As private equity targets emerging companies, PE investors are expanding VC deal terms and dynamics.
By Mike Turner, Shing Lo, Tom Evans, Robbie McLaren, Farah O’Brien, David Walker, Jon Fox, Katie Peek, and Catherine Campbell
Emerging companies have historically been backed by venture capital funds, but as Europe’s startup scene matures, involvement by more traditional private equity investors is growing, particularly in the tech, consumer, and digital health sectors. The number of PE investments in emerging companies has increased year on year, with investments in companies such as Wolt, Moonbug Entertainment, Zwift, Klarna, Epic Games, and Oatly demonstrating the range of opportunities available to PE sponsors in this space. While PE investors are increasingly familiar with VC deal dynamics, they are also pushing to align growth-deal terms more closely with traditional buyout concepts.
Investors typically invest in a growth company as a minority investor at the top of a stack of existing institutional investors, meaning they are unable to exert the level of control usually seen in buyout deals. One board seat and a limited set of reserved matters are likely to be the limits of their influence. Alignment with fellow investors is therefore an important dynamic, and something that we are seeing deal teams consider at the outset of the transaction.
Investors also need to potentially get comfortable with founder management holding the balance of power and influence. Unlike a traditional buyout, where the sponsor has control, founders will not want, or expect, to relinquish control to financial investors. In most cases, one or two founders will be responsible for all of the key decisions, subject to a set of reserved matters.
A lack of control over exit is another concern. PE investors are used to being able to control an exit through majority voting (at both shareholder and board level), and ultimately through drag rights and unilateral IPO trigger rights. Minority investors in emerging companies, on the other hand, will typically need the support of other investors to exercise a drag and typically lack an IPO trigger. Recent deals have shown that founders frequently control the exit, with minority investors granted at most a blocking right if anticipated returns fall below a certain threshold.
Meeting in the Middle
As PE investors seek growth equity investments, we are now seeing increased convergence between typical PE buyout and emerging company deal terms. While venture capital investors typically expect a non-participating liquidation preference (i.e. the option to have their money back in priority to the ordinary share return, or to participate pro rata in the ordinary share return), PE sponsors are going one step further to protect themselves in a downside scenario by requesting a participating preference (i.e. their money back in priority, as well as pro rata participation in the ordinary share return) or coupon accruing on the preference return. PE sponsors are also exploring a right to have their shares redeemed if an exit has not occurred by a certain date, to provide the exit certainty that they are lacking in the VC construct.
There is also a push to introduce more robust governance rights and structures. For example, PE investors have sought the right to remove founders from the board if their conduct brings the company into disrepute. In light of recent high-profile controversies, sponsors are keen to mitigate reputational risks associated with bad founder behavior, though this type of protection continues to be hard-fought.
PE sponsors require more robust compliance to fulfil their internal requirements and prepare the business for an IPO. Though founders can be reticent to spend the time and cost, ultimately they often welcome the assistance of a PE sponsor in this regard.
Our view is that venture and more traditional PE industry terms will continue to converge, but PE sponsors will still need to be very sensitive to the expectations of founders when investing in growth targets.
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