The Continued Growth of Venture Buyouts – an Updated Perspective
In late 2018, Industry Ventures published a white paper on the evolution of the software buyout landscape and the emergence of a new category of small, tech-focused buyout funds targeting venture-backed technology companies. Among our key assertions was that smaller, verticalized SAAS businesses are particularly well-suited for buyout exits.
In light of this, we anticipated that buyout exits would become more prevalent among a broader array of venture-backed technology companies, with a growing percentage of venture-backed technology companies exiting to small buyouts, based on their growth, profitability, and business model dynamics.
Over the last two years, we have seen these trends play out firsthand, as we launched a new strategy around this thesis and have been deploying capital against this large and growing opportunity set. Given the recent growth that we’ve seen in the small tech buyout landscape and the large number of relevant venture-backed buyout candidates, we wanted to share a few observations that we found particularly relevant, especially in the context of COVID-19’s impact on the venture capital ecosystem.
The Growing Venture Buyout Market
Over the last 20 years, as a firm we have witnessed a steady and material increase in VC-backed companies exiting to buyout, as well as disproportionate growth of VC buyouts relative to buyouts overall. This trend has been especially pronounced in recent years and is one we expect to continue in this dynamic environment.
According to Pitchbook, “VC-to-PE buyouts not only account for a rising percentage of PE deals, but also of VC exits. Between 2000 and 2019, the number of VC-to-PE buyouts has grown at a CAGR of 18.1%, compared to overall buyouts at 9.5%. During that time, PE buyouts went from accounting for 2.4% of VC exits to 19.2%.” 
In our view, we only see this market opportunity to continuing to scale in the years ahead. According to Preqin, there was $94.8B of unrealized value across 2,468 venture funds with vintage years of 2010 or earlier as of Q3 2019 . This trapped value will require a release valve as LPs become less receptive to extensions in less certain economic environments. Through our leading secondary franchise, we have already seen many secondaries change hands in older funds — and in many cases participated in those deals — but those transactions only represent a small portion of this value, and we anticipate that many of the underlying companies will need to seek acquirers in the immediate future. Another trend that we have noticed through our secondary activities has been the disproportionate increase in the sale of companies in tail end funds to buyout relative to buyer exits in the broader venture ecosystem.
Furthermore, there are over 6,000 active venture-backed companies that haven’t raised a round in more than five years and haven’t exited, according to Pitchbook . We anticipate that a large portion of these businesses have achieved profitability based on their operational lives, and many likely represent attractive opportunities for nimble buyout funds.
COVID-19 is Accelerating the Trend Toward Venture Buyouts
Liquidity declined broadly across venture in the first three quarters of 2020, during which time we saw the cumulative value of venture exits fall by 35% as of Q3 2020 relative to Q3 2019. Venture-backed IPO value — the largest source of venture liquidity over the last 10 years — declined proportionately (38%) during this same period. The value of venture buyouts, meanwhile, fell a more modest 28%.
When exit activity was at its lowest during Q2 2020, venture liquidity overall was down 76% by value, while the value of venture buyouts had declined by only 18% . While the IPO market has certainly rebounded dramatically amid a surge in unicorn offerings in Q4 2020, private equity has proven to be a more resilient exit pathway for venture-backed business during the course of the pandemic, largely driven by add-on activity by PE-backed strategics.
We have seen COVID-19-driven trends within venture further enhance the attractiveness of venture-backed software companies for private equity buyers. In particular, many of these businesses have sought to right-size their P&Ls and balance sheets to extend their runways in a less certain funding environment. In a survey of VC funds conducted by Industry Ventures in April, 92% of respondents reported seeing headcount reductions at their portfolio companies, with the majority weighing cuts between 11% and 30%.
According to Keybanc , SAAS companies with more than $5M of ARR are planning on increasing their free cash flow margins by more than 7% relative to 2019, in many cases at the expense of growth. This same cohort of businesses reduced their ARR forecasts by nearly 50% relative to original plans. The survey also found that 35% of headcount-reduction-driven savings initiatives were targeted at sales teams. Not surprisingly, these businesses have seen meaningful slowdowns in new bookings, which, as a percentage of starting ARR, fell from 36% in 2019 to 14% in 2020.
