Hot capital market balanced by a lack of early-stage investors
Michigan’s venture capital and angel investment industry is growing up fast, getting more sophisticated and starting to make later-stage investments into companies.
Meanwhile, private equity firms continue to operate in a hot acquisition market, and family offices are taking a large presence as well and competing more for deals.
Those were some of the perspectives from a panel of professionals who met with MiBiz for a roundtable discussion on the state of private capital in Michigan. Participating in the conversation were:
- Paul D’Amato, managing director of Grand Angels Venture Fund II
- Mike DeVries, managing director at the Grand Rapids office of EDF Ventures and chief investment officer at Start Garden LLC
- Dale Grogan, managing director of the $15.1 million Michigan Accelerator Fund I and managing director at Charter Capital Partners
- Matt Johnson, a partner at Warner Norcross & Judd LLP who works with family offices and emerging growth companies
- Gretchen Perkins, a partner at private equity firm Huron Capital Partners
Here are some highlights of the conversation.
From your perspectives, what do each of you see going on in the capital markets right now?
D’AMATO: I wear two hats with Grand Angels and with the venture fund. We’re seeing from an angel perspective a lot of activity in the angel groups, angel groups getting more and more sophisticated, and new angel groups starting up and experimenting with different models of how to run a successful angel group. Grand Angels (is) working with other groups to get them on their feet, but also learning from other groups as well.
We’re starting to syndicate more with other angel groups on larger and larger investment rounds. On the whole, we’re seeing angel groups moving later — maybe to emerging growth companies — (and with) larger dollars amounts (and) million dollar rounds, as opposed to quarter of a million dollar rounds and that kind of thing, which I think is very healthy.
From the venture side, we’re seeing more co-investment opportunities with other capital groups. That’s becoming more the norm. It’s always been a big thing, but sharing diligence is just becoming easier with other venture groups and people are interested more in syndicating and building collaborative networks with their venture fund. It seems very positive.
DEVRIES: Deal flow is as robust as it’s ever been. There’s no lack of opportunity. I think there is a bit of a consolidation in the capital markets right now. More and more venture funds are moving into later-stage deals. Pre-revenue companies are finding it more difficult than it has been in the past to get funded.
As regions like Grand Rapids or Michigan in general become involved in the capital markets, eventually those outside of the region discover that, so we’re seeing more than just Michigan-based opportunities. There are more opportunities coming from the coasts to Michigan because there’s some knowledge that there is capital here. So I think we’re in a real transition period in the venture world.
More often, we’re getting companies from out of Michigan coming to look for capital, but I do think we’re getting — and not the amount we’d like to see — capital sources looking into Michigan for deals here. The industry’s just getting more competitive.
GROGAN: It seems to me that the venture industry is maturing significantly in Michigan. After the thaw in Michigan in 2010 and ’11, lots of funds started coming into being and so we’re now seeing that maturing where those initial investments were made.
We’re starting to see a separation in the quality of the investments, and there’s a separation also occurring in terms of the entrepreneurs. Those guys that know what they’re doing that have access to the markets are finding velocity. Those that don’t are still going to have a tough time, particularly when you look at the angel groups and early-stage investors moving downstream.
PERKINS: We’re investing in businesses that have been around for a while and have a track record. It’s very hot right now. The market is hot, valuations are high — they’re higher than they were in 2007 and pre-downturn — and that’s because debt is very liquid right now. We’re arguably in the fifth to the seventh inning of this expansion. Who knows, but there’s been enough positive years coming out of it that if you have a good enough track and if you’re going to consider to sell, now is a great time and the banks are lending a lot. Banks and non-banks are lending at high multiples, so that pushes prices up.
If you have a really nice business, that will go for a turn or more above what it should — or historically what people will pay for — because there’s a lot of capital in the market and there’s impetus to deploy it. So prices being paid are high.
If you look at the type of sellers, private equity firms — those that are in the business of getting a return for our pension funds and college endowments — we’re selling everything we can in 2014 and 2015 because of this market.
