Investment Criteria – Warsaw Equity Group

What venture capital funds can learn from private equity funds?

Author: Paweł Maj, Investment Director, Warsaw Equity Group

The vast majority of investment funds focus exclusively on one model. Either venture capital or private equity. There are relatively few examples, such as Warsaw Equity Group, where we combine these worlds by investing both at VC and PE growth stages. We work with startups on strategic and operational level focusing on value creation. You can read more about our investment criteria in our tab: Investment criteria – Warsaw Equity Group

Just as important are the differences between VC and PE as the similarities that unite them. VC funds are said to be more dynamic than PE. Here, the growth of a startup is more important than operating profit. Meanwhile, PE funds are said to be more conservative and focus on investing in profitable companies.

According to analysts’ predictions, 2023 will be a time of great change in the start-up market. The article published in My Company Poland (February 2023) includes my opinion on this topic. As investors, we’ve turned away from “growth at all cost” approach and started to focus on startups that combine growth with good unit economics.

Therefore, let’s compare VC and PE funds and see what VCs can learn from PE funds.

Differences:

PE funds usually invest by buying existing shares from the current owners (cash in the hands of shareholders) and VC funds usually invest by increasing capital (new issue of shares, cash in the bank account of a given company).
PE funds typically invest in mature companies that are generating positive cash flow, while VC funds invest at a much earlier stage (before companies are profitable, and pre-seed and seed VC funds even before a finished product is created or a startup begins to generate revenue).
PE funds usually take control of a company by buying between 50% + 1 and even 100% of the shares. VC funds, on the other hand, usually invest in minority stakes (usually around 5-20%).
When investing, PE funds assume that each of their companies will be successful (i.e. their shares will be sold at a higher valuation than when they were bought), as they invest in mature companies (already generating profits and positive cash flow), which are much less risky than investing in start-ups. On the other hand, VC funds invest in startups at a much earlier stage (when they are still unprofitable, and in the case of pre-seed funds, even when a startup doesn’t have a product ready), which means that they expect as many as half of their investments to fail (defined as selling their shares for less than the value of their investment), This means that they expect even half of their investments to fail (defined as selling their shares below the investment value, and in extreme cases even losing everything if a startup goes bankrupt), but at the same time they hope that 5-10% of the portfolio companies will be spectacular successes (increase in company value by 30 times or more), enabling the fund to generate a profit for its investors.
PE funds usually invest alone and VC funds usually co-invest with other VC funds.
PE funds generate a return on their investments mainly through financial engineering (leverage buyouts of the companies they invest in) and by increasing the EBITDA of the portfolio companies (optimisation of internal processes as well as mergers and acquisitions), and VC funds mainly through the rapid revenue growth or unique IP of their portfolio companies.
VC funds invest in a much larger number of companies than PE funds. VC funds invest at a much earlier stage and with a higher risk per deal, thus spreading the risk of the portfolio and increasing the probability of investing in a fund returner (an exit that generates at least an amount equal to the size of the fund) by investing in a much larger number of companies/start-ups (a pre-seed fund should invest in +100 start-ups, but a later-stage fund might invest in only 20-30 start-ups). PE funds invest at a much later stage of a company’s development with much less risk, so they can accept a much smaller number of companies in the portfolio (typically 10-30), which also allows them to focus more on each of them.

Similarities:

VC and PE funds raise capital from external investors called LPs (limited partners), including fund of funds (private and public), high net worth individuals, pension funds, insurance companies, corporations and university endowments.
VC and PE funds invest in private companies (or, in the case of PE, in listed companies which they delist after purchase) with the aim of earning a return on their investment in the future.
VC and PE funds charge their LPs (investors) a management fee of 1-2% per annum, calculated on the value of the assets under management, and a carried interest (performance fee) of approximately 20% of the profits generated for the LPs (assuming the fund’s profits exceed the agreed minimum profit level, known as the hurdle rate).
VC and PE funds invest through investment vehicles that typically operate for 8-10 years, half of which is spent building a portfolio (initial investments) and half on building value/supporting companies and exits.
VC and PE funds expect to earn 3x the capital they have raised for their investors over the 8-10 year life of the fund, although each has a diametrically different approach to portfolio risk management.
VC and PE funds are very selective, investing in around 1% of the companies analysed.