At the same time, churn has remained fairly low across the industry, likely driven by customer demand for efficiency-creating SAAS products to address pandemic-related challenges. The trajectory of smaller SAAS businesses has inherently changed through COVID, with slower growth but improving margins and sticky customer bases.
Naturally, many of the venture-backed businesses that have prioritized cash preservation over growth will fall off the growth curve required to achieve an outsized exit for their venture capital shareholders. Companies will still seek funding to drive expansion, but many are becoming less attractive to VCs looking for hyper-growth businesses. That said, we believe these companies are achieving profitability faster and with better margin profiles, rendering them more attractive to buyout funds.
With venture funding down at the smaller end of the market — dollars invested in sub-$25M VC funding rounds were down 10% in 2020 relative to 2019, contrasted by a 14% increase in dollars invested into $25M+ rounds — and a serendipitously well-positioned small PE buyer landscape, we anticipate that many of the businesses that are now optimizing for profitability, rather than growth, will find homes with smaller buyout funds.
In some cases, select venture-backed businesses are also benefiting from sector-related COVID tailwinds, bolstering their attractiveness to private equity buyers that have begun to lean into certain COVID-winning themes, sectors and verticals. As the pandemic has played out, we have seen a notable increase in interest in certain sectors, including fintech and digital payments, online education, ecommerce, and cybersecurity, among others, where there are perceived to be long-term tailwinds, as illustrated below.
The Buyout Universe Continues to Scale
As buyout funds continue to become more acquisitive within the venture capital ecosystem, more buyers will almost certainly emerge to address this expanding opportunity set. We are already starting to see a growing number of emerging small tech buyout funds as the tech buyout landscape continues to change.
In fact, the amount of capital raised by the “big three” tech buyout funds — Vista Equity, Thoma Bravo, and Silver Lake — as a percentage of total capital raised by tech-focused funds overall, has begun to fall, as the following chart shows. This stems from the fact that generalists are now raising tech-focused funds, the mid-tier of tech specialists is continuing to scale, and the number of smaller buyout funds entering the space continues to grow.
This consistent increase in the incumbent tech buyout investors’ fund sizes has driven many to launch smaller strategies to address the lower end of the market. In some cases, those new strategies have begun to graduate from the lower end of the market themselves as their fund sizes scale. In more recent years, we have seen teams spin out of the larger firms to address the opportunity set within small tech buyout. Below we have compiled some data looking at the fund size progression at larger tech-focused firms, along with some of their lower market-focused strategies, and recent spinouts:
The trends set in motion or accelerated by COVID-19 have further hastened the emergence of new specialist tech funds, whose strategies are attracting more capital in a less certain environment. The tech sector continues to garner significant LP interest, with tech buyout funds accounting for 22.5% of all PE capital closings in 2020, which was significantly higher than the five-year average of 14.1%. Below is a sample of some of these smaller specialist investors who are filling the void at the lower end of the market:
These smaller, more specialized tech-focused funds have been a more dominant force in 2020 than in the past decade. While this trend has been accelerated by a unique and unprecedented set of circumstances, it is nevertheless one we believe will continue well into the future. Looking ahead, we expect the burgeoning cadre of small, specialist tech investors with fresh dry powder at their disposal to drive increased venture buyout activity for many years to come.
Please contact Lindsay Sharma (firstname.lastname@example.org) or Kemper Ahl (email@example.com) with any questions or if you would like to receive a hard-copy of this article.
1. Pitchbook 2019 Annual Report
2. Source: Preqin Data, 2019
3. Pitchbook Data, July 2020
4. Q4 2020 PitchBook NVCA Venture Monitor
5. Keybanc 2020 Private Saas Company Survey, August, 2020
6. Pitchbook: PE Tech Funds II, October 2020