What I hear from folks who are advising business owners now is you’re seeing a lot more privately-held businesses coming to market, and that’s fairly classic. The private owners are the last to come into a hot market. So that either signals the nearing end of a hot market, or it signals 2016 is going to be another year of high valuations, and despite markets being hot, they are getting choppy.
JOHNSON: Our clients are coming to us for strategic acquisitions and they’re competing with other buyers in the market that are not as strategic as they are that maybe wanted to offer more money. But from a legal perspective, I think there is sometimes more pressure on lawyers to get more creative in transaction structure and be able to bridge the gap in price some way — or from an investor’s side, you try to come up with more creative tools for investors to invest.
It used to be you bought preferred stock and that’s what you got. That’s now definitely no longer the case on the venture side, so there’s some pressure on lawyers to try to parse through what the SEC is doing with crowdfunding and all sorts of stuff (including) Reg A+. … There are all these different rules, and we’re trying to see the SEC catch up with the investment community. It’s going to be interesting to see how that plays out over the next year or so.
Why do startup companies at the pre-revenue stage find it harder to attract investments?
D’AMATO: Fewer people are investing there. … We do investment in pre-revenue (companies) for medical devices and life science companies as a whole, but for software, investing in pre-revenue is just something we don’t touch. It’s hard. I don’t know where they get the capital. It may be friends and family at that point.
DEVRIES: A macro-perspective is that it’s more LP-driven than venture fund-driven. I think many of the limited partners out there are saying that their analysis of pre-revenue companies would suggest returns aren’t there. Those they hire to manage their funds are getting money when they do post-revenue investing. Much of the behavior of general partners is driven by investors, and I think the facts are out that if you’re into the pre-revenue world, statistically you’re going to finish behind those who invest in the post-revenue world.
There are outliers. There are guys that get it and can make money in that space — and consistently have — but I think the general population of pre-revenue investors in the past 20 years has underperformed those that invest post-revenue.
GROGAN: If there is this cluster of new funds that came into the market in 2010, ’11 and ’12, you’re also looking at the life cycle of the funds. We have to invest the first three, four or five years so we can harvest later. It takes longer to get out, so as we get into it — and for us, we’re completing year five — we can’t take on a new investment unless it’s going to get out realistically within a year or two or three. … You can’t start from zero when you’re in year five of your fund. It just doesn’t work, particularly when you’re looking at regulatory stuff like life science and medical devices. It just takes too much time.
What’s the outlook for those pre-revenue companies?
DEVRIES: We’re going to see a continued disconnect between those who need capital on the pre-revenue side. It’s going to get worse in 2016. I don’t think it’s going to improve. That continued supply of those companies just compresses value, so I think there are going to be some bargains in that space. At our level, we’re going to look for opportunities in those pre-revenue companies to see if there’s some real up side. At the same time, we have a portfolio to support and we’ll be supporting that.
Is there a role for state government to continue to seed new funds, particularly in that pre-revenue space?
DEVRIES: To me, that’s a dicey road to go down because state governments have a motive that is less than purely financial. It’s really economic development at its core. And when you’re a general partner in a fund you’re trying to manage, and one of your limited partners happens to have kind of a contradictory investment thesis, it gets really challenging … to try to perform and live up to the standards of a state government. If they want to co-invest in deals, then that makes more sense. But to straddle a general partner with the edict to ‘invest into our state’ makes it really hard.
GROGAN: But I have to say, we’ve had an excellent experience with the state. We were at the tail end of the 21st Century Jobs Fund. Remember that they had $12 million left and they split that between the two funds. (Editor’s note: Michigan Accelerator Fund I was one of the two.)
Their comment was it’s largely economic (development) investment, so once the dollars go off of the books they don’t ever expect to see them back — and if you get something, God bless you.
