Opportunities in consolidating markets

How VCs and PEs can collaborate and learn from each other to create successful exits.

After years of unprecedented economic growth, the sentiment has changed. A wave of consolidation in categories with too many players or where access to funding is limited is anticipated. So, what are the consequences and opportunities for VC and PE? How can investors from both categories work together to achieve successful exits in these unprecedented times? 

With this in mind, we hosted a roundtable that brought together European VCs and PEs. During this roundtable we discuss how the two categories have been converging in the past years and whether the current economic climate provides an opportunity for both to work together. 

We discussed a handful of statements with a group of 14 principals and partners from selected investment firms. Here are our 6 key takeaways.

#1 Company valuations will continue to decrease in venture capital but remain resilient in private equity

Valuations have ‘normalised’ across all growth stages over the past quarters, and high interest rates will continue to pressure returns. Additionally, the changing economic environment has also made it more challenging for companies to achieve their growth targets. Looking at the total number of investments, we’ve seen a harder hit on later-stage valuations when compared to Seed/Series A. 

On the other hand, investors are sitting on a historically high amount of capital yet to be deployed (“dry powder”) over the coming years. Therefore, the competition for great deals will only continue to increase as there are not enough investable companies within existing mandates. This applies to both VC and PE. 

Looking ahead, VC-backed companies trying to extend the current runway through cost-cutting or bridging rounds will eventually need to raise again. How this affects valuations in the longer term is yet to be seen.

Plummeting valuations are primarily noticeable within VC. The PE market continues to move ahead at full steam and valuations remain largely stable, albeit with adjustments for interest rate hikes. This also has to do with the different nature and maturity of businesses that PE is involved with. There are nuances for specific markets that may be more influenced by the ongoing macro environmental volatility. 

Although higher interest rates also impact PE, valuations in this space seem to be more resilient as capital is widely available and the supply of PE-qualified companies is limited.  

#2 Despite the headwind, there are clear opportunities for growth in venture capital and private equity 

The market definitely remains to present strong growth opportunities, both for VC and PE. 

For VC, normalised valuations give investors the possibility to deploy their capital under better and more realistic conditions. Obviously, the high valuations from the past can create complexity on the cap table and result in challenging situations for founders and existing investors if these valuations can no longer be justified.

For PE, there is an opportunity to identify VC-backed companies that are profitable or show a clear path to profitability and no longer fit the VC model. This aligns with the ongoing trend of PE slowly moving downstream.

The possibility of using M&A to gain market share is also increasing. Lower valuations allow for better deal-making and give both investors and founders the opportunity to execute reasonable mergers and acquisitions. This results in an opportunity to grow and exit at a reasonable return.

#3 VC and PE will become more operationally involved in their portfolio companies

As the market is becoming more dynamic and mature, so is its complexity. This demands for more operational involvement from investors. Either by design (e.g. based on investor strategy and vision) or out of necessity (restructuring). 

Where VCs typically offer strategic guidance and industry connections, PE investors focus on improving the performance and value of the companies they invest in by implementing operational improvements, financial restructuring or strategic acquisitions. 

#4 Non-top-tier investors will need to rethink their business model and investment focus to survive in the long term

Investors that can rely on a strong reputation and track record (“top-tier”) will continue to develop an unfair advantage over others. They will have access to capital at the best conditions, access to the best deal flow and therefore also add most value from experience and value-add capabilities and resources. 

There will also be space for the group that is closely following the top-tier firms as there are simply enough companies and capital to invest.

Firms that are ‘stuck-in-the-middle’ will have a hard time providing good returns. We can conclude that it’s important to pick a niche and develop a specific investment thesis, geography, business model or sector focus. Now more than ever, focus and differentiated added value are key to thriving. 

#5 VC-backed M&A will see a strong surge in the coming years

During and after the previous economic crisis, we’ve seen a strong uptake in VC-backed M&A. Coming years expect to show a similar trend, especially as there have been so many new entrants, resulting in over-crowded categories. 

As markets contract and capital is harder to come by, consolidation is the logical next step. Now is the time to rethink M&A as a lever for sustainable growth.

#6 The current market environment provides clear opportunities for VC and PE to create successful exits

Well-capitalised companies will increasingly seek for acquisitions to grow their core business, normalising valuations will ease deal-making and record amounts of capital are yet to be deployed for the proven winners. 

The market currently presents two clear opportunities for both VC and PE to realise exits: consolidation within overcrowded categories and exploring alternative growth paths for early to late-stage VC-backed companies that are no longer fit for the traditional VC route.

As VCs increasingly push their portfolio companies towards profitability, these companies become less attractive for a follow-up Venture Capital investment and more attractive to Private Equity. This shift creates a playground for Private Equity to make a move on. They could focus on companies that have strong products and solid revenues.

Whilst both categories will probably never work together on the same deal, there’s a clear greenfield to create successful exits together. Obviously, taking into account that each investment case brings its own ways to measure success, mainly driven by the timing of the investment, the conditions under which investors joined the cap table and the financial instruments applied.