By Alex Webb
Private equity has often found it tough to invest its $1.3 trillion of committed capital in technology companies.
For all of their desire to get into the game, tech’s bubbly valuations meant private equity investors often couldn’t justify writing big checks, and some of the hottest startups’ lack of profitability made it hard to raise the debt on which the industry depends to fund its deal-making.
The pandemic-induced downturn may herald a change to that equation. On Monday, Airbnb announced it had raised $1 billion in debt and equity securities from Silver Lake, the tech buyout giant, and Sixth Street Partners. It granted the investors warrants that can be converted into shares, valuing the San Francisco-based company at $18 billion, a drop of almost half since it last raised funds in 2017, the Wall Street Journal reported.
Airbnb also agreed to pay the new investors an interest rate of more than 10%. Such generous terms would be unimaginable under normal conditions: The tech bros are getting desperate.
It won’t be the last such move. As equity markets tumble, private market valuations are also falling. And as companies need cash to see themselves through the crisis, ready access to capital is also drying up. That’s creating windows for private equity funds to invest under more favorable conditions.
To make the most of the situation, they’ll need to get creative. Leveraged buyouts are private equity’s staple, but with the cost of debt soaring, such deals are becoming harder to fund. What’s more, many firms need to prioritize reinforcing the balance sheets of existing investments to ensure they can weather the storm, shoring up their operations and ensuring employees are safe.
All that means that while buyouts are being put on the back burner, opportunistic funding of companies — especially those whose underlying businesses are strong but which have been hit disproportionately by the impact of the virus — through debt or equity is on the rise, according to Nikos Stathopoulos, a partner responsible for tech investment at BC Partners in London.
The Airbnb example is instructive. Silver Lake, which has been behind buyouts of Dell Technologies and NXP Semiconductors in the past, and Sixth Street are this time relying on debt and equity instruments to get regular returns and a minority stake.
While venture capitalists might gamble on getting a 10-fold return on their initial investment, a buyout company looks perhaps to double its initial outlay when it exits an investment.
The difference is the risk: a VC firm is likely to see no return at all on many of its bets, while PE wagers on what it thinks are sure things. Between the two is a category known as growth equity: the returns are lower than VC and higher than PE, but the risk is higher than the latter too. Private equity has been creeping steadily into the growth market, a trend that will accelerate as long as funds’ terms permit it.
Insight Partners announced a new $9.5 billion growth equity fund last week, its biggest ever, adding to $160 billion of growth funds raised globally over the previous two years.
This isn’t to say buyouts are impossible: On Tuesday, Nordic buyout firm EQT AB agreed a deal in principle to acquire Air Liquide’s cleaning products business for some 900 million euros ($980 million) including debt. Rather than relying on banks to underwrite loans and distribute them to new investors, they might instead turn to private credit funds and commercial lenders. It’s a more expensive option, but that extra cost can be offset by the lower deal valuations.
Should private equity gain a bigger foothold in tech, then it will accelerate an overdue trend: A focus on the importance of cash generation. The stumbles of WeWork, Uber and others had already brought profitability under scrutiny.
In order to secure capital in today’s environment, companies will need to demonstrate the ability to generate cash once conditions return to normal. Those businesses with reliable cash flows already — and in the enterprise software industry there are plenty — may be less vulnerable anyway.
For sure, the number of new private equity deals is likely to slow. But there will be some openings that firms won’t pass up.