But I would say that you can’t stop halfway. You are 10, 12 years into this investing into economic development through early-stage investing. To stop that and to pull the Venture Michigan Fund, I think, is extraordinarily shortsighted. You spent hundreds of millions of dollars creating this micro-economy and this environment for early-stage investments. To stop and say, ‘Well, we didn’t really like that’ — I think that’s foolishness. You have to play all nine innings in a baseball game.
D’AMATO: The inconsistency of funds — however they come from the state — distorts the market. So if you start it and stop it, it’s sort of the worst. The funds don’t know how to react. The companies don’t know how to react. These are long-term projects. They are 10-year funds. The companies may be raising money for several years, and it comes in and out of vogue for the state whether they’re interested in it or not.
THE FORECAST FOR 2016
Looking more broadly, what do you see happening in 2016?
D’AMATO: From an exit perspective, I’m concerned about going into an election year and what the public market will be like. About a third of our investments are in life sciences, so we’re interested in that market and it’s been volatile. The debates will certainly have a lot do with reimbursements and drugs and the expensiveness of health care in general, and this could have an effect on the public market, and that will have an effect on our ability to exit some of these companies. We’re looking at strategically what that means for some of our portfolio companies that could be positioned otherwise to either IPO or exit in that period.
DEVRIES: Exits are what everybody hopes for and wishes for, but at the end of the day, we all know we’re going to support these things for longer than we all planned on. So 2016 will be a year of supporting existing portfolio companies. We hope we can drive them far enough and fast enough to participate in this hot market of mergers and acquisitions, but a lot of our companies aren’t ready for that yet.
PERKINS: 2016 will be another strong year … because I don’t see any big economic cliff in 2016. Things are fuzzier in 2017, but it’s an election year (in 2016) and usually things just kind of muddle on until after that and then things break loose. So I think it’ll be another good year. … It will be a strong and stable year with a lot of focus on add-on acquisitions because organic, top-line growth is harder and harder to get in this sort of economy.
GROGAN: We’re going to have to see some sort of reconciliation between the venture market at the upper end and realistic valuations with the public market. We’ve seen a number of companies in the past say they cannot go public because they’re going to take a down ride, and that’s just not sustainable. So you have that at one end of the spectrum, and then you have this enormous gulf between the billion-dollar valuations and these sorts of sub-250 valuations and there’s nothing in (the middle). My guess is the upper end needs to come down and the lower end has to move up.
How long will the period of elevated valuations continue?
PERKINS: I feel like the debt markets are topping out. Valuations are topping out. (They’re) still strong, but if you got seven and a half times EBITDA for something last year, you’ll probably get seven to seven and a half times EBITDA this year, rather than kind of a half-step up, which is what we have seen over the last two or three years.
GROGAN: I think valuations will be a little more carefully managed this year, particularly as it relates to new investments. With follow-on (investments), that’s more horse trading among friends. But when you look at the new investments, I think you’re going to see some carefully modulated values.
REGULATIONS: A CHILLING EFFECT?
The JOBS Act requires the SEC to look at the definition of an accredited investor every four years. If the SEC were to come and ask for your advice, what would you say?
PERKINS: An accredited investor in a crowdfunded startup company is different than the type of investor in a $500 million private equity fund. So the one-size-fits-all (definition) simply creates a lot more work for everybody along the chain, and that hinders things.
D’AMATO: I think increased regulation in that space would just take capital out of the market — and take capital out where the market needs the capital (in) the early stage. Regulations can add value if they are adding some additional level of security or validity, but I don’t see where this one does that. I think this is simply creating rules for the sake of creating rules, so I think the government should establish the rule of law and get out of the way.
JOHNSON: They talk about what truly is an accredited investor nowadays. Is the income threshold still accurate? Is it not? And then what about the soft component of that — education, experience and things like that? You may get someone who knows the market really, really well but doesn’t have that income threshold and why aren’t they an accredited investor? … You need that income threshold, you need those objective criteria so you feel comfortable when making an offer that you are meeting the qualifications. I think less is more in this situation and leaving it alone for now is the appropriate thing to do. Maybe put some sort of index to the income threshold so it ratchets up a little bit, and they’ve been trying to do that for 10 years but haven’t been successful.
