The New Risk Rules for Private Equity.
Private equity firms like ours, Pharos Capital (www.pharosfunds.com) are tasked by our investors with the goal of generating as much return as possible with the least amount of risk. As such, every question that we ask and every decision that we make in the due diligence process tends to revolve around managing the risks that we have identified, or making sure that we will get an attractive return on our investment if our new portfolio company performs well. While this seems obvious on many levels, part of the cause of the `internet bubble' was that one particular exit strategy, the initial public offering, tended to bias return estimates upward for venture and private equity firms because of the extraordinary valuations that public shareholders were willing to pay for companies that were in their development stages. Venture firms saw the opportunity to identify companies early on that might be attractive to the public markets, help shape them and `get them ready,' then take them public, realizing large gains on companies that were still works in progress, while sharing the risks of those developing businesses with public shareholders. In this way, many individual investors and mutual funds became de facto venture capitalists by taking companies into their portfolios that had not yet matured into stable operating businessess. While this could potentially work out for the public shareholders if the investors making those portfolio decisions had been able to buy in to those companies at `start-up' valuations and create enough diversification to allow the few winners to take care of a larger number of losers, the process breaks down if valuations are so high that upside is constrained on your winners and losers have further to fall. Lots of venture firms made a great deal of money in this fashion until the public market shareholders got burned enough times to understand the unusual risks they were bearing. At that point, the ability to exit through an IPO became difficult or impossible for venture backed companies. Of course, the rest is history, as venture returns soured since their portfolio companies needed additional capital and were unable to tap public sources and alternate methods of exit were not able to justify the higher and higher prices paid by VC firms for business plans.
One of the techniques that Pharos uses to manage this type of risk on behalf of our investors is focusing heavily on exit strategy prior to making any commitments. By making sure that we are not reliant entirely on the IPO market to exit our portfolio companies, we are able to create a balanced analysis of returns under various scenarios. For example, we are likely to look at acquisition multiples that have been paid for comparable companies to the ones we are considering. We will look at public company comparables for an IPO valutaion estimate. We will look at future cash flows to see whether the company would be likely to be able to recapitalize itself with debt or to repurchase our shares at predetermined pricing. Once we know the answers to these and many other related questions, we can set about determining how much we can afford to pay for a particular business and still feel like the risk-return is a good one. Only if we have multiple exit strategies, each of which show favorable returns, can we proceed with our investment.
What does this mean in real life? It means that it is quite unusual for us to invest in low-margin or commodity-type businesses. Even if those types of companies are quite stable and profitable, it is difficult to attract high mutliples on exit. Without high margins, returns will have to come from very high growth in sales (which is often quite difficult) or through acquisitions (which will often acquire much more capital). It means that we will be looking for companies that have a proprietary business model and have a competitive edge versus its peers (if it has any). It means we like market leaders, even if the market that they are leading is still developing. It means that we like business that provide enormous value to their customers, as opposed to simply being low cost providers of goods or services.
One example of a company that we have enjoyed working with is Atherotech (www.atherotech.com) . Atherotech's value proposition is fairly simple- it saves lives. Atherotech provides a more complete and more accurate cholesterol test than the standard lipid panel that we have all had done on many occasions. By providing physicians with more information about the types of cholesterol in patients' bloodstreams, people at risk of heart attacks or other coronary diseases are identified earlier and more accurately so they can seek the treatments that they need. In this case we invested relatively early in the development of the advanced cholesterol testing market, but we knew that the potential size of the market for accurate cholesterol testing was quite large. We also knew that the company's patent protection on its technology would allow the company to sustain its margins while still providing a great value to patients and doctors. Lastly we knew that the company could grow to be an IPO candidate, but also that any number of labs or medical equipment manufacturers would be interested in acquiring Atherotech as an entry point into the very large cholesterol testing market. All-in-all, it met our tests, and has proven to be a solid investment.
