VC Firms Creep Into Buyout Territory, But Can They Survive the Credit Crunch?

There’s no shortage of LBO shops that lost their shirts (and even shingles) after failed ventures into the VC world in the late 90s. This, I’m convinced, was the birth of the phrase “stick to our knitting.”

But what about the inverse? During the recent buyout boom, with LBOs both easy to finance and popular with investors, VC firms have wandered up-market into unfamiliar “growth equity” territory. Firms like Battery Ventures, Austin Ventures, North Bridge Venture Partners, Sequoia Capital, Polaris Venture Partners and Technology Crossover Ventures have begun doing recaps, carveouts and traditional LBOs.

So they’re here, in your lower middle-market, doing your deals. But what will they do now that buyouts are out of vogue? Can they hack it, and if so, will they thrive and multiply?

I’ve asked a handful of investment professionals the following questions: (1) Why do VCs move up-market (2) Will this trend increase despite a slow time for buyouts, and (3) What do the returns look like?

Topic 1: The Why
According to John LeClaire, head of private equity at law firm Goodwin Procter, the reasons aren’t purely opportunistic. As firms raise larger funds, they must deploy it in proportionally larger chunks. Larger investments mean larger companies, which by definition means later-stage companies.

“As funds get bigger, it’s very labor intensive to deploy the money if you’re putting it out in $5 million pieces,” he said. Not to mention the risk. Writing bigger checks to the same sized companies is much riskier.

Also, with the exit market looking grim, firms realize they need to support a company for longer than they have in past cycles, said Bob Geiman, a partner at Polaris Venture Partners. Having operational partners on hand makes that job easier. Polaris has invested in both start-ups and later stage companies since its start in 1996, but increased its activity on the growth equity side as its funds grew in size.

Topic 2: Will they stay?
In short, yes. Each professional I spoke with parroted the “middle-market is still thriving” line. I get it, the bottom half the buyout market relies on less leverage and is therefore less damaged by the credit crunch than the large and mega markets.

But is the concept of a venture capital firm doing recaps a sustainable one? Another yes, and here’s why: The ability to partner with management applies to both venture and growth equity investing. Uniquely private equity-oriented skills, such as financial metrics, bank negotiations and operational improvements, can be easily hired in, LeClaire said.

And, according to Battery Ventures’ Tom Crotty, private equity investing is a way for sector-focused firms to diversify across stages. (Battery is currently raising an overage fund, check out a PEhub analysis of the firm’s strategy.)

So the VC/PE hybrids aren’t going anywhere, in fact, as exit opportunities for VC-backed companies dry up, the model, with its longer-term focus, may become more common! While some of the would-be competitors to these VCs have graduated to bigger investments (see: TA Associates, Summit Partners), the lower middle-market remains a crowded field.

Topic 3: The Returns

Firms like North Bridge and Sequoia keep growth equity and venture investments in separate funds, but most of the hybrids lump ‘em all together, making it difficult to tell if one brand of investment is carrying the other.

There’s always Dan’s theory of “PE envy,” based on the assumption that venture funds rarely hit the outsized returns of an LBO shop. But a few anonymous observers insisted that the returns are ultimately similar. The difference lies in the how you get there. In venture capital, “all you need is one home run,” to offset a handful of strikeouts the saying goes. In private equity, shoot for “six triples, a walk and a grand slam.”

Read more: A very different attitude from VentureWire, published pre-credit crunch.