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Michael Carmen and Matthew Witheiler discuss the changing environment for late-stage private companies looking for strategic capital to move to the next phase of development prior to an expected liquidity event, such as an IPO, and the potential investment opportunity it may create.
Q: WHAT ATTRACTED YOU TO THE LATE-STAGE GROWTH MARKET?
Carmen: The inspiration came to us about five years ago, when we saw evidence that opportunities in the late-stage growth market were changing relative to what we’d seen over the prior five years. Specifically, companies are staying private for longer. For example, the average age to IPO for VC-backed companies increased from 4.6 years during the 1990 – 2001 period to 6.4 years during the 2002 – 2018 period.1 As a result, companies are often more mature when they do go public. Businesses with market capitalization below US$1 billion have decreased as a percentage of the public market, from 53% of the Russell 2000 Index in 2005 to 23% as of 31 December 2018. Amid these changes, we recognized that the late-stage growth companies were often in need of capital to accelerate growth prior to, or in lieu of, an IPO or sale.
The volume of these deals has increased over the last several years. At Wellington Management, we have been investing in private companies for more than a decade, but we have participated in an increasing number of deals in recent years — and the number of deals we have had the opportunity to consider is significantly higher than it has been in the past decade. Importantly, we believe the quality of these opportunities has improved as well. In many cases, these are companies that we think are leaders in their industries and that could already have been public a decade ago.
We see several potential advantages to investing in these types of companies. Late-stage companies typically trade at a lower valuation relative to their publicly traded peers, due to their inherent risk. Investors with the appropriate experience and skill set may be able to identify companies that are attractively valued, have high return potential, and are at the lower end of the risk spectrum. Additionally, they may be able to capture a larger portion of their growth potential by investing prior to an IPO. And finally, they may be able to provide these companies with the opportunity to accelerate their growth prior to an IPO or other liquidity event.
When we add all this up, we see late-stage growth companies as a potential sweet spot in today’s market.
Q: IS THIS A CYCLICAL OR A STRUCTURAL OPPORTUNITY?
Carmen: We think the changes in the late-stage growth segment of the market are here to stay. Costs and regulatory pressures, such as those brought on by the implementation of the Sarbanes-Oxley Act, are primary reasons we see opportunity in this area. Companies have been using private capital to shore up their balance sheets and provide additional financial flexibility so they can choose to go public at the right time. Not having to report earnings each and every quarter provides the freedom to try new things by expanding into new markets or launching new products.
We think investments in late-stage growth companies could perform well in a market environment where growth companies are recognized and rewarded for their growing businesses, often in the form of a successful IPO. But even when IPO activity is not robust, we believe that these companies may be attractive acquisition targets for established businesses looking to expand their reach, acquire strategic technologies, or broaden their product or service offering.
That said, a market retrenchment or a shift to a total “risk-off” environment with respect to equity investments or capital spending may cause these companies to experience a delay in liquidity events. A recessionary environment would also be challenging because there could be a confluence of poor fundamentals and a weak IPO market. Of course, these environments would have a similar or potentially even more negative impact on equity markets broadly.
Q: HOW HAS THE ENVIRONMENT CHANGED SINCE YOU BEGAN RESEARCHING THIS LATE-STAGE GROWTH OPPORTUNITY?
Witheiler: There have been several changes worth noting. The ecosystem has grown, with increased investor interest and a greater number of companies choosing to stay private longer. The entry of new capital providers in the space, such as earlier-stage venture capital firms, has allowed high-potential companies to be more selective in who they choose to work with and bring on to their capitalization table prior to pursuing an IPO — with a preference for value-additive, patient capital partners who afford management teams their autonomy on business operations. We believe this combination of factors is positive for investing in this space.
Q: WHAT HAVE YOU LEARNED SINCE FIRST IDENTIFYING THIS OPPORTUNITY MORE THAN FIVE YEARS AGO?
Carmen: There are several points that have come into sharper focus. For example, the late-stage growth opportunity set is even bigger than we anticipated. Our experience has also reinforced our belief that relationships are incredibly important in this space, in terms of deal flow and seeing as many quality opportunities as possible. This includes relationships with entrepreneurs, VC firms, and banks. Finally, we’ve seen evidence that late-stage growth companies see value in working with an experienced institutional investor with deep expertise and contacts across industries.
Q: HOW DOES THE LATE-STAGE GROWTH OPPORTUNITY COMPARE WITH TRADITIONAL VC OPPORTUNITIES?
Witheiler: We think later-stage, more mature companies offer the potential for returns that are comparable to VC funds but with less risk and a shorter time frame to liquidity. Traditional VC funds typically invest earlier in a company’s life cycle, and that could be an opportunity to capture a higher return in individual deals. However, the trade-off is that earlier-stage deals typically introduce more risk. Traditional VC funds thus have the potential for a greater number of individual deals that fail. In terms of liquidity, investments in earlier-stage companies may take longer to liquidate than those in late-stage companies.