Over at the Union Square Ventures blog, Fred Wilson discusses the failure rates expected in venture capital. He suggests a third of all deals are hit out of the park, a third are mediocre, and the last third fail (although his own firm’s empirical data suggests more of a 40/40/20 split). He also suggests that the overall cash return on such a portfolio may be 3-4x, which is pretty good if you can get it.
Private equity is quite different; we expect all deals to do well. Not out-of-the-park, but well enough to hit target returns (at least 20% IRR or 2x cash). Private equiteers generally believe this low-risk moderate-return approach is more successful than the high-risk high-return approach favoured by venture capitalists.
Now, although this difference in investment strategy may seem subtle, it actually means private equity and venture capital are miles apart in execution. Without decent growth, venture capital is toast. However, even with very low-growth, private equity can still bear fruit. How? Leverage, deal structure and multiple arbitrage.
This isn’t to suggest PE and VC are in any way substitutable. But, like all investments, we can analyse and consider the implications of each strategy.
One of the major implications, especially in mid-market private equity, is that we don’t mind skipping over high-growth businesses. We know there’s less competition for lower-growth businesses and that less competition means lower purchase multiples. And, with an eye firmly on moderate target returns with very low-risk, we know paying a lower multiple is a great risk mitigator.
We also know that stable revenues are more conducive to leverage, and leverage amplifies our returns. While leverage also amplifies our risk, we know particular deal structures can transfer some of that risk to other investors in exchange for a taper on our returns above a specified target. This is okay for us, because remember, we are more concerned about mitigating risks than overshooting our target by orders of magnitude.
So, as you can see, lower-growth (aka boring) businesses can actually serve our cause more effectively. You may see larger private equity funds going crazy with mid-20s purchase multiples in public markets, but down here at the mid-market level, we have choice. We can invest in the most boring businesses you’ve ever seen, conservatively apply debt, structure the deal well, simplify and organise management, exit when the time is right at a higher multiple, and achieve our objectives, even without significant increases in revenue. In private equity, we love boring.