Buyouts and Venture Capital Investments

Buyout and venture capital funds are the two critical private equity investments regarding the number of funds and invested amounts.

Characteristics of Valuations of Venture Capital and Buyout Investments

Firms financed through venture capital are typically less mature than buyout targets. Venture capital firms have a specific industry focus, such as biotechnology, and emphasize revenue growth. When private equity firms make buyout acquisitions, the weight is on EBIT or EBITDA growth, and characteristically a portfolio of firms with stable earnings growth is acquired.

The table below gives a summary of the key differences between venture capital and buyout investments.

$$\small{\begin{array}{l|l|l} \textbf{Characteristic} & \textbf{Venture Capital Investments} & \textbf{Buyout Investments} \\ \hline \textbf{Cash Flows} & {\text{Predicting cash flows is}\\ \text{relatively low with potentially}\\ \text{unrealistic forecasts.}} & \text{Cash flows are stable and predictable.}\\ \hline
\textbf{Product Market} & {\text{Lacks market history since it is}\\ \text{a new product with an unproven}\\ \text{future market.}} & {\text{Perfect market position and}\\ \text{can be a niche player.}} \\ \hline
\textbf{Products} & {\text{Products are based on new technology}\\ \text{with uncertain prospects.}} &\text{Have well-established products.} \\ \hline \textbf{Asset Base} & \text{Have a weak asset base.} & {\text{Have a solid asset base that can serve}\\ \text{as the basis for collateral lending.}}\\ \hline \textbf{Management Team} & {\text{Team members are new despite}\\ \text{having an entrepreneurial track record.}} & {\text{Team members are strong and with}\\ \text{vast experience.}} \\ \hline \textbf{Debt vs. Equity leverage} & {\text{They are mainly equity funded}\\ \text{with occasional use of leverage.}} & {\text{Utilize vast amounts of debt}\\ \text{with a large percentage of}\\ \text{high-ranking debts.}} \\ \hline \textbf{Risk Assessment} & {\text{Uncertainty in the assessment of risk}\\ \text{as a result of new technologies,}\\ \text{new markets, lack of operating history, etc.}} & {\text{Risk can be easily measured}\\ \text{as a result of more business and}\\ \text{long operating history.}} \\ \hline \textbf{Exit Procedures} & \text{Difficult to anticipate exit.} & {\text{Predictable exit through secondary}\\ \text{buyouts, IPO, sale to a strategic buyer.}} \\ \hline\textbf{Operations Management} & {\text{A high cash burn rate is required}\\ \text{due to company and product immaturity.}} & {\text{Potential exists for restructuring}\\ \text{and cost reduction.}}\\ \hline \textbf{Working Capital Requirement} & {\text{The growth phase requires}\\ \text{a lot of capital expansion.}} & \text{Low working capital requirement.} \\ \hline \textbf{Due Diligence} & {\text{Technological and commercial due diligence}\\ \text{is typically conducted before investing,}\\ \text{while financial due diligence is limited since}\\ \text{portfolio companies have no or limited}\\ \text{operation history.}} & {\text{Firms involved in a buyout typically conduct a}\\ \text{complete due diligence process before}\\ \text{investing in the target firm (i.e., financial, strategic,}\\ \text{commercial, legal, tax, environmental).}} \\ \hline \textbf{Performance Monitoring} & {\text{Majorly monitors achievement of targets defined}\\ \text{in the business plan and growth}\\ \text{management.}} & {\text{Cash flow management, strategic,}\\ \text{and business planning are}\\ \text{typically monitored.}} \\ \hline \textbf{Returns of Investments Portfolios} & {\text{They are characterized by very high}\\ \text{returns from a limited number of highly}\\ \text{successful investments and a}\\ \text{significant number of write-offs from}\\ \text{low-performing investments.}} & {\text{Characterized by lower variance}\\ \text{across returns from underlying investments,}\\ \text{bankruptcies are rare events.}} \\ \hline \textbf{Involvement in Capital Markets} & \text{Less active.} & \text{Significant players.}\\ \end{array}}$$

Question

Which of the following is least likely to be a characteristic of buyouts?

1. Significant players in the capital markets.
2. Low working capital requirements.
3. Its products are based on new technology with uncertain prospects.

Solution

The correct answer is C.

Products based on new technology with uncertain prospects is a characteristic of  venture capital investment.

Reading 38: Private Equity Investments

LOS 38 (c) Compare and contrast the characteristics of buyout and venture capital investments.