Private Equity & Venture Capital: navigate smarter amidst Covid19 and state programs
Putting basics into ‘the new context’
Introduction
Most of the analysts now probably expect a pipe shape rebound with lasting realignment and adjustment in areas from the long list: more flexible business models, supply chain diversification, digitalization, cybersecurity just to name a few. How has the Covid19 shadowed the short-term outlook and how did affect the fundamentals of PE & VC? What was being reinforced, and what has been changed so far?
Covid19 led to increased risks and risk awareness, red flags, lengthened deal processes with scenarios rewritten. But also to the rise of E-commerce in general and more attractive entry pricing. In Hungary, the start-up ecosystem was boosted by state programs in recent years. While institutional development is unquestioned, capital abundance coupled with limited management capacity on the investors’ side may lead to weakening efficiency of the state programs in Covid19 times.
Antavo, Newstream, ChatBoss Team, Neumann Diagnostics, Epam, AImotive, Codecool, Vatera, Aerinx, Plantcraft, Logiscool, Starschema, Tresorit…..You are definitely familiar with some of these successful names boosted by private equity venture capital investments in Hungary. Executives of leading Hungarian Private Equity and Venture Capital firms with long track record László Czirják iEurope; Levente Zsembery, xVentures, András Dunai, Lead Ventures, Zoltán Tóth, Euroventures shared their insightful thoughts on the Hungarian situation on HVCA’s recent online event moderated by Lénárd Horgos, Absolvo. Some of their views are valid outside Hungary. Funny enough and will be referred to it later, there was no representative in the audience from the domestic large corporate sector.
The above-mentioned panelists represent typical PE and venture capital firms investing private funds mainly in Hungary and in the CEE-SEE region. The lower investment threshold is EUR 0.5–1.0 million and the upper is typically 5 million, in specific cases can go up to 7–8 million per company. There is no industry preference as such, companies invested are from seed pre-seed, early MVP stage to scale-ups, and growth stages. Preferred areas typically IoT, mobility, customer loyalty, cybersecurity, biotech, life sciences, medical device, advanced energy, insurtech, software, AI, and perhaps more B2B than B2C.
The team is the most crucial, but not the only one for PE/VC investors to consider an investment
Team. The founder and management team is the most important to take into account when a decision should be made about an investment. One founder, though with experience, is not enough. In many cases, there is technical knowledge but that is not enough, too. The VCs usually feel that teams are incomplete. There are either technology or business overweight teams. As a minimum, a company needs a technical expert and a businessman. However, there should not be too many founders, 3–4 maximum. The PE/VC investors are looking for the drive in the team, their hunger for success, and beyond their expertise how they put their full commitment into the venture.
Product and market fit. Beyond the team, the other element of utmost importance is the existing and revenue-generating capable product and the market knowledge, especially for early-stage investments. Market knowledge should be based on regular meetings with players, market research, surveys. This is one of the most important mistakes even to date that the founders commit. Related to that, many times the founders think that the VC does not value their professional experience. While this is not the case, VCs cannot base any decision on the founders' view or opinion on something alone, and they do not necessarily know the market either. The product should be confirmed by the clients, not the opinion of the founders or VCs which matters.
Human factors#1: Sense of reality. It doesn’t apply to the idea or the high-level business vision, rather much more specific, more operational issues instead to have a feeling whether their judgment is realistic. For example: what does the company assume about its customers, how the sales cycle looks like, what are the entry barriers? What kind of labor they need, how can they hire? It is important for an investor to assess the entrepreneurs’ sense of this kind of reality.
Human factors#2:Their human goals. What are the life goals of the founding team? Where will they see themselves in 10–15 years? They have to exit and should be aware of this. VCs need to know if their goals are different deep in their souls because this will lead to conflicts in the short term, already.
Human factors#3: Integrity. If there is no trust if PE/VC feels discomfort, uncertainty, or if moral problems arise, there is no investment. It happens that the team is good, but there is no chemistry between the founders and PE/VC. Back and forth there is no trust. The best in this case if they do not work together.
Human factors#4: ‘Abundance of ideas’. Theoretically, several ideas of the same founder could be funded by the same PE/VC. This, however, cannot be considered a good sign because the founder must concentrate his resources on one core project. It is difficult to ride several horses at once.
