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Value quest

1 Finding opportunity

How do investors find value amid the crowd of private companies?

We live in an era of disruptive innovation and this disruption is both a threat to existing business models, products and services and an opportunity for economic growth. Funding the front edge of innovation and helping the next wave of leading companies grow and scale is a vital component to that growth, but what are today’s investors looking for? How do they evaluate opportunities? How can private companies maximize their attractiveness to the investment community?

Venture capital investment across the globe rose to the highest levels in two decades in 2015 and the year saw more unicorn births (private, VC-backed companies under 10 years old achieving a valuation of US$1b or more) than ever before. Meanwhile the proceeds from initial public offerings (IPOs) dropped 24%. Against this background, EY’s valuation survey offers insights into what drives investors’ valuation decisions, when in a private company’s life cycle they choose to invest and what returns they target.

Warren Buffett famously said, “Price is what you pay. Value is what you get.” How do investors across the globe apply valuation criteria when considering potential new opportunities? Do venture capital, private equity and institutional investors think alike, or favor different strategies? Are there significant regional differences in investment appetite? And what can pre-IPO companies do to maximize their value to these different investor groups?

Investors routinely get hundreds of pitches a month from young companies seeking funds. So EY asked investors what matters most to them when they decide to back a private company.

Top three things entrepreneurs should focus on:

The strength of your team

The strength and breadth of your core management team is the most important single factor for investors. Attracting and retaining star talent is more than an operational imperative – it strikes directly to company value.

The company you keep

The extended team – the external advisors you hire along the way to support you – is a close second. From the investors behind you to your financial advisors, your reputation is enhanced or diminished according to the external team you have on-side.

Grow fast with a clear path to profit

Investors need to be convinced that your business model will deliver profits. As competition for market leadership intensifies, your ability to capture markets quickly and profitably, is a key driver of value for investors.

2 Team spirit

The strength of the management team in a private company seeking funds is by a wide margin the most important company-specific factor investors examine before making an investment in a private company, cited by 65% of respondents.

Having a top investment banking, legal and audit team involved enhances the story; the value of reputation really matters.

— Oliver Pursche, CEO,
Bruderman Brothers

“The most critical component,” agrees Oliver Pursche, CEO of investment banking firm Bruderman Brothers, “is the depth of the bench so that it is not reliant on a single individual.”

The critical importance of top management does not surprise Avi Zeevi, General Partner for Carmel Ventures in Tel Aviv. “I believe any entrepreneur will face a very, very competitive market, so the team needs to be able to raise its voice above the noise, reach its market and then grow the company,” Zeevi says.

A close second, however, is the reputation of the external advisory team.

“Getting the team right is critical, and that includes the external team,” says Pursche. “Having a top investment banking, legal and audit team involved enhances the story; the value of reputation really matters.”

In certain countries, reputation is essential

Reputation is even more important for certain countries. Nearly all respondents in France (91%) and Japan (90%) agree that their views on valuation are influenced by the company’s current investors, compared with just 66% of US-based investors. In general, investors from the US and Germany are less focused on reputation and more focused on financial performance.

In China, 72% of respondents agree that their view on valuation is influenced by the reputation of the company’s sponsorship. Again, there are potential political motivations and personal relationships (guanxi) here that motivate investors to align with certain other investors and potential IPOs, especially as the central government has held an important role in maintaining the valuation of certain firms.

3 Growth vs. profit

 

[Recently], we saw the pendulum swing back toward recognition of profits as a vital valuation metric. Topline growth or user growth alone is not going to cut it.

— Rama Velamuri,
Professor of Entrepreneurship
at the China Europe International
Business School

Reputation is just one part of the puzzle. Pursche says, “At the end of the day, earnings and revenue growth are going to matter. Selling millions of widgets at a loss isn’t a great business model.” Pursche adds, “I don’t think revenues and profits ever really went away as important factors in company valuation, but QE [quantitative easing] and easy money distorted those fundamentals for a bit. The era of cheap money is slowly coming to an end.”

“In 4Q 2015, we saw the pendulum swing back toward recognition of profits as a vital valuation metric,” warns Rama Velamuri, Professor of Entrepreneurship at the China Europe International Business School. “Topline growth or user growth alone is not going to cut it.”

Federated Kaufmann Fund’s Senior Portfolio Manager, Jonathan Art agrees. “In the long run … profits always matter.”

Investors have stepped cautiously into 2016 and are sticking to the basics when looking at financial metrics. Most frequently, respondents look to earnings before interest, taxes, depreciation and amortization (EBITDA) and sales multiples as the key financial metrics of appraisal — 51% of respondents chose these as preferred metrics.

With respect to capital structure, China (63%) and the US (61%) prefer a debt-to-last-12-months EBITDA ratio of 2x to 4x rather than higher levels, vs. 50% of total respondents who say this. Further, more than a quarter of total respondents (27%) (and 79% of French and 60% of Japanese respondents) have no specific limit.

We asked investors to describe their intended investment horizon, and the scale of returns they seek when making pre-IPO investments.

