Private equity firms are diversifying their investment strategies

The venture capital market has seen a long-term expansion in the number and types of investors seeking minority (non-controlling) investments. Increased competition for investment opportunities and a greater diversity of competitors in these markets has created new opportunities for growing companies across a broad range of industry sectors, but also new challenges for investors.

Private equity firms are diversifying their investment strategies

Financial investors, especially private equity firms, regularly turn to debt to expand their influence and boost returns on capital. But with high interest rates showing little sign of abating anytime soon, the cost of this debt makes debt-financed acquisitions less attractive. Moreover, an uncertain market outlook has these companies seeking additional protection against downside risk.

As a result, private equity firms are partnering with co-investors more frequently and asking sellers to take more equity in target companies. Firms that traditionally targeted buyout options are doing more majority recapitalization transactions rather than relying on earn-outs to close valuation gaps, and majority recapitalization firms are starting to focus more on minority investments. The shift toward minority investments allows private equity firms to further diversify their investments and mitigate the potentially large downside scenarios of majority recapitalizations.

The shift towards minority investments allows private equity firms to further diversify their investments and mitigate potential large downside scenarios by reallocating capital to majority shareholders.

This also means that much larger private equity firms are exploring opportunities in the more traditional “middle market” space, thereby pushing middle market firms downstream into earlier stage target opportunities.This shift has led to new players entering and taking notice of the venture capital market.

Strategist on the Ground

At the same time, large industrial companies (often referred to as strategic investors) continue to increase their use of minority investments as a “third pillar” of their innovation strategies, alongside traditional mergers and acquisitions and R&D.

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

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

This pressure from strategic investors means that issuers and financial investors alike may have to address a broader set of competing development and commercial objectives in each fundraising round.

Investor Protection

Successfully investing in this market often requires a higher level of care and strategic alignment than in the past. To be successful in minority investing, investors (both financial and strategic) must:

• Determine the business goals of your target and other investors. It is important to understand the relationship between the target company (including the board or management team) and the existing investor group (including the founders) and what each party’s primary drivers and measures of success are. Often these various stakeholders have different (and sometimes competing) priorities. Investors should review any preferential commercial or intellectual property rights granted to co-investors and specifically understand how the investment proceeds will be used. Some investors will seek full or partial liquidity, while others value dilution (including economic power and voting rights).
• Rely on attention, not compensation: It is rare for target companies to provide compensation to minority shareholders. While it is important to negotiate minority rights, it is also important to conduct pre-investment due diligence to determine whether there are any issues that may pose undue risk to the investment. Given the small size of the investment and limited budget, companies and firms may choose to “stage” due diligence by conducting financial and accounting due diligence before technical and legal due diligence. While certain aspects of due diligence may be more streamlined than in majority shareholder recapitalizations, due diligence is still crucial in minority shareholder transactions.
• Use business objectives to drive your investment documents. Traditional mechanisms for protecting investments, such as tag-along (or co-selling) rights and first refusal (or subscription) rights, may not be sufficient depending on the determined business objectives and investor group. The “market” in the “bundle of rights” may be different depending on whether the investor is a financial or strategic investor. For example, a strategic investor should consider seeking first refusal on a sale of a business or a co-development agreement if the investment is the first step towards an acquisition. Also, market trends may make the target company perceive a greater risk in raising funds from a strategic investor if there is a concern that the relationship between the growth company and the strategic investor may make other commercial customers in that market wary of the relationship.
• Manage risk strategically. Consider whether your investment objectives require you to phase or time your investment so that benefits are realized only while performance criteria are met. If commercial agreements are necessary to achieve these objectives, carefully consider any cross-default clauses in your agreements with the target company and design appropriate mechanisms for winding up the commercial agreements. This may also provide the strategic investor with an “off-ramp” to its equity investment. Defaults under the commercial agreements may trigger put or redemption rights under the purchase agreement.
• Consider your target legal structure and its implications and benefits. The type of existing investor and the type of existing investment will affect the investment structure, approval requirements and required documentation. It is important to investigate whether special tax situations such as qualified small business stock or S corporations will affect the investment structure and significantly increase transaction costs or dilute issuer interest altogether.
• Traditional minority protections remain important. Investors, working with their legal counsel, should consider incorporating the following minority shareholder protections into their investment documents:
  • Right of first refusal/right of purchase to shares issued in future funding rounds;
  • Preferential Purchase RightsRegarding transfer of shares by co-investors and founders;
  • Co-Sales RightsRegarding the sale of shares by co-investors and founders;
  • Confer a right or redemptionThey allow investors to sell their shares to the target company upon the occurrence of certain events, such as the divestiture of a business unit or a material breach of a contract, or upon the expiration of a certain period of time (such as five to seven years from the original purchase date), but exercising these specified rights is not without risks.
  • Right to InformationRegarding the financial performance of the target company
  • Observer rights and/or seats on the board of directors;
  • Right to consent Having the power (as preferred shareholders and/or directors) over certain major company actions, such as incurring debt, changing the company’s business, issuing shares, amending the articles of incorporation and approving the sale of the company.
  • Blocking competitors’ rights to future pay increasesThis is to prevent future investment 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 weather high interest rates and market volatility, the importance of thorough due diligence and strategic consistency cannot be overemphasized. Adopting innovative strategies such as minority investments and increased collaboration will position investors to capitalize on emerging technologies and growth opportunities. Ultimately, those who skillfully adapt to changing market conditions will not only mitigate risks but also grow their portfolios significantly.