Entrepreneurs still not always understand and accept how does a PE/VC investor works
The investor needs to be in the picture on strategic issues. Trust is crucial, within the team, between the investor and the company. The investor mentors, give directions. They are together as a great rowing team. The investors don’t act on operational issues because they can’t take the responsibility for that. They help companies to find out what mistakes are being made. The most desirable if the founders are open to the suggestions of the PE/VC. There is no obligation to accept it, but the decision better to be made after analysis. The investor sometimes reaches out to the operation, for example, when the company is growing at a rate that exceeds all expectations. E.g. at Vatera.hu back in the day, processes should be created. Companies, where at least one founder was able to make day-to-day operational decisions, worked well. If the slaps come and the company only turns to the investor to tell what to do, that’s a very bad sign. Good co-operation is when the owners signal themselves, if there are strategic issues and discuss those with the PE/VC.
Smart money came to fashion recently, but it is difficult to interpret it if in general PE/VC typically invests in innovative companies-industries where it sees the high added value. PE/VC is not better on the specific professional area than the founders. However, backed by a waste ‘case study collection’, provides their extensive hands-on management experience. Rarer are models where the venture capital investor spends some time with the team doing business development. Based on pre-set KPIs, the investor also undertook sales and HR activities for a 1–2–3% additional share. But this is not considered typical.
When, after a while, it turns out that the product/market survey was not appropriate and the gap between the original plans and the actual performance is becoming more and more open — this is very easily happening in the case of fashionable consumer products, for example — the entrepreneur has the feeling that it is under the pressure of the investor expectations for the next funding phase. The entrepreneur thinks that the investor has an interest in this solely, thus, it pushes to reach the expected growth indicators, with respect to the necessity of the exit, but it is not interested in ‘the success of the company’. This is not PE/VC that this type of entrepreneur needs.
PE/VC asks minority ownership with related rights for their investment
By default, minority ownership with related rights. Venture capital is strictly not involved in the day-to-day operations of the companies. VC reviews strategic decisions and expects the company’s management to provide information on these decision points.
Venture capital does not require a profit share difficult-to-manage legally. In the case of funds related to the state, the repurchase of ownership is done from the cash generated by the company. For private equity or VCs using private funds, this is not really typical because the essence of venture capital is a time-bound exit paid out by a third party, preferably an incoming strategic owner.
More importantly, PE/VCs expect the founder(s) to incorporate their knowledge, time, fanaticism, and commitment fully. PE/VC does not require a mortgage on personal property. On one hand, it reinforces commitment by putting its own resources into the venture. On the other hand, those entrepreneurs may not even need private equity or VC because they pay with a very expensive asset: their ownership.
For the expected 3–5X cash-on-cash return overall, the best portfolio companies may contribute with 10X
Obviously, PE and VC are significantly riskier investments than providing financing by a bank. Simply because due to its nature, a significant portion of the investments fail, a smaller portion generates a low-to-average return, and very few stand out only. This latter should offset the loss in order to meet the required normal return on the investment fund level, as a whole.
In practice, the risk profile and return expectation are completely different in the case of the startup/seed phase, in the growth phase, when the investment is needed for further growth of the company, and at larger companies, at which, in principle, the probability of default is lower. In the case of funds that invest in startups and early-stage companies, often even one investment brings in the total return of the whole fund. The reality is a 3–5 times expected cash-on-cash return on average, the best investments can yield 10 times, but this is far from being realistic for the portfolio of the fund.
Companies require PE/VC support to tap the international markets with follow-on investments
The goal of any domestic venture capital firm is to support their companies in which they have invested to tap at least regional, but rather the international or global market since the domestic market size is very limited. This capability will allow the involvement of foreign strategic investors in the next round. In the first stage, PE or venture capital supports strategy elaboration, the door opening. Not only the investor should choose the company carefully, but the company also has to choose the right investor. If the first investment was successful, the next stages are easier. The best sign for the market is a follow-on investment. The best is if the PE/VC can double-triple the initial investment in a second round. If it is not realized, it is possible to explain it, e.g. with the position of the fund as a whole, but then it is more difficult for the company to attract outside investors, definitely. Stock exchange sales alone are not a goal.
Covid19 differentiates and requires PE/VC and founders to act smarter
Economy. The extent and length of the economic downturn cannot yet be judged responsibly mid-2020. Most analysts do not expect a quick rebound, but rather a more protracted, pipe shape correction. Sales cycles have lengthened. The supply chain disruptions can bring about a lasting realignment. Even more certain that digitalization is accelerating, the companies involved have been given a boost.
Risks. A truism, the risks have increased everywhere. This is reflected in deal flow, pricing, structures, and processes. There are no new dispreferred industries because the very affected ones have typically not been PE or venture capital targets in Hungary so far. This period will be a serious test of management capabilities for crisis management, whether companies can execute a successful turnaround from the invested capital. Clearly, E-commerce in the broadest sense is relative crisis-resistant showing nice growth with high and non-falling valuation.
