the investment committee, how much diligence have they done on the market, business, technology and the conviction? Because they do have a propensity to almost bid on everything they come across.
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One of the things we see with funds is there's just a lot of cyclicality on how they bid based on where they are in their fund life. So Mike, maybe talk a little bit about the dynamics of what are investors like early on in that fund's life versus late in the fund's life.
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So earlier on they tend to be more focused around larger platform transactions. And what I mean by platform is this is the first investment in that thesis. They're ultimately going to acquire additional businesses or build up around that asset. And so those platform transactions, because they have so much dry powder, they tend to be larger and they tend to be more aggressive from a valuation perspective. They then use tuck in acquisitions and obviously organic growth to lend down that multiple over time to give them extra juice on that irr. But earlier on they're looking to make those larger transactions. They also have a lot more dry powder and longer time horizon to return money back to their LPs later on in a fund. They tend to be a lot more judicious on how they're deploying that capital, understanding that the timeline will likely shrink. They will have to come up with some creative structures to extend that timeline if they do decide to do that. But a lot later on tend to be tuck in acquisitions for existing platforms which tend to be done at slight discounts to whatever that platform is and so greater necessity if that is the case later on. One, understand how much dry powder is left in the fund and timeline for returning LP money and all of that fund dynamics. But two, if you are looking to be a tuck in to a strategic or a port co of theirs, understanding how they value that asset is crucial. They're obviously not going to come out and tell you that. But having experience and bidding dynamics and structure tends to get a lot more visibility on that side. But it tends to create some turbulence in terms of while they were able to bid really highly early on, they're getting a lot more judicious on how they deploy that capital later.
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And I would say this is something founders don't really think about at all. And obviously investors don't really talk about this dynamic with their funds, but it's something to root out. There's actually a fair amount of public information on this point. Like you can see when they raised their new fund or announced it and start to do some math. What you don't really know necessarily is where they are in that deployment cycle.
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Yeah, great additional point there. Mike is a portfolio company of theirs, but they made that investment four or five years ago. They're probably going to trade that transaction in the next year or two. Any new dollar they're looking to put to work is virtually not given enough time to see full value from an IRR perspective and so be wary of that.
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Right.
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It's a great fit strategically, but they might be hamstrung because they know they're going to have to trade that deal in another year or two.
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We'll see deals all the time where and this isn't so much the fund length Mike's talking about the hold time of the portco they're invested in. And if they're getting ready to sell that business in a year or two, they're gonna bid horribly for your business. Like they might offer You a half cash, half stock deal. Because if they pay you full price and a good price, they don't have any time to earn a return on that. And if you just looked at the math of that situation, if they did, it would destroy the return, the irr of what they've already built up in that portco. They're just not gonna do that. So if you they're late in hold time with a portco, they're a bad buyer. Inversely, if it's pretty early, that's where you see a ton of M and A done. Because they have a chance to capitalize on the growth, on that additional capital they've invested and maintain a good irr. But we see that all the time. That's the point. I think founders understand the least and are just oblivious to because they're obviously just focused on, well, it's a good fit strategically, but literally you could see it'd be a bad buyer. And then as soon as they sell that port co to another private equity firm, which is now early in their whole time, they could become a really good buyer. So that certainly still matters. And a lot of the things we've been talking about up till now have been newer funds or small funds versus more established funds. But one thing that stands for both is what we call the starved partner syndrome. And sometimes depending on the reason why the partners starve, they can be a great buyer and really overbid. So Mike maybe talked about the concept of starved partner and talked about the difference between they've just been losing on deals, maybe on valuation versus maybe there's something with that partner that allows them not to be successful successful.
