In Tech Sector, LBO Does VC and VC Does LBO –

Every year, hundreds of buyout firms scour increasingly broader ground in search of deals. And every year, venture capital firms bring hundreds of companies to the exit threshold, looking to pocket a profit on their investment. But when the two parties meet, the revulsion is mutual.

Because of entrenched cultural and strategic differences, such as appetite for risk and the desire to lever, venture firms don’t want to sell their companies to buyout firms, and buyout firms don’t want to buy venture-backed companies.

Some market observers, however, think the worlds of venture capital and buyouts increasingly will converge as buyout firms become more interested in the tech sector-a space heavily dominated by venture capital firms. The convergence will be pushed further as venture firms, eager to apply their technical know-how to different markets, begin to reach up into the maturing niche of tech-sector buyouts.

If there is to be success in trolling for deals among venture fund portfolios, private equity professionals say it will happen in situations where buyout firms act like strategic buyers. And, in cases where technology companies resemble steady-eddie widget makers, market players say the buyout opportunities are being pounced on by tech-savvy private equity professionals, many of them from venture capital firms.

“The kinds of businesses venture capitalists want are by definition not good for buyout firms,” says Paul Cleveland, a managing director of mergers and acquisitions at Hambrecht & Quist L.L.C. In the venture world “the idea of multiples of EBIT is an absurd concept, because these companies don’t have EBIT.”

Indeed, the standard leveraged buyout is almost impossible if the acquired company lacks a predictable cash flow. Most importantly, say general partners, no bank will lend to a company that doesn’t show earnings. For this reason, buyout firms have tended to shy away from newer, high-growth industries, including high technology, which tend to have unpredictable if not nonexistent cash flow and often require an all-equity investment. But as buyout firms have grown accustomed to investing beyond the traditional LBO parameters, the concept of structuring deals without debt has become less of a stretch.

For their part, venture capitalists and the companies they back would sooner eat crow than sell to a buyout firm. Even when an IPO is not feasible for a young company, large strategic buyers can pay much more to acquire a venture-backed company than a buyout firm is willing to, say industry observers. “The valuations in the public market and among strategic markets are more attractive,” says John Michaelson, president of Needham & Co., which operates a later-stage venture capital fund.

Snagging a clean tech company can be expensive. “In the tech markets, you pay a huge premium for purity,” says one partner at a buyout firm, who asked not to be named.

A Buyout Shop Crosses Over

The sale of a venture-backed company to a buyout firm is rare indeed. Most industry players, when pressed, could not name a single deal of this nature. John Zappettini, a managing partner at Plantagenet Capital Management LLC hadn’t heard of one either until his firm bought a controlling interest in BigOnline (formerly BigBook Direct) in November (BUYOUTS Dec. 21, 1998, p. 8). BigOnline is a company that develops Web sites for small businesses, and by the time it was picked up by Plantagenet it had worked its way through numerous venture rounds from the likes of Hambrecht & Quist, Brinson Partners, Altos Ventures and New Enterprise Associates.

When investing in the BigOnline deal, however, Plantagenet had to act more like a later-stage venture capital firm than a buyout firm, Mr. Zappettini says. The transaction did not employ leverage, and the company is not one that most buyout professionals would warm to. BigOnline was a troubled company whose original business plan-to provide a business directory on the was swamped by the competition. Plantagenet funded a convertible debenture of less than $5 million, with the stipulation that the firm would gain control of the company for the interim of the financing arrangement. Some of the remaining venture partners committed to the debenture as well.

According to Mr. Zappettini, Plantagenet, based in San Francisco, was formed specifically with the goal of turning around companies like BigOnline. “It was always our intention to look at busted high-tech ventures,” he says. “BigOnline had a good business plan, but it was not well executed from the inside.”

A venture firm, may be able to warn a buyout firm that the technology of a company it is targeting may become obsolete.