Red flag. The approach is now rather deal-based. A lot of people, riding the Covid19 wave, either launched a startup quickly, warmed up cases that had been rejected 2–3 years ago, or ’Covidized’ their unsuccessful projects. These are not credible, so from the point of view of private investors, there must be a red flag for all aimed at analyzing and solving Covid19.
Investor attitude. Investor caution has come to the fore, with both funds and wealthy individuals investing their capital more cautiously. The quick, easy access to money that has been characteristics in recent years is being corrected. At the same time, the market situation moves the valuation downwards improving the entry situation before the next cycle.
Deal-flow. The deal-flow in CEE is still relatively strong, but the volume of transactions will decline in the short term. Due to the increased risks, investments are dragging on, we are in a period of depression with a significant economic impact. In a period like this, there is really a need for smart investors who enforce companies to face the realities and also supports rewriting the scenarios.
Pricing. Valuations are downward adjusted, obviously. With higher volatility, these have reached a more realistic level. The effect of this downward valuation trend is different for startups, whose pricing is problematic by default, typically not DCF-based, the intuition plays a much more important role. In the case of startups where a significant decline in sales has been presumed compared to the original plans, no investment is made at all, these cases are rejected.
Process. The deal process, the contract elaboration process, has clearly lengthened. Basically, business planning has become more cautious, prudent taking longer time, it has become more meticulous, with the elaboration of more scenarios. The importance of actual sales and customer base has become even more important versus the expectations. The startup segment is very much different in this respect as well, their plans never live on for more than a few months.
Structure. The terms of the deal, the warranty structures remained basically unchanged. However, caution is built in obviously: the investors ask for a way out in certain situations. These are dealt with the clauses that provide for rights of withdrawal in the event of a material adverse change.
Strong state involvement: institutional development with capital oversupply led to buoyant start-up scene and challenges
The saying says if there are enough investment opportunities, the capital earning the investment will appear. If there is investable capital, it generates investment. The latter happened in Hungary. There was no liquidity, no money for early-stage investments. The state has created this market, for which there seems to be no alternative to the early stages of business at present.
Although not yet Tallinn and Berlin, the startup ecosystem has been spectacularly strengthened by state and EU funds, incubators, competitions, events, startup programs, this is unquestionable.
The impact of state and EU funds involvement is visible. In the recent period, the state has poured HUF 170 billion in fresh capital into the market from its own or EU resources, either with purely public fund managers or in the form of co-investment. Without public and EU money, many things would not have happened. Overall, the effects are positive.
There are some problems and challenges, however. On the one hand, public fund managers have to manage 100–150 companies, objectively, for capacity reasons, they might not act as smart money to provide adequate management support to companies. This can be particularly problematic in the current period of abrupt economic downturn. To hear about a number of projects where it was difficult to find funding for the next phase, or otherwise, not good companies also obtained funding. All this may predict that the effectiveness of these programs will decrease. On the other hand, the overall size of the programs may seem excessive considering the market size, their crowding-out effect is significant. Fine-tuning would be needed where public involvement is appropriate, where its net impact is positive, and where private investment is more effective.
Undoubtedly, capital programs have also been an opportunity for companies that may not have access to funding from private funds. The experience with the state ownership, in general, may raise concerns in such cases that purely market considerations may be compromised in investment decisions.
There are at least two additional elements that distinguish the domestic market from international examples. So far, despite the active role of the state, these have not been changed. One is that there are no serial investors in Hungary, who build up to something and sell, build the next one and sell, and so on. This type of driver is not visible. The typical case is that one becomes an investor after its first success. This is not bad either, because at least it remains part of the ecosystem, but still, it is not the same.
The other missing element in the ecosystem is the clients of these companies, the domestic large corporates. Despite the fact that the ownership role of the state or actors close to the state has strengthened in the Hungarian corporate sector, the domestic startup has to tap a foreign market in order to acquire its first customer. There is no home market, and the large companies that can pilot these startups or early-stage companies are not open enough, so these have to enter international/global markets.
The role of impact investment is expected to grow further. A significant part of innovative enterprises, e.g. in life sciences, biotech, etc. have positive social or environmental effects. These are already making this element part of their fundraising strategy. At the same time, the role of venture capital investing funds from the market or public/supranational funds may differ. For the former, the primacy of the required return for the impact investment remains. While the latter has more room for maneuver thus, its stronger role expected in the future.
Everyone has one or two exceptional success stories, but the rise of female founders and leaders is still slow in general. There are welcomed state initiatives already, yet still, approximately 3% of start-ups have a female founder only in Hungary. Obviously, it is also socially embedded. Even today, it’s harder for women to start a business. Their larger role would be important because the experience shows that their values, thinking, approach, and solution to problems are different.
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