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So the concept is partner. They obviously have to deploy capital to justify what they do for a living. And at a certain point in time, if they don't have any new deals, it's difficult for them to get their economics. And so you see this idea or this mentality, the longer they go without a platform investment, they tend to get a little bit more antsy or aggressive on transactions that fit what they're looking at. And so what you can see is more aggressive bidding, but even more aggressive nature of how they interact, interact with founders, with us. Their aggressiveness towards willing to do third party diligence outside of exclusivity, spending money, doing a lot of the things to get them in a good position to win. The caveat is the investment committee isn't starved in many of these cases. And so it's difficult for founders to appreciate this partner really wants to do my deal. But the ic, who has a lot of different opportunities across the board, particularly the larger the fund, might not be as starved. So while you're getting told how excited and aggressive they want to be, that partner is ultimately going to have to make that case to the investment committee. And if they don't have the ear and they aren't more senior in nature, there is a greater propensity to be told one thing and being pushed back not by that partner, but the firm or the fund who's going to make that decision. And so really important to make sure you appreciate how often that partner is going to ic, how bought in the investment committee is to this opportunity and understanding their position in that fund. Right. A large 10, 20 billion fund, there's 20 plus partners. Any one of those partners is probably not going to have a ton of pull individually as opposed to, hey, there's three partners in a sub $5 billion fund and they want to do this transaction. Greater likelihood they have the ear of the investment committee and they're willing to adjust. So could be really good dynamics, but need to be cautious on getting the deal killed. From an investment committee perspective, that's a
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huge risk with these bigger funds. So early on in this podcast, we were talking about some of the risks of the smaller funds or the newer funds in terms of their dynamics. But this is an area where there's a clear difference, where sometimes the smaller the fund, the more confidence you have. I'll give you an example. We did a deal probably five or six years ago. It was a relatively new fund, but they had raised a decent size. And the thing that was most persuasive to us, as we were talking to the founder of the firm and we basically said, I am the investment committee. I'm the sponsor for this deal. I want to do it. Basically, there is no investment committee risk versus there are some large firms out there. We spend as much time trying to figure out how much stroke the partner has with the IC as we do trying to understand if the partner really likes the deal because that is a significant risk of a very large fund. So we're talking like 20, 30 billion dollars. Recently we were dealing with a partner, clearly loved the deal, wanted to do the deal, but his boss's boss decided they weren't going to pay any more than X for companies for the next year because they were kind of worried about the current economic situation. This is a fund that's not just a software fund. They do everything. That kind of stuff happens totally outside of the partner's control. But it's just an additional risk factor where some of these bigger funds and the reason why they have these ICs, they like to put a little bit more structure around their decision making so they're less likely to overpay and just in general make good decisions. But that can be a really risky element that I think founders don't understand. And frankly, the partners don't talk about it a lot. They kind of make it sound like it's a rubber stamp. In a lot of situations it is not a rubber stamp approval. So you want to understand how informed the IC is. Some of these funds will hand out, Lois, without the IC really signing off on them or very little sign off. You want to understand what risk you're taking internally with decision making. And we see that being a big problem in deals. Maybe talked a little bit about sometimes there's this concept of a new partner that shows up at a fund. So maybe they switch from one fund to another. How do you kind of evaluate them and how risky they are from the perspective of getting a deal done?
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It's challenging because it really depends on where they came from and where they're going to. And a lot of the things that we've talked about have great overlap with those things. So the overarching fund is going to make the decision. The partner is the sponsor and internal champion. We have seen good experience with partners that are moving from one fund to the next to increase how they are looking at transactions or what they can actually get done from an investment committee perspective. And so that can create a lot of good conviction around that champion. The challenge becomes, since they are new with the investment committee, do they have that ear? Do they understand what gets through and what doesn't? And so there can be greater dynamic similar to the starved partner syndrome where they want to do the deal but they don't quite have the dynamic ready and enough credibility internally to push things through when maybe something doesn't gray out perfectly.
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And I'd say the riskiest situation there is, let's say it's kind of a non software fund who has hired a new partner to lead their software efforts. Generally, the people on the ic, the people who are non software people, don't understand how software deals price some of the dynamics there. So you see a lot of head scratching decisions and frankly a lot of really cheap multiples because if they're used to paying two or three times revenue for a business, they think five or six times sounds like a really big multiple. So that's another thing to watch out for. I would say new partner who's leading software at kind of an older, stodgier fund that has not done software. That is a really risky proposition in our mind and we treat that with a lot of care. Well, on today's podcast episode we talked a lot about fund dynamics, right? How to think through that, how it impacts the ability for them to bid up, how it impacts deal risk, closing risk. All those things. Definitely some things to consider as you're talking to firms. And unfortunately a lot of this is just based on working with these firms over time. You can't get access to a lot of this information publicly. So a lot of it's just about having a lot of reps with these firms to understand how they work. But Mike, thanks for joining us on the podcast.
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Yeah, thank you.
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VistaPoint Advisors is a founder focused investment bank that advises software and Internet founders through M and A and capital raised transactions. We are a fully unconflicted investment bank who only works for founders on the sell side. So you know that we're always representing your best interests. Security is offered through VistaPoint Advisors member Finra Sipic. This has been provided for informational purposes only. It is not intended to address all circumstances that might arise. Testimonials from past clients may not be representative of the experience of other clients and there is no guarantee of future performance or success. Clients are not compensated for their comments. If you have any questions about the process of selling your business or raising capital, reach out to a member of our team or check out the four Founders section of our site by visiting four Founders Doc Guide.