Technorati Tags:
Private Equity
Venture Capital
Investment
Risk Management
Private equity firms like ours, Pharos Capital (www.pharosfunds.com) are tasked by our investors with the goal of generating as much return as possible with the least amount of risk. As such, every question that we ask and every decision that we make in the due diligence process tends to revolve around managing the risks that we have identified, or making sure that we will get an attractive return on our investment if our new portfolio company performs well. While this seems obvious on many levels, part of the cause of the `internet bubble' was that one particular exit strategy, the initial public offering, tended to bias return estimates upward for venture and private equity firms because of the extraordinary valuations that public shareholders were willing to pay for companies that were in their development stages. Venture firms saw the opportunity to identify companies early on that might be attractive to the public markets, help shape them and `get them ready,' then take them public, realizing large gains on companies that were still works in progress, while sharing the risks of those developing businesses with public shareholders. In this way, many individual investors and mutual funds became de facto venture capitalists by taking companies into their portfolios that had not yet matured into stable operating businessess. While this could potentially work out for the public shareholders if the investors making those portfolio decisions had been able to buy in to those companies at `start-up' valuations and create enough diversification to allow the few winners to take care of a larger number of losers, the process breaks down if valuations are so high that upside is constrained on your winners and losers have further to fall. Lots of venture firms made a great deal of money in this fashion until the public market shareholders got burned enough times to understand the unusual risks they were bearing. At that point, the ability to exit through an IPO became difficult or impossible for venture backed companies. Of course, the rest is history, as venture returns soured since their portfolio companies needed additional capital and were unable to tap public sources and alternate methods of exit were not able to justify the higher and higher prices paid by VC firms for business plans.
One of the techniques that Pharos uses to manage this type of risk on behalf of our investors is focusing heavily on exit strategy prior to making any commitments. By making sure that we are not reliant entirely on the IPO market to exit our portfolio companies, we are able to create a balanced analysis of returns under various scenarios. For example, we are likely to look at acquisition multiples that have been paid for comparable companies to the ones we are considering. We will look at public company comparables for an IPO valutaion estimate. We will look at future cash flows to see whether the company would be likely to be able to recapitalize itself with debt or to repurchase our shares at predetermined pricing. Once we know the answers to these and many other related questions, we can set about determining how much we can afford to pay for a particular business and still feel like the risk-return is a good one. Only if we have multiple exit strategies, each of which show favorable returns, can we proceed with our investment.
What does this mean in real life? It means that it is quite unusual for us to invest in low-margin or commodity-type businesses. Even if those types of companies are quite stable and profitable, it is difficult to attract high mutliples on exit. Without high margins, returns will have to come from very high growth in sales (which is often quite difficult) or through acquisitions (which will often acquire much more capital). It means that we will be looking for companies that have a proprietary business model and have a competitive edge versus its peers (if it has any). It means we like market leaders, even if the market that they are leading is still developing. It means that we like business that provide enormous value to their customers, as opposed to simply being low cost providers of goods or services.
One example of a company that we have enjoyed working with is Atherotech (www.atherotech.com) . Atherotech's value proposition is fairly simple- it saves lives. Atherotech provides a more complete and more accurate cholesterol test than the standard lipid panel that we have all had done on many occasions. By providing physicians with more information about the types of cholesterol in patients' bloodstreams, people at risk of heart attacks or other coronary diseases are identified earlier and more accurately so they can seek the treatments that they need. In this case we invested relatively early in the development of the advanced cholesterol testing market, but we knew that the potential size of the market for accurate cholesterol testing was quite large. We also knew that the company's patent protection on its technology would allow the company to sustain its margins while still providing a great value to patients and doctors. Lastly we knew that the company could grow to be an IPO candidate, but also that any number of labs or medical equipment manufacturers would be interested in acquiring Atherotech as an entry point into the very large cholesterol testing market. All-in-all, it met our tests, and has proven to be a solid investment.
Technorati Tags:
Private Equity
Venture Capital
Investment
Risk Management
posted by Bob Crants | 3:02 PM
|
0 comments
