Startup funds go private

Private equity's rising profile in technology investments became palpable this summer, as Agilent Technologies Inc. sold its semiconductor group to two buyout firms and as former Federal Communications Commission chairman Michael Powell joined Providence Equity Partners, with $9 billion in telecom and media holdings. And the activity on the street underscores the headlines.

Individual private equity firms, as well as syndicates, now take part alongside venture capital firms in Series A and B startup financing. The success of established investment firms has attracted hedge funds — the aggressive high-profile, high-risk investment companies that specialize in derivatives and futures-based financial instruments.

"The significant change in private equity in the last couple of years has not been based on firms' becoming more familiar with technology sectors but on the sheer increase in money available for investment. There is now more than a $1 trillion in capital from private equity groups," said Loren Lancaster, managing director of Core Capital Group (Colorado Springs, Colo.).

But startup executives should not assume that equity firms will part with it without first conducting due diligence on a par with VCs.

That applies even to hedge funds. "Hedge funds can own common stock in public companies, allowing them to participate in a market in ways that are not open to a private equity fund," but "the additional freedoms don't make that much difference in practice," said Chris Allick, founder and managing partner at San Francisco investment bank Instream Partners. "At the end of the day, they are competing for the same pool of investment dollars. So they tend to be very sensitive about risk and just as thorough as a venture or private equity fund in looking at an opportunity."

New ball game
Equity firms' role in tech investment once was limited to the occasional buyout of a semiconductor company by such leading lights as Texas Pacific Group. In the deal-laden 1990s, a company that had been through two or three rounds of venture financing usually could depend on an initial public offering in a roaring Nasdaq market or on acquisition by a larger company. When a private-equity firm got involved in bridging or buying stock, it was almost seen as a sign of management weakness. But the post-crash environment has altered that perception.

"There has always been a role for private equity in electronics, but when you see deals like the privatization of Agilent's semiconductor business [sold to Kohlberg Kravis Roberts & Co. and Silver Lake Partners for about $2.65 billion], it's clear that the profile is rising," said Instream Partners' Allick.

Ryan Jacob, principal with Evolution Capital LLC (Santa Monica, Calif.), said growth in the number and types of hedge funds has meant more competition across the board among private investment groups looking to guarantee profitability to investors. Hedge-fund managers have become more diligent in analyzing companies, he said, and the funds have teamed with traditional private-equity firms to make joint investments in early rounds of financing for semiconductor, software, consumer and systems companies.

Some executives of startups, exasperated with demands by venture firms for offshore outsourcing of various functions, look to private equity investors to accept a higher ratio of U.S.-to-offshore employees. But that might be wishful thinking.

"The venture funds may apply the strictest set of assumptions to a business plan, since they are the ones most familiar with the high-tech industry, but hedge funds do not represent easy money," Evolution Capital's Jacob said. "As for outsourcing, any investor in the 21st century is going to ask, 'What can be done offshore?' "

Much of the perceived distinction between traditional high-tech venture funds and private equity funds boils down to tradition, Allick said. "Venture capitalists have traditionally focused on a particular high-tech sector in which they had deep expertise. Outside the tech sector, funds tend to be called private equity rather than venture."

Investment rules for both venture and private equity funds can vary case by case he said, defying generalizations about how a particular fund can and cannot invest. And both private and VC funds "bring two things to the relationship besides money," Allick observed. "One is their expertise in an area of business, and the other is relationships that could be valuable to the company."

Allick did note that huge leveraged-buyout specialists like Kohlberg Kravis Roberts "have the ability to put a lot more money into an individual company. You have real giants out there, like Carlisle [Enterprises LLC], or Warburg [Pincus LLC], which just raised a single fund of $8 billion. Firms with this kind of capital are starting to look in particular at opportunities in China. There are semiconductor manufacturing and Internet buildout plans over there that require really enormous levels of investment to get off the ground."

But none of this dismisses the role of venture capital, said Jacob and Lancaster. Private-equity firms occasionally will become involved in a startup that is just moving out of angel investment, but, in general, private sources still prefer to wait until a venture coalition has provided a round or two of financing. Often, they said, a venture firm or a team of VC funds will seek out a private fund to turn over a company that may not be ready for an IPO.

"Why is the stock market going sideways?" Lancaster asked. "Because the smart money is outside the public markets."

Vish Mishra, senior venture partner at Palo Alto venture capital firm Clearstone Ventures, said a shift in the way the private equity companies are investing hints at tighter ties with VCs. Equity companies "are used to writing big checks, which means they have traditionally focused on mature companies," Mishra said. "But lately we have seen some of them coming in early, when the valuations are still low. [It's] a way of teaming with the more-traditional venture firms to make sure they have a place at the table later on, when the company is bigger and its capital needs are greater."