There is a growing new class of buyout funds on both sides of the Atlantic, doing Pre-PE buyouts in the later-stage VC world, taking advantage of the liquidity crunch to buy promising startups at a discount, with the objective of transitioning them into viable PE  assets.

These opportunities are enabled by the current situation where later stage startups (typically Series C onwards) are battling to raise new funds in order to reach breakeven or to grow. This usually comes down to a valuation mismatch between new investors and the existing shareholders, many of whom are VCs that were caught up in the frothy valuations before the 2022 inflation-driven slowdown.

The new later-stage investors are price-sensitive due to the drop in valuations in listed tech startups and in new IPOs. Trying to achieve acceptable IRR over a relatively short time window forces them to come in at lower prices or to keep their powder dry for better opportunities.

This trend is still in its early stage, according to an article in the FT, but funds like UK-based Resurge Growth Partners and Tikto Capital, and San-Francisco-based Arising Ventures and Industry Ventures are raising tens of millions of dollars to address these opportunities, a trend which they expect will continue through 2024.

The target startups do not yet show the characteristics of a PE (Private Equity) buyout, with the combination of solid growth and profitability, and the cash flows to support leverage. They are still immature but have the potential to transition to PE assets with a responsible investment programme and, in some cases, a change in management or an operational turnaround.

 This could be seen as an extension of the VC to PE trend, where increasingly later stage VCs are exiting through PE firm buyouts, rather than strategic buyers or IPOs This has grown from 8% in the 2006-2010 era to 24% of total exits now.

These would be startups that are mature enough to justify a PE buyout with the valuation to make it attractive to existing shareholders. Pre-PE buyout funds are taking a bet that that they can transition their startups to PE assets, and get a hefty discount for this risk.

There is nothing like money on the table to get robust boardroom discussions going. According to Resurge Growth, they are looking to do transactions in the £10m-£30m range. The valuation discussion is no longer hypothetical and VC shareholders have tough decisions to make.

However, the very positive side is that it provides options to the startup, and could be the difference between going on to better things or dying on the vine. As an Arising Ventures billboard in San Francisco says: “We invest in second chances.”