What VCs can learn from PE funds:

Involvement in each portfolio company as an owner, not just a minority shareholder.

VC funds focus primarily on supporting their stars (best performing companies with the potential to return 30x or more of the amount invested) and spend less time or none at all on their remaining portfolio companies. PE funds, on the other hand, support each of their portfolio companies, working to build value and maximise the potential sale price, as each investment (even the less successful ones) has a significant impact on the performance of the overall fund. In addition, PE funds commit their entire teams to supporting portfolio companies, employing advisors, experts and mentors not only to help with the next round or exit, but also to provide strategic and operational support.

Take full responsibility for each portfolio company.

VC funds often co-invest with other VCs, with the lead investor (usually the fund that invests the largest amount in each round) having the most decision-making power and the other investors in the round playing a more passive role. What’s more, in the case of a next round, new investors (including a new lead investor in particular) take over decision-making from existing investors. This blurs the lines of decision making and responsibility in the company, and at the same time the founders/managers of the company are often faced with a dilemma in taking advice, especially if it is conflicting.

On the other hand, PE funds invest alone and take full responsibility for the portfolio companies, as they are the only investor and cannot transfer responsibility to anyone else. From the company’s perspective, this means that a PE fund is much more involved in supporting its portfolio (hiring a much larger team, investing more time and resources), which also translates into a much higher probability of success for such an investment.

A long-term approach to working with portfolio companies.

VC funds invest with a 3-5 year horizon to exit, but they work closely with their startups for the first 12-24 months after their investment, hoping that the startup will attract more investors in the next round to take responsibility for its growth. This short-term perspective also applies to the approach to financing capital needs – VC-backed startups are indeed in a continuous fundraising process (the interval between rounds is on average 12-24 months), and most of the cash raised in follow-on rounds comes from new investors.

On the other hand, PE funds take a long-term approach to their investments, remaining hands-on throughout the investment period and providing their companies with all the capital they need to develop until the exit (PE fund portfolio companies usually do not need to raise capital from follow-on rounds until the company exits or at least goes public). For the company, this means that it can focus fully on its operations without being distracted by raising the next rounds of financing, as is the case with VCs).

Careful approach to investments in terms of valuations and due diligence.

VC funds decide relatively quickly to invest in a given startup (usually within a few weeks from the first meeting to the signing of the term sheet), often accepting high valuations relative to the stage of the project and its traction (in this case, VCs assume that the startup will quickly grow up to its valuation, an extreme example of which we saw between the 2020-2021 bull market, during which investors accepted valuations several times higher than the long-term average), and conducting superficial due diligence.

On the other hand, PE funds take months, not weeks, to make an investment decision, approach the company’s valuation cautiously (assuming that the EBITDA multiple at the exit will be similar to the one at the time of investment, so that the increase in the company’s value, which will generate a profit for the fund, will come mainly from the increase in EBITDA during the investment period and possible financial leverage of the transaction), and carry out in-depth due diligence (covering the team, the company, the technology, the market, the competition).

Ongoing operational involvement with portfolio companies.

VC funds rarely become operationally involved (focusing mainly on helping their portfolio companies raise capital and exit), and when they do, they respond to existing problems by putting out fires rather than systematically building value.

PE funds, on the other hand, analyse each of their companies in detail and become operationally involved if there are alarming signals, bringing in external advisors/experts if necessary.

Article was originally published in Polish language in January 2023 (MamStartup.pl):Czego fundusze venture capital mogą nauczyć się od funduszy private equity? – MamStartup

Business development is part of our DNA. We’re not focused on chasing unicorns.