Is there any hope that maybe the SEC will do something that opens up and increases the capital pool?
JOHNSON: From a legal perspective, since it’s an election year, I don’t think you’re going to see much movement from the SEC. They’re going to face a Congress that may not be as agreeable with changes. … Maybe we’ll see some sort of movement in the definition of an accredited investor, but I wouldn’t expect it. … I think it’s more about just trying to flesh out the new rules related to the JOBS Act and how that’s actually going to truly impact capital markets, and I don’t know if there’s going to be a large-scale change from the legal side of things.
How has SEC regulation affected the capital market?
GROGAN: Doing third-party fundraising is just so onerous now that it’s almost not worth it. … When you’re raising money for others, it’s become so difficult with the work that you have to go through and the compliance efforts. And now, are we testing and validating that these are accredited investors? … The intent might be to protect the investor, but that practicality is just ridiculous. It will just eviscerate the capital markets if that remains in place.
PERKINS: Regulatory requirements shift the movement of capital from one place to another. There’s no question that the amount of public offerings of small to middle-sized companies now versus pre-Sarbanes-Oxley is completely down. That’s just not an ability of a $50 million or a $100 million company anymore. That’s just not a place to go raise capital anymore.
And post-Dodd-Frank, with the registration requirements of funds, there is no question why there is an explosion of independent sponsors — folks who are basically from our industry finding deals, negotiating a transaction, and then shopping among funds for the capital. Doing all that is required in a regulated fund environment is not what they want to do. It’s not just worth it anymore.
What is the fundraising environment out there right now, whether for a venture fund, for recruiting angel investors or for a private equity fund?
D’AMATO: There’s no doubt it’s better than it was. Our current fund is three times the size of our last one, so that’s positive. It’s interesting. Capital lags the market. We’re raising money in this environment and deploying it two to four years out, so it’s hard to look at it in terms of a macro-environment. It seemed good (in 2015). I think it will be pretty similar (in 2016). From there, it will be anyone’s guess.
DEVRIES: With the people that I talk to who have been out looking for money, the limited partners seem to be at the institutional level. The limited partners seem to be in more of a consolidation phase than they are in an expansion phase. They would rather up their commitment to the funds that are part of their portfolio already that have performed than take a flyer on a new fund or a second or third fund that they’re not part of. That becomes a real challenge at a macro perspective for Michigan-based funds because everybody is so young and track records are largely based on unrealized valuations as opposed to realized returns. I think it’s hard for Michigan-based funds to go out there and find limited partners that allow them to kind of grow the capital size that they are trying to manage.
GROGAN: What we’ve learned is you don’t show up in front of pension plan fund managers and say, ‘Hey, I’m here. Here’s my pitch. What do you think — $10 million, $20 million?’ It doesn’t work that way. So we’re spending so much time meeting and sort of priming the pump for these other investors for years and years. That’s just the game.
How has the investor profile of people willing to put money into a fund changed?
PERKINS: You’re seeing more outside of the U.S. investors. You’re seeing folks from Europe looking for yield here in the globe-safe currency — more now than versus a decade ago, and even more than five years ago. I don’t have any data to back that up, but anecdotally, you see different funds having a lot more European LPs.
DEVRIES: I’m not sure it’s fund-based. We’re seeing a lot of aggregation of various Chinese investors coming in at the deal level — and I don’t have data, I just have anecdotes — where they’re putting together some pretty large investments. I’ve seen $30 million and $50 million coming into any one series of investing, all kind of a syndicate of Chinese investors. I would have never dreamed of pursuing that kind of money 10 years ago.
THE RISE OF FAMILY OFFICES
How about family offices? Are they getting involved in deals?
