The Lion's Den Vol. 9 - The Timely Symbiosis Between IRR, DPI and LBOs

Why public boards of VC-led companies will start feeling pressure to sell from every direction

There’s an old Mark Twain quote that goes something like “The only two certainties in life are death and taxes”. The original quote actually precedes Mark Twain’s by ~100 years and I would (humbly) suggest one more certainty: we are about to see a big wave of public tech companies going private in the next 24 months.

The way I see it, we are in the midst of a 3-act play:

• Act 1 (past 5-7 yrs, but mostly 2019-2021): Abnormal investor FOMO => unprecedented IPO volumes, lower entry bar to the public market and, consequently, murky quality

• Act 2 (we are in it now): Rapid return to sanity driven by macro trends => strong investor pullback, market cleanup and many “zombie companies”

• Act 3: New “normal” reality => TBD what that looks like or when it happens

If you’ve been following my posts, you’ve read my thoughts on why I expect near-zero IPO activity on one hand and heightened activist campaigns on the other hand. So far, I’ve been pretty close - we’ve seen one quasi-IPO of Mobileye (it was really a private placement to 3 investors at a discounted valuation with almost no float. Share price will mean very little in the near future), while multiple other prospects like Instacart have postponed their IPO plans. Concurrently, activists have been pushing the envelope by going after previously darling tech names like Wix and even supposedly “untouchable” names like Salesforce.com.

We are clearly in the market cleanup stage and in this post I’ll share why I believe the next transactions to expect are take-privates (LBO, MBO, etc.) and why the math actually works even at seemingly low valuations.

Increasing Pressure from All Directions

Being a publicly traded tech company these days is not a lot of fun, even for the most established companies, but being a relatively new, VC-backed public company is just painful. Many of these companies have lost 50-80% of their IPO value, have little float or research coverage and are unable to tap the market for capital. They still need to report transparently even at a time when macro trends are working against them, they need to prove (and quickly) that they can somehow switch on the profitability toggle without breaking things, and they still have to spend time and money on maintaining a public company infrastructure. Ah, the good old days of being private…

This reality is here to stay and will inevitably test the patience of key constituents:

• Founders - Most of the successful founders I know love building companies, developing products, meetings customers, etc.. Few thoroughly enjoy the quarterly earnings cadence, the IR conferences and the extreme transparency to investors who are sometimes more short-term focused.

• Employees and C-level Execs - Have seen their net worth shrink and their options “swim” out of the money. Even the best "culture companies” are going to struggle convincing people to stay vs. joining higher upside startups or lower risk corporates.

• Venture Capital Funds - Those same early-stage investors who looked like heroes 12 months ago and kept holding post-IPO have seen their TVPI/RVPI returns dwindle on a daily basis. At the end of the day, these investors must be asking themselves if they are doing justice to their limited partners by holding public stock and spending time on public boards in a market they have no expertise in.

• Limited Partners - Throughout Act 1, many LPs have been exceedingly flexible with GPs when they chose to double-down on early-stage bets, set up opportunity funds and even dabble in buying IPOs and thereafter. At least from my conversations with LPs, the keyword now is distributions or DPI. These institutional investors want to see capital returned to them, even if it’s a lower mark, because the return on capital math simply makes sense (see below). Importantly, I’m not observing LPs wanting GPs to stop investing - I am hearing quite the opposite (albeit with different levels of appetite for risky businesses), but when the lenses are pointed to the public market, the sentiment is pretty clear - GPs should find distribution opportunities.

The Price Can Be Right (Even if Not as Lucrative as Expected)

The other important constituent to fill the void here are the PE shops. I recently co-invested alongside Turn/River in the $570M take-private of Tufin, a network security software company, and there have been several other transactions this year (Thoma Bravo acquired ForgeRock and UserTesting, both were public for 12 months or less!). PE firms are well positioned to benefit from this environment because:

• They have a deep understanding of the dynamics above and can help GPs/LPs with needed liquidity

• They can identify low-hanging growth/cost opportunities that are harder to execute in the public market

• They might have an M&A play that’s easier to execute as a private company - both UserTesting and ForgeRock seem to be part of a broader combo strategy