Author: Przemysław Danowski, Managing Partner, Warsaw Equity Group

Despite the tempting prospect of looking for and having a significant stake in a company valued at over $1 billion in our portfolio – we have decided to take a different route. One that is less media-savvy but equally effective. This isn’t because of a lack of ambitioun. Given the small number of companies with unicorn status in our region, especially in the group of companies that were established less than 10 years ago, we decided to pursue a more “down-to-earth” and, in our opinion, more effective investment model – especially in terms of portfolio structure. At Warsaw Equity Group (WEG) we search for the optimal financing models for our companies while remaining flexible. We believe that strong businesses are built first and foremost thanks to a competitive/technological advantage – not just by giving a growing business access to funds raised in the venture capital model. We believe that this flexibility is important, especially in the long term, when is vital to keep in mind the concept of economic cycles and the fact that cheap financing is not always available.

History is on our side

At Warsaw Equity Group, we invest the private equity of the our two founders, who have worked together in business for nearly 30 years. It is access to these private funds that gave us a great deal of flexibility in terms of developing our strategy – allowing them to work best for the companies we invest in and – consequently – give us satisfactory rates of return.

Over 30 years, we have made nearly 60 investments in both the private equity and venture capital segments. We have also carried out venture building investments.

We successfully executed investments in which we held controlling as well as minority stakes achieving an average return on capital of 8x. Among the projects from which we exited or completed a partial exit are such companies as Gadu Gadu (84x), Vigo Photonics (20x), Artifex Mundi (15x) and Tektura Opakowania Papier (8x).

Until 2015, our strategy could be described as opportunistic. We had no defined sector criteria, and our investments included both restructurings and growth companies. Since 2015, after Krzysztof Dziewicki and Przemek Danowski took over responsibility for WEG’s development, we decided to exclude restructurings from our strategy. We focused on cleaning up our existing portfolio and worked intensively with our growth companies. Until 2020, we primarily pursued follow-ons. In addition, we made investments in two new companies.

During the 2015-2020 period, we also refined the operating model and services offered to our companies. Our entrepreneurial approach in working with companies has evolved into a strategy that we call ‘Partners for Growth’. In this new strategy, we have placed a great emphasis on a partnership-based approach and openness that allows us to communicate effectively and overcome challenges that arise – together. We have also decided to invest exclusively in growth companies, supporting them with our team’s unique set of skills, which they have developed doing business on various markets (including Poland, USA, UK and China), in private equity and venture capital investing as well as the consulting and investment banking industries.

WEG’s business model

Our model for building the value of our portfolio companies is built on three pillars: Business, Human Capital and Community.

In the Business pillar, we provide the capital needed to execute a growth strategy, while focusing strongly on strategic development, setting objectives, executing initiatives and preparing the organization for scaling. We then support it in achieving the highest possible efficiency in key processes.

A pillar that we consider absolutely critical to success is Human Capital. As part of this pilar, we help select talent best suited to specific strategic implementations, build organizational culture and support leaders in their individual development i.e. through a mentoring programs. Dawid Bienkowski is the person responsible for this part of the puzzle in our team.

We complement our offer by building a community – enlisting experts and advisors who can support the implementation of a companies’ strategy using their insight, contacts and knowledge of best practices in a given industry/on a given market.

Our investment focus

The changes implemented have resulted in dynamic growth of our organization, which has allowed us to take another step in the evolution of our investment criteria.

We currently manage more than PLN 600 million and execute our ‘Partners for Growth’ strategy by investing in companies at various stages of development, investing from PLN 4 to 40 million in CEE growth companies. In the venture capital segment, we invest from PLN 4 to 20 million, while in the PE growth equity strategy we invest from PLN 20 to 40 million.

In the venture capital segment, we invest in late seed/series A companies experiencing dynamic growth with recurring revenues of at least EUR 50 thousand MRR, in the case of software, or EUR 50 thousand first margin in the case of hardware. In the PE growth equity segment, we invest in companies with lower growth rates, but with sufficient scale to build a growing yet profitable business.