GROGAN: It’s interesting to see the level of sophistication for the family offices. … They’re in the deal flow much more than they might have been in the past several years. Family offices might not have been on every single stop. Now it’s just part of the rotation because they are doing these direct syndications and that’s not something that we’ve seen before. We’d seen fund investments, but not necessarily side-by-side investments or fill investments, and now that’s becoming the norm and that’s part of every negotiated agreement with some of these larger investors.
JOHNSON: I think it’s interesting to see the family offices getting more sophisticated. That’s definitely happened the past few years across the spectrum of family offices. They’ve decided to get a little more organized, not only in how they run their in-house business but also in how they’re seeking to deploy funds.
How do family offices differ from other capital sources in their approach to investing?
JOHNSON: At times, you have a social aspect to the investment. It’s not just ‘what kind of return am I getting with the investment?’ but ‘do I believe in this particular fund and what this fund is doing? Is it a Michigan-based fund? Is it going to invest in Michigan?’ Or in some cases, they’ll have a religious basis to them or some other basis that the family is looking for. It brings a different dynamic to the investor pool of not just having that ‘what’s my return going to be?’ but ‘what am I investing in and where am I going to see my funds deployed?’
Are you running into family offices more in competing for deals and fundraising? What are the family offices looking for?
PERKINS: We’re seeing them in two ways. Both as investors for our fund when we’re going to fundraise, and they are also competitors in prospective acquisition candidates. They’re professionalizing this function of deploying capital.
They’re hiring people from the private equity industry, and so they are able to move along with the pace that is required. You hear that from the investment banking community — that they’re more prepared to compete. In the past, if it was head-to-head against a private equity firm, they just might not have been able to move as quick and thus would lose out, but they’ve bulked up and are more sophisticated.
They are also an increasing source of LPs for us as well. They’re being more professional about their family wealth and a piece of it’s going to go here with a nice diversified set of investments.
JOHNSON: The (second and third generations) may not be involved in the business anymore, so they’re relying more on professional managers to not only run the business but also manage their wealth.
D’AMATO: We’re seeing more with the family offices co-investing as well. They’ll invest in our fund but plan on co-investing in every one of our deals at the same time to reduce the management fees.
They add value other ways, too. It’s helpful to have them as sort of a known co-investor in the deal. We’re interested in larger deals, so being able to control more funds in each investment helps us. Having more co-investors, yeah, it’s more work, but it also helps.
We do see some deal flow coming back from the family offices as well. It’s not just competing for deals. They’re interested in having us look at things. So we get referrals — from some more than others.
Why are family offices getting more involved?
PERKINS: It’s search for yield. It’s putting money to work in a productive, disciplined way to continue the revenue streams down the road. I really think it’s just that simple.
JOHNSON: It’s deploying the capital in the right spot. The big family offices have always had capital. Now they’re just choosing to deploy it in this method because they think it’s the right use, especially if the business that generated the wealth to begin with is healthy.
DEVRIES: It will be interesting to watch over the next decade if this trend continues or it if goes away because the big institutional venture players understand the necessity of sticking with it for a long time. You can’t take a year off. And we’ll just see if that discipline is built into the family office structure or not because right now family offices are the place to go … for everybody raising money.
Coming out of the recession, there’s been a lot more venture capital, angel and private equity investing going on in Michigan, and more people investing in funds. What needs to happen to continue the momentum? What could kill it?
JOHNSON: Success is going to drive it. Failure is going to kill it. I think the other thing that’s important is an educational component. There’s so much out there to educate the family offices, to educate the limited partner investors, to educate all the players in the market as to what their options are to invest. Right now, crowdfunding is getting a little bit more of a buzz now that they’ve passed some of the JOBS Act rules. I think it’s important that everyone understands the limitations to crowdfunding. The more education you can give people, the smarter investors get, the more they’ll choose what’s right for them, which hopefully is continued growth of the market as a whole.
GROGAN: It’s two sides of the same coin. Success will keep it going. A sustained effort is what’s required. If there are other places where a guy can make money running out of the market, you’ll see the money going there. Right now, venture capital and private equity are in vogue because you’re delivering returns that you can’t find in other places.