  • 46% of institutional investors say they have a time horizon of five years or longer.
  • In-depth discussions with managing partners showed an appetite for an even longer investment term (7+ years).
  • More than half of all respondents (52%) say they will accept returns of 10% to 20%, although private equity investors seem more demanding: nearly half (48%) seek returns of 20% to 30%.

“Returns are relative to the growth opportunity still in front of a company and the risk associated with hanging around for that,” argues Ray Bingham, an advisory director of Riverwood Capital Management. “PE funds have another variable they need to factor in: the fund’s need for liquidity, to return a certain amount of capital each year.”

In aggregate, investors and companies are making mostly rational decisions about good, sector trends ... but sometimes they make marginal calls on specific opportunities and specific companies.

— Whitney Bowers, private equity investor, HgCapital

4 Is tech still king?

Which kind of companies are investors gravitating toward? And what role do they expect to play in companies they’ve made investments in? The survey shows that while technology IPOs may dominate the headlines, investors are also attracted to the potential blurring of lines between technology and financial services, as “financial technology” (fintech) startups get more attention. Moreover, investors aren’t seeking to gain a dominant position in the companies they’re backing.

“As a growth investor, you want to have enough equity to influence and earn a board seat,” says Bingham. “That is typically in the 10% to 20% range.”

Tech is still king – but so is specialization

The role of boutique investors, with real expertise in specific sectors like biotech or big data, may be underestimated. This is especially true since technology and biotech investments round out the top three industries in which our survey respondents make investments.

The days of the generalist in investing are mostly gone, but the days of specialists are still ahead of us. Firms that have been the most successful over the past five years have been both sector specialists and activists in term of pursuing excellence in operational performance.

— Whitney Bowers, private equity investor, HgCapital

Whitney Bowers, a private equity investor with HgCapital based in Boston says, “The days of the generalist in investing are mostly gone, but the days of specialists are still ahead of us. Firms that have been the most successful over the past five years have been both sector specialists and activists in terms of pursuing excellence in operational performance.”

The interest expressed in fintech investments could reflect the recent interest in companies at the frontiers of both sectors, given recent high-profile IPOs. In contrast, media, real estate, transportation and retail are “out of favor” among our respondents. This matches EY’s overview of the IPO market in 2015, where most deals occurred in the industrials, health care, technology, consumer products and materials spaces.

Yet, experts note that in today’s world it’s hard to escape technology’s influence. “Every sector now is at some level a technology play,” says Pursche.



Snapshot: Regional differences

The survey showed some differences by region, underscoring that what appeals in one market may not appeal in another. Here are some of the standout findings:

  • German investors place more importance on market growth (55%) and valuations of peer companies (48%) than investors in other countries.
  • While the majority of all investors tend to invest locally in their own markets, US investors are the most likely (35%) to make cross-border investments, while Japan (26%) is the least likely.
  • French investors favor telecoms significantly over their peers (27% versus the average of 10%).
  • UK investors show a similar bias toward investments in media and entertainment companies (26% versus the average of 7%).

These speak to differences in culture, regulations and investor sentiment, and are important factors to understanding how investors view pre-IPO companies.


Close to home or new pastures?

Investor respondents conduct less cross-border investment than what one might expect in a globalized economy. They tend to stick to tried and tested areas of investments based in familiar geographies. Investors in the US are significantly more likely to invest in North American companies; investors in Japan are more likely to invest in Asian companies, and so on. What’s more, their return expectations are similarly modest.

This is not true of the whole investment community, however. “We are cross-border investors,” says Bingham. “We invest in growth wherever we find it. It’s just more difficult to give those investments what they need over and above just cash and for me private equity investing is far more about what you can bring as a contributor to the effort, leveraging your network, than it is about capital investing.”

5 Path to profit

Most respondents are active in early rounds – in total, around two-thirds of respondents say they invest in growth rounds and venture rounds. As we would expect, round preferences are closely matched to investor types — with institutional investors more likely to wait until the IPO to invest.

But some investors are investing earlier or later than one would expect. For instance, 65% of institutional investors say they invest in the venture round—even more (69%) say they invest in the seed round. And more than a third of venture capitalists say they come in at the initial public offering.

“Investors in pre-IPO companies will be much more focused on the ability of the company to go public, and that profitability is not three years down the line, but within 12 to 18 months,” Zeevi says.

Velamuri agrees: “There’s no question that tech has shortened the runway for a number of companies but also enabled a lot of competition – brutal competition.”

Research shows that institutional asset managers who buy shares pre-IPO typically do so in order to build a long-term position, and often add to that position at the IPO and in the aftermarket. Institutional investors are patient: 46% of survey respondents say they will maintain investments beyond three years.

EY’s Global IPO Trends 2015 4Q Report predicts a new kind of IPO over the coming months and years; one in which “more stable businesses come to the public markets later.”

Investors in pre-IPO companies will be much more focused on the ability of the company to go public, and that profitability is not three years down the line, but within 12 to 18 months.

