Crossing the Rope Bridge: How Private Equity Firms Can Enter the Startup Realm

We are seeing the rise of more structured, well-rounded startups. Here are some tips for private equity firms that want to enter the startup realm.

Dry powder. It’s two words that scare the majority of private equity firms. According to Bain & Company, what is categorized as “dry powder” (unused cash for investments) surpassed $1 trillion as of the end of the year 2013.

On the other side of the spectrum, as the Wall Street Journal’s Mike Wursthorn pointed out earlier this month, many PE investors (primarily pension funds) are sitting on even more “dry powder;” as combination of unused funds to put into the industry, along with high returns coming from PE firms themselves.

So what’s the problem here? As one of my colleagues in private equity put it best, we’re dealing with “a market of two extremes.” On one side, we have great companies with expensive price tags, thanks to strategic buyers with cash-laden pockets. On the other side, poorly managed and feeble companies with bargain bin prices to match. The cost to fix all of the leaks in the latter group almost always outweighs the financial benefits, so PE firms are stuck at a crossroads.

Enter the startup world.

We are seeing the rise of more structured, well-rounded startup founders piecing together teams and business models for companies that are addressing significant issues within their respective industries. Moreover, private equity firms, as large as TPG and as small as Stripes Group (and even big hedge funders like Tiger Global and David Einhorn), are putting their dry powder to work. The problem is, there isn’t any playbook for the industry to follow.

As someone who’s made the jump from PE to the venture capital world, and sees a lot going on in the startup industry, here are some tips for PE shops that want to enter the startup realm.

Stick To Your Guns, Sector-Wise

The first pitfall I’ve seen firms do is chase after the next hot startup. It’s not a terrible decision, but by investing in the later rounds, firms get significantly smaller stakes than they would thanks to the high valuations and thus lower-than-desired returns.  Investing in the early stages (or even building relationships in the beginning) pays dividends; from personal experience, startup teams have come to us in current and later stages with favorable valuations and terms because they see what we bring to the table. Even if you’re a generalist PE firm, focus on one or two sectors that your shop has succeeded the most in, whether it’s consumer, financial services, healthcare, enterprise, etc.

Top Floor (Network) Digging…

Firms should tap into their short-level network (portfolio companies and PE colleagues) to see what they’re seeing in the startup world. The management teams of your firm’s portfolio are more tapped into what’s going on in this world than deal teams ever will be. Keep abreast of what they’re seeing, because it could range from a professional connection to a personal one. If you’re a private equity firm and are reading this, I’m more than happy to help. Feel free to e-mail me here.

…and Bottom Floor (Meetup) Mingling

Meetup, arguably the most prominent website dedicated to finding great events by category, is a phenomenal place to do some on-the-ground startup sourcing. Firms should send their VP-level and below colleagues to as many tech- and/or sector-related Meetups as they can. I subscribe to over 80 Meetups for tech and startups alone, and my firm only focuses on the consumer sector!

A Two-Way Relationship

How can a private equity firm show itself as a benefit to startups? When a firm targets a startup and wants to engage in discussions with the team, it is beyond important to pitch the operational expertise your firm brings to the table, whether it’s your advisors, operating partners, or brand recognition within the portfolio. Always treat every conversation as a reverse pitch.

Start Something On Your Own, Fund-Wise

One private equity firm I talked to recently built a venture capital fund in the guise of a shell company, with the plan of using the $10 million fund to invest $100,000 to $200,000 in startups. Part of the plan was to help grow them to a level where the firm could then make PE-style deals within their criteria. I thought it was a brilliant idea because (a) it helped decrease the dry powder, (b) it helped build the firm’s reputation among startups, and (c) it impressed their investors.

Most Importantly, Swallow Your Damn Pride

I recently attended ACG Intergrowth, one of the largest private equity conferences, to re-introduce myself to my colleagues as a member of the VC community. Many of them scoffed at the startup world but heralded some of its most successful startups (Warby Parker, Airbnb, and Uber, to name a few). Moreover, at another private equity event, one person on a panel discussion, who has covered the consumer sector for over 30 years, when asked to name some of his favorite startups, included Warby and Harry’s but failed to get ANYTHING right about what their pure business models were.

Startups and venture capitalists have a VERY poor view of PE thanks to a still limited education effort. Every single firm going into the realm, above anything else, has to know that they are starting from scratch on educating startup founders, not just about their own firm and reputation, but also about their industry as a whole; that it’s not as terrible as the mainstream media marks it.

There are many private equity firms that have powerful networks, resources, and reputations for building companies into powerful institutions. It’s a scary bridge to cross at first because there is less quantitative data and more qualitative reward at first, but there are great men and women who need the help to grow their startups into the next strongholds of their sectors. Private equity can help them cross their own rope bridges and be financially successful in turn.

Download the complete pdf guide here.

Sumeet Shah

Sumeet Shah has worked in and covered the private equity industry for 5 years and seen the industry transition from the late 2000s financial crisis to its current state. You can find more information about Mr. Shah here or follow him on Twitter at @PE_Feeds.