Plantagenet had the remaining venture capital investors select one person to sit on BigOnline’s restructured board of directors. In February, BigOnline acquired Salt Lake City-based World Connection, an online shopping company, for an undisclosed amount, using the capital from the Plantagenet debenture. World Connection had no venture backers. Plantagenet plans on acquiring another Web site company in the next week, also with no venture backers.

BigOnline’s future is still uncertain, Mr. Zappettini says, although he is confident that his firm may be able to take the company public in the near future or sell to a strategic buyer.

Mr. Zappettini says he gets calls and books from countless troubled venture-backed companies in search of liquidity. Typically, they can’t do an IPO, strategic buyers won’t touch them, and their venture capital investors are wary of going another round. “It’s amazing what comes across my desk,” Mr. Zappettini says. “Companies that have been through two or three rounds of VC money, and then they’ve just run out of light. By the time these tech deals get to us, there’s some external factor that just won’t make them work.”

Mr. Zappettini says he turns down almost all these venture-backed deals and may have had enough of this overall strategy. “I’m on the edge of the fence of whether I want to continue with this,” he says.

At least one other buyout firm is looking for deals in VC land. Bruce Rauner, a managing partner at GTCR Golder Rauner, dismisses the notion that his firm can’t compete with strategic buyers for tech companies. “We are a strategic buyer,” he says, referring to his firm’s strategy of backing management teams who build companies. GTCR is currently backing AppNet Systems Inc., an information technology platform that is making acquisitions of Web site development companies (BUYOUTS Aug. 17, 1998, p. 9). A majority of the smaller Web-development companies AppNet is targeting have venture money.

Again, however, GTCR’s backing of AppNet was structured solely with $100 million in equity, a transaction that most buyout firms would regard as anathema to their strategy.

LBO Interest Causes VC Wariness

Even if the price is right, some buyout professionals may experience resistance from venture-backed companies for other reasons. Walter Kortschak, a general partner at Summit Partners, cautions that managers in companies that are venture-backed are suspicious of buyout firms because of their reputation for removing original management. “If you’re a CEO of a fast-charging company, buyout firms are not your top choice,” he says. “If you go public, at least you’re still independent and can execute your own strategy.”

Summit, which does both venture capital and buyout transactions, does not have any companies in its buyout portfolios that were acquired from venture capital syndicates, though Mr. Kortschak says his firm has considered a few. He says for such a transaction to take place, the company in question would need to have technology that was “a little long in the tooth”-not fast-growth-and of limited importance to a strategic buyer.

Still, Mr. Kortschak says he thinks lenders are growing more comfortable with high-growth tech companies, and that this comfort will eventually translate into venture capital firms viewing buyouts as appropriate exit strategies at some point in the future.

Other private equity players agree. Paul Rossetti, a managing director at American Securities Capital Partners, says he thinks the strategies of both venture capital and buyout groups are evolving. “More and more buyout guys are using a non-leveraged approach,” he says. “They realize that they can get their return from growth.”

This realization, Mr. Rossetti says, will lead buyout firms to do deals with venture capital firms that are sponsoring low- or mid-tech companies that do not have any obvious strategic buyers. Mr. Rossetti adds that if the public markets should become a more hostile environment for tech IPOs, as they have been for the health-care industry in recent months, buyout groups will experience an increase in popularity among venture capital firms.

Tech Gets Seductively Boring

As the tech industry matures, sectors that investors once viewed as risky and high-flying, such as software and consumer electronics, are beginning to resemble other established industries, where the earnings are predictable and the growth not so explosive. Boring, a venture capitalist might say. But to a buyout professional? Alluring.

While buyout firms mostly pass on companies that are still wearing their venture diapers, some G.P.s see opportunities for buyouts among more mature tech companies which have technology that is no longer sexy. But even in these, mostly low-tech, areas, traditional buyout firms face competition from other financial buyers who have backgrounds in technology-namely, investment bankers and venture capitalists who are starting to look for buyout opportunities.