• Above all, they can take a sophisticated longer-term view on what normalized tech multiples might look like in Act 3 and buy the multiple arbitrage today

While these dynamics are all fairly straightforward and easy to understand, price is the rubber meets the road. Traditionally, take-privates are done at a ~20-40% premium to the 30-day VWAP, which could imply a meaningful down round for companies that lost 50-80% since IPO and seemingly a dead end for deals to happen. However, PE firms that know their space, have high conviction on synergies and the underlying value of a business as well as a longer-term view on generating an exit, can actually afford to pay a much higher premium to get a deal done. For example, Thoma Bravo paid a 97%(!) premium to UserTesting’s 30-day VWAP, which seems high but you could argue they’re only paying ~4x EV/NTM Rev. and that’s before any realized synergies from the planned merger with their other portfolio company, UserZoom. Given the median EV/NTM Rev. for software companies has traditionally been 7-8x (now around ~5x), given that Thoma Bravo is an experienced operator and that there likely will be meaningful synergies as part of the combo, you could also argue this was a steal…

PE firms will continue to aggressively treasure hunt in the public market, which means VC-led boards are going to face an interesting dilemma: sell now for 60-100% premium OR develop strong conviction that the price will be meaningfully higher than that in [2-4] years to justify holding on? It all comes down to math:

Putting the Acronyms Together for Some Math

Let’s look at company “NewPubCo” as an example and assume the company had a marvelous IPO in 2021, 1 year ago, at $10.00/share:

• 70% of the company is held by VCs/angels who bought throughout the 4 years preceding the IPO at an avg. of $2.00/share

• 15% held by IPO/public investors who bought 1 year ago at avg. of $10.00/share

• 15% held by founder/execs who hold stock/options at $2.00/share

The above % holdings are just to illustrate that at this point in NewPubCo’s life, the VCs (and founders) pretty much call the shots. Now let’s assume NewPubCo, like many of its peers, has experienced a massive 80% drop in value since IPO and is currently trading at $2.00/share. Along comes a PE firm and offers the board a whopping 100% premium, or $4.00/share. Here are 3 very plausible scenarios the board could be thinking through:

1. Accept the $4.00/share offer, take the profits and move on

2. Decline the offer, remain a believer and hang on for 3 years for the stock to hit $6.00/share (~3x increase, or ~44% increase/yr) and then distribute profits

3. Decline the offer, remain a believer only to see the stock “rallying” to $3.00/share over 3 years (roughly equivalent to the ~12% avg. S&P return over time so )

Scenario #3 is obviously a bad use of time, capital and attention. While scenario #2 seems to clearly be the best outcome, it really isn’t for two main reasons: First, there is real risk of waiting for 3 more years hoping the stock would increase 44%/yr (not exactly a modest base case) and holding off the much desired distributions to LPs. Second, the reality of time value of money - if you assume GP/LPs are targeting 15-25% IRRs (let’s go with 20%), then the present value of $6.00/share in 3 years is…$3.47/share today. In order to generate a meaningfully superior outcome that is at least 50% higher than the $4.00/share being offered today (otherwise, why bother), you’d need to believe NewPubCo’s stock would somehow reach $10-12/share within 3 years. That’s 5-6x and 73-82%/yr climb! Not unheard of in bull markets, but can GPs really have strong conviction around that in today’s market? Not to mention that there are no assurances that even with a high share price the GP would be able to fully distribute its stake.

The table below illustrates the range of outcomes (on a present value basis) based on exit price and discount rate and comparing those to receiving $4.00/share right now:

At a 20% discount rate (if that’s the targeted return, that should be the cost of equity for this exercise), NewPubCo’s board would need to feel VERY confident that they could get from $2.00/share today to at least $7.50/share in 3 years to not accept $4.00/share right now.

Final thought: As an investor, I view this period as an exciting deployment opportunity. This is a great time to deep dive into public companies’ TAM, strategy, execution and KPIs and develop a strong conviction around companies that are fundamentally undervalued/misunderstood, that can flourish as private businesses again and are actionable. Exciting times!

Onwards!
Omer
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