— Avi Zeevi, General Partner, Carmel Ventures

Maintaining a wide network

The surveyed investors are not focused on leading deals. Almost half (42%) prefer co-lead roles and 36% prefer minority positions. Institutional investors express strong preference for a position as co-leads – more than half want (54%) co-lead positions, while only 13% want a minority position. Half of VCs and PEs prefer the minority position. These results imply that investors like to co-invest and benefit from strength in numbers. This in turn suggests that management teams may need to devote more effort to maintaining a greater number of relationships and to communicate effectively with them.

At the same time, more than a third (38%) of respondents say their minimum equity stake for investment is between 20% and 50%. Nearly a quarter (24%) prefer a stake between 11% and 20%.

In our survey, respondents from France (64%) and the UK (62%) are far more likely to seek a 20% to 50% stake, while just 29% of US respondents make that selection. This is a possible indication that French and UK respondents are more likely to “swing for the fences” rather than develop a portfolio of investments.

6 Optimizing investment

Investors don’t seem to require big returns for new investment opportunities either. Overall, respondents look for a minimum 10% to 15% revenue growth, while private equity investors are a little more aggressive.

Liquidity in markets is often affected by global factors, but this doesn’t prevent a correctly valued business from achieving its desired exit goals.

— Scott McCubbin, IPO Leader, EY UK and Ireland

Most investors look for revenue growth between 10% and 15%, whether they are VCs, PE investors or institutional investors. And when it comes to internal rates of return, around half of all respondents (48%) say they will accept an internal rate of return (IRR) of 10% to 20%. Again, institutional investors will accept a lower targeted rate of return; 57% say their target is 10% to 20% (versus the average of 48% for all respondents).

For entrepreneurs, exit routes are evenly balanced

The relative merits of an IPO and a trade sale are more evenly balanced than some previous surveys have reported. Among our entrepreneur respondents, a company sale (39%) was marginally preferred but still more than one-third (35%) of investors see an IPO as the gold standard.

Respondents from China (47%) and the US (48%), however, are more likely to see an IPO as the preferred exit strategy. “High valuation at home makes IPO the preferred exit for many Chinese investors," says Terence Ho, Greater China IPO Leader, EY.

“Despite a volatile market in 2015, China outperformed in terms of returns to investors through IPO exit, and this trend is expected to continue,” Ho says. “The changeover from the approval-based to the registration-based IPO regime in 2016 will shorten the time required for an IPO, and in turn the investment life cycle for an investor.”

With more US-based respondents than any other country, American preferences have raised the percentage of responses in turn.

When it comes time to exit a significant investment in a public company, all three investor types prefer marketed sales. Regionally, US respondents are equally divided between marketed sales and block trades.

7 The upshot

The low interest rate environment around the globe seems to have had a beneficial effect on the IPO market. Our survey results have revealed that investor expectations have become more modest.

Despite all the fears of a new tech bubble, 62% of our survey respondents believe pre-IPO companies have appropriate valuations. Survey sentiment is that a gradual market correction is more likely than a sudden crash. They believe the IPO market will continue to reward investors, and there is no clear consensus that the unicorn market is about to burst.

In a market crowded with firms contending they are “disruptive” or can fundamentally alter the tech landscape, investors will look for some external validation to a company’s prospects. They are influenced by the advice and reputation of a company’s external financial advisors as much as a business plan or proprietary technologies.

And when it comes to exiting the investment, the respondents are split — 39% prefer the sale of the company, while 35% prefer an IPO. Institutional investors in particular prefer an IPO – 47% of those respondents listed that as their preferred exit strategy.

For companies considering going public, it’s worth vetting investors, since reputation of existing investors (and investment banks) is a key metric for potential investors. Even without the next “killer app,” a solid management team and strong base of investors may go a long way. And despite the hype, investors are keeping a level head in general – and companies should too.

This study was undertaken in collaboration with Oxford Economics, to provide a global snapshot of the strategic funding landscape of private companies.


Who we surveyed

  • EY commissioned Oxford Economics to conduct a survey which had 550 respondents, roughly split between institutional investors (37%), private equity firms (33%) and venture capital firms (30%).
  • Among institutional investor respondents, 68% are from smaller funds (US$1b to US$9.9b in assets under management (AUM); 11% have US$10b to US$24.9b in AUM; and the remaining 21% have more than US$25b in AUM.
  • 53% of venture capital and private equity respondents have AUM between US$500m and US$999.9m; 39% have AUM between US$1b and US$4.9b; the remaining 8% have more than US$5b in AUM.
  • 60% of respondents are located in the US/Canada; the other 40% are split between Asia-Pacific (APAC) and Europe.
  • Respondents tend to be industry analysts (43%) or portfolio managers (43%). Chief financial officers, chief investment officers, partners and chief executive officers each represent less than 5% of the total.

Contacts:

Jacqueline Kelley
Americas IPO Leader
David A Brown
US Equity Capital Markets Leader
Dr. Martin Steinbach
EMEIA IPO Leader
Scott McCubbin
UK and Ireland IPO Leader
Ringo Choi
Asia-Pacific IPO Leader
Terence Ho
Greater China IPO Leader
Gary Nicholson
Oceania IPO Leader
Shinichiro Suzuki
Japan IPO Leader
Bryan Pearce
Global Venture Capital Leader
Jeff Grabow
US Venture Capital Leader