The foray of venture capital firms into the buyout market has been slow but significant. Dick Smith, an investment banker with NationsBanc Montgomery Securities, says most of the tech company recapitalizations he sees are by venture capital firms pushing upward in their acquisition strategies, not by buyout firms dipping down.

The trend is not hard to identify-venture firm Kleiner Perkins Caulfield & Byers is teaming with The Blackstone Group to do buyouts in the tech sector (BUYOUTS Feb. 8, p. 1). Firms like Wind Point Partners, Sprout Group and Summit Partners started out as venture capital firms but now do buyouts and recapitalizations. For example, in October Needham and Sprout Group made a leveraged acquisition of Viewlogic, a software developer, from parent company Synopsys for $73 million. The transaction bore the marks of a classic buyout-Viewlogic had stable cash flow but not much growth potential.

“If you’re a CEO of a fast-charging company, buyout firms are not your top choice. If you go public, at least you’re still independent and can execute your own strategy.”

Steven Brooks, a partner at Broadview Associates, a new buyout firm managed by former technology sector investment bankers (BUYOUTS Feb. 22, p. 12), says he doesn’t see too many opportunities among venture-backed companies. Instead, his firm is focusing on divisions of public companies that want to do a recapitalization. Recaps, Mr. Brooks says, give the seller more liquidity than an IPO, but give the management an attractive equity piece not afforded by a straight merger. This strategy, combined with the ability to assess risk in technology companies, is how buyout firms will realize opportunities in the technology space, he says.

Some industry observers feel that investment bankers or venture capitalists with backgrounds in technology are better at identifying and seizing good deals in the tech sectors than are buyout firms with experience in more traditional industries.

“The chance that [a firm like Kohlberg Kravis Roberts & Co.] will feel good about understanding something like enterprise software is much less than the chance that a venture capital firm will feel good about doing a buyout in that industry,” Hambrecht & Quist’s Mr. Cleveland says.

In an effort to address the growing opportunities in tech sector buyouts, some traditional buyout firms have taken steps toward becoming more knowledgeable about the space, including using the resources of venture capital firms. In 1994, Texas Pacific Group hired David Stanton, a former venture capitalist at Trinity Ventures, to head the firm’s technology initiative. Since then, TPG has made a number of leveraged buyouts of technology companies. In early 1996, it acquired GP Com, a telecommunications divestiture. In August of that same year, TPG bought Paradyne, a network equipment manufacturer, and GlobeSpan, a maker of semiconductors. In February 1998, TPG took Zilog, a foundering chip maker, off the public market. Most recently, the firm last year acquired Swiss pay phone supplier Landis & Gyr Communications.

For the GlobeSpan deal, TPG used 100% equity, but a source familiar with the deal says the firm plans to take the company public soon and could realize as much as a 20-times return on its original investment. All the other tech deals were leveraged, but never more than 66%, a source said.

First Case of LBO/VC Partnering?

Of great interest to buyout professionals seeking to enter the tech world, and to venture capitalists looking to do buyouts, may be TPG’s partnering with venture capital firms on each of its tech deals. Partners from Sprout Group advised TPG on its investments in GlobeSpan and Paradyne and invested alongside the firm in minority positions. Mayfield Fund, a Menlo Park, Calif., venture capital firm, advised TPG on its acquisition of Zilog.

Although Zilog reportedly ran into trouble early in TPG’s ownership of the company, owing to a sales slump in Asia and a general malaise in the semiconductor industry, a spokesperson for TPG now says that Zilog’s turnaround is complete, but that the company’s return to profitability would not have been possible without the technical expertise of the management team and of TPG’s technical advisers.

Mr. Stanton says one valuable aspect of partnering with venture professionals is that they can better assess the technological risk of a company because of their proximity to the front lines of tech innovation. A venture firm, he says, may be able to warn a buyout firm that the technology of a company it is targeting may become obsolete, a prospect that no doubt leaves many G.P.s longing for the staid comfort of widgets.