In the pre-seed and seed segments, we make investments using the ‘fund of funds’ formula. We assume an investment in one fund of 1 to 3 million EUR and gain exposure through 5-7 funds to 200 projects that are at a very early stage of development.

In the first half of 2022, we invested about PLN 20 million in 2 projects. We plan to invest another PLN 200 million in 10-20 projects over the next 2-3 years – with a decisive focus on automation and sustainability in our strategy.

In the first of these segment, we are investing in projects and technologies that automate processes in companies and increase their efficiency. We believe that the trend of automation and efficiency-seeking will become increasingly important, particularly as companies struggle to remain competitive in a market where more and more technologically advanced products will be available, and access to an employee, especially one who performs repetitive tasks, will be increasingly limited – particularly at reasonable rates that make sense in economic terms – for an existing business.

In the second segment, we are investing in projects designed to achieve a positive environmental and social impact. Increasing public awareness and simultaneous activities, including legal regulations, to reduce carbon emissions will result in the development and bringing to market of appropriate technologies. At the same time, these ventures will require more patience from investors. Investors’ expectations (rate of growth in the initial post-investment phase, investment horizon, level of risk, etc.) will have to evolve. We believe that, as an investor with private capital, we are predestined and at the same time responsible for participating in the implementation of these kinds of investments.

Softwarehouses with products related to automation or sustainability are also in the spectrum of our interests – these are bootstrapping businesses with an appetite for continued dynamic growth. We also invest in more mature companies that are on the IPO path, 2-3 years before the IPO.

We want to invest in projects that have the potential to achieve, at the time of our exit, depending on the strategy, valuations ranging from a large few hundred million PLN to several hundred million USD. Such a defined approach allows us to think flexibly about financing company strategies, reduce the risk of failure and thus decrease the pressure of us chasing unicorns.

We have decided to specialize in the above segments. Additionally, to become a better ‘Partners for Growth’, we decided that our team should become more specialized. Pawel Maj is responsible for the venture capital segment, and Arvin Khanchandani is responsible for sustainability. Further specialization will allow us to add more value in cooperation with the entrepreneurs, founders and shareholders of our portfolio companies.

Private equity and venture capital investment will increase in Poland and CEE

Although the private equity / veture capital market has developed significantly in Poland as well as CEE as a whole, there is still a large gap between this region and the most developed markets or the European average. Treating Poland as a representative of the CEE region, we see on the basis of Invest Europe data that in 2021 venture capital and private equity investments accounted for 0.015% and 0.19% of GDP, respectively, while the European average is 0.1% and 0.762% (for the UK these ratios are 0.262% and 2.474%, respectively). Thus, in Poland and the region as whole, there is a very large range of 4-6 times in comparison to the European average and 13-17 times when compared to the UK – the European leader in this respect. This difference should decrease thanks to the emergence of new local funds as well as the increased activity of foreign funds in the region. Competition among funds will grow significantly and, in our view, generic venture capital business models will have to modify over time – especially given the fact that the era of cheap money

has come to an end in this cycle. Already today we see that out of just over 100 active venture capital funds in Poland, 150 foreign funds have made at least one investment in our country.

In 2018-21, there was an undoubted boom in the private equity/venture capital market and inflated valuations caused led to an abundance of cheap money on the market. Under these circumstances, the dominant venture capital strategy was the “founder friendly at the stage of investment approach” approach – one that accepts a very high valuations and extremely liberal transaction terms. This was when venture capital funds, among others, attempted to secure access to the best companies – which defined as those with the potential for dozens of times return on capital and the potential to achieve unicorn status – in other words companies which fit the standard pattern of venture capital investment and portfolio construction.

In our opinion, this approach will change in the coming years and venture capital funds will take a more active role in securing their rate of return. Models that will be “founder friendly” from business development to exit will prevail. These will require quite a bit of work from the management teams and a relatively large amount of support – also for those companies that may not reach unicorn status. WEG already offers this kind of cooperation model today.