What has to happen at a micro-level is we have to have returns. We have to demonstrate that you gave us capital, we gave you a multiple back in a prescribed time period that was above the market. If you do that, guess what: You get to do it again — (but only for) realized (returns), not on paper. It’s dollars back and the best time to raise money is right when you’ve given somebody a check back. So that’s why we are in this hurry-up-and-wait mode. People need to be able to hand checks back to their LPs (and say), ‘OK, now it’s time for the next fund.’
PERKINS: We have a few more tools, I think, in the middle market private equity industry to get money back. A couple of years ago, just based on the timing of things, we hadn’t gotten a lot of exits back to the LPs and they weren’t getting it from the market as a whole because everybody was kind of in the same environment. So we did a number of dividend recaps. We paid down debt. We were able to re-leverage the businesses and get some money back to the LPs, which they really appreciate at times when they’re not getting it from other places. We didn’t want to sell those businesses in the market. We wanted to wait until we had finished our plan and done the things operationally that we knew would create value and we just weren’t ready.
These days, what sectors are attracting the most capital?
JOHNSON: This year, more than in the past, we’ve seen clients bring real estate deals to us to review from a legal perspective. They want to put some of their funds back into real estate deals. Granted, it’s only a very small handful, but compare that to years before, where it was none — some people are getting a little bit of an appetite for real estate.
PERKINS: In our world, it’s going to consumer products and to health care. We’ve had numerous kind of year-end investment bankers coming into our office and showing us where deals are being done and it’s health care and consumer products because consumer product businesses are strong. If you have one, you’re selling it.
GROGAN: Right now, from what we’ve seen, health care I.T. is the big play. Health care is starting to settle down. We’re starting to understand where the market might be going. I.T. has a fast-win/fast-lose ratio. You’re going to know right away … and with money trying to see fast returns, that’s attractive.
We know that health care is outperforming every other sector in the market. It’s really the convergence of reporting, of wearables, and in all of those sort of transitions into wellness and self-reporting stuff. That’s where we see the big play is going to be.
D’AMATO: In the short run, I totally agree that health care I.T. is really hot. … I think there will be some interesting opportunities actually in drug discovery … because what people are able to do now is structure-based drug design and computational-based drug design, which was impossible before. The ability to model proteins on a computer is accessible. It’s never happened before. People will be able to design drugs that they prove on a computer will work. They can do a billion experiments in a week on a computer, where you could do a hundred in your lab in a month before that. It’s a fundamental change that means drugs will be more specifically focused to more diseases and targets that were untargetable before.
What sectors outside of health care have grabbed your attention?
D’AMATO: I’ve been trying to wrap my arms around the “Internet of Things” thing a lot and I see some opportunities there. I’m interested in what other people are not interested in. The software world has been too overpriced and too expensive for us, so we haven’t done a lot of software investing. So I’m more interested in what is not as attractive right now.
DEVRIES: We really see this physical product world and this convergence of the technology world playing a huge role in investing in the next 10 years. What we see as opportunity is large strategic companies don’t know how to participate in the technology creation. They have R&D groups, but they are not quick enough to exploit these new developments that are going on. So we see where the venture world is going to be key partners of strategics — as opposed to competitors of strategics — in identifying those technologies that can be embedded into these products that are being made by these large corporations.
What does that mean for places like West Michigan?
DEVRIES: We think that speaks really well for the Midwest, specifically for Michigan, where we still make stuff. When (Start Garden announced the Seamless Accelerator) nationally, we were shocked at how many coastal developing companies contacted us and basically said, ‘There’s no makers of stuff out here. We can program to the moon, but we can’t make it. We’re finding that we have to come back to Minnesota, Michigan, Wisconsin, Illinois today to find the guys who can actually run the machines that build these things.’ Our manufacturing base that for the past 20 years has kind of gone stagnant on us and has been a job loser, we think we’re going to begin to see how technology merging into physical product helps bring back this manufacturing base here.