Private Equity Firms are Diversifying their Investment Strategies

The venture capital markets are experiencing a prolonged expansion in both the number and type of investors willing to make minority (non-controlling) investments. This heightened competition for investment opportunities and the increasing diversity of competitors in these markets is providing new opportunities for growth companies across a wide range of industry sectors, but also presents new challenges for investors.

Private Equity Firms are Diversifying their Investment Strategies

Financial investors, particularly private equity firms, regularly rely on debt to extend their reach and enhance their return on capital. However, with high interest rates showing little sign of receding soon, the cost of this debt has made debt-financed acquisitions less attractive. In addition, the uncertain market outlook has caused these firms to seek greater protection from downside risk.

As a result, private equity firms are more frequently partnering with co-investors and asking sellers to retain more equity in the target company. Firms that have traditionally targeted buy-out options are engaging in more majority recapitalization transactions instead of relying on earnouts to bridge any valuation gap, and majority recapitalization firms are expanding their focus on minority investments. The move into minority investments allows private equity firms to further diversify their investments and mitigate potentially larger downside scenarios with majority recapitalizations.

The move into minority investments allows private equity firms to further diversify their investments and mitigate potentially larger downside scenarios with majority recapitalizations.

This also means that much larger private equity firms are seeking opportunities in the more traditional “middle market” space and, thus, pushing middle market firms downstream into more early-stage target opportunities. This shift has brought new players into and focus on the venture capital market.

Strategics On the Scene

At the same time, large operating companies (often known as strategic investors) are continuing to increase their use of minority investments as the “third pillar” of their innovation strategy, alongside traditional mergers and acquisitions and research and development.

Strategic investors often use minority investments to gain early access to breakthrough technologies, enhance innovation collaboration, optimize centers of excellence within the target, and obtain preferential commercial rights, all while the target company continues to operate and innovate independently. Larger strategic investors also may have access to surplus cash on the balance sheet to fund minority investments without having to leverage with debt.

Strategic investors often use minority investments to gain early access to breakthrough technologies, enhance innovation collaboration, optimize centers of excellence within the target, and obtain preferential commercial rights, all while the target company continues to operate and innovate independently.

This push from strategics means that issuers and financial investors alike may need to navigate a broader set of competing development and commercial objectives during each financing round.

Investor Protections

Successfully investing in this market often requires a greater level of diligence and strategic alignment than in the past. To achieve success in minority investments, investors (both financial and strategic) should:

• Determine business objectives of the target and other investors: It is important to understand the relationship between the target company (including its board of director or managers) and its existing investor group (including founders), and what the key drivers and measures of success of each party will be. Often, these various stakeholders will have different—and sometimes competing—priorities. Investors should review any preferential commercial or intellectual property rights granted to co-investors and understand specifically how investment proceeds will be used. Some investors may be looking for full or partial liquidity, while others may be more concerned with dilution (including economic and voting power).
   
• Rely on diligence rather than indemnification: It is uncommon for target companies to provide indemnification to minority investors. While it is important to negotiate certain minority investor rights, it is also important to perform pre-investment diligence to determine whether there may be issues that may create too much risk for the investment. Given the smaller size of the investments and limited budgets, firms and companies may choose to “stage” diligence by performing financial and accounting diligence ahead of technical and legal diligence. While certain aspects of diligence may be more streamlined than in majority recapitalizations, diligence remains extremely important in minority transactions.
   
• Use the business objectives to drive investment documents: Traditional mechanisms of protecting an investment, such as tag along (or co-sale) rights and preemptive (or subscription) rights, may not be sufficient depending on the determined business objectives and investor groups. Depending on whether the investor is a financial investor or a strategic investor, the “bundle of rights” may vary as to what is “market”. For example, strategic investors should consider asking for rights of first refusal on sale of the business or joint development agreements when an investment is an initial step towards an acquisition. Target companies may also see greater risk in taking funding from strategic investors because of marketplace dynamics if there is concern that a growth company’s relationship with a strategic investor might cause other commercial customers in their market to become wary of that relationship.
   
• Strategically manage risks. Consider whether the investment objectives require that the investment should be staged or timed so that any benefits are only earned as long as performance standards are met. Where commercial agreements are necessary to achieve these objectives, carefully review any cross-default provisions in agreements with the target company and design appropriate mechanisms to unwind any commercial agreements. This may also provide strategic investors an “off ramp” in their equity investment, where a default under the commercial agreement may trigger a put or redemption right under the purchase agreement.
   
• Consider the target’s legal structure and its implications and advantages. The types of existing investors, and the types of existing investments will impact investment structure, approval requirements, and required documentation. It is important to investigate whether special tax situations, such as qualified small business stock and/or S corporations, will impact the investment structure, significantly increase transaction costs or even dampen the issuer’s interest altogether.
   
• Traditional minority protections remain important: Investors should work with their counsel to consider incorporating the following minority protections into their investment documents.
  • Preemptive/subscription rights to stock issued in future financing rounds;
  • Rights of first refusal, on transfers of stock by co-investors and founders;
  • Co-sale rights, on sales of stock by co-investors and founders;
  • Put rights or redemption rights, allowing the investor to sell their stock to the target company if certain events occur, such as sale of a business unit or breach of material agreements, or upon the expiration of a period of time (such as five to seven years from the original date of purchase), though the exercise of these particular rights are not without risk;
  • Information rights, regarding the target’s financial performance;
  • Board observer rights and/or board seat;
  • Consent rights (both as a preferred stockholder and/or as a board member) over particular major actions of the company, such as incurring debt, changing the nature of the company’s business, issuing stock, amending the governing documents, or approving a sale of the company; and
  • Competitor block rights on future raises, to prevent future investments from competitors.

In conclusion, the dynamic landscape of the venture capital market is ushering in a new era of investment opportunities and challenges. As private equity firms and strategic investors diversify their approaches to navigate high interest rates and market volatility, the importance of meticulous due diligence and strategic coherence cannot be overstated. By embracing innovative strategies, such as minority investments and increased collaboration, investors can position themselves to capitalize on emerging technologies and growth opportunities. Ultimately, those who adeptly adapt to the evolving market conditions will not only mitigate risks but also drive substantial growth in their portfolios.