COMMENT
What Venture Capitalists Do

By David Kuo (TMFDragon)
July 18, 2005

Venture capitalists are often misunderstood. They are frequently portrayed as money-grabbing asset strippers that have little regard for the future of employees. Naturally, many venture capitalists will disagree with such statements!

Venture capitalists often invest in companies that cannot easily raise money elsewhere. These include money for start-up businesses and funds required for companies in turnaround situations. However, venture capitalists also know that not all their investments will pay off. Consequently, sometimes businesses may be sold piecemeal, which can give the impression that viable concerns have been stripped of its assets.

Generally, it is estimated that for every ten bets that venture capitalist make, two will fail, six will be marginally profitable and just a couple will triumph. Nevertheless, the two successful investments can provide lucrative returns that more than compensate for lacklustre returns elsewhere, with the initial sum being multiplied several times.

To be successful, though, venture capitalists need to realise their investments regularly. This is so they can continually reinvest money into more profitable projects. Consequently, venture capitalists are unlikely to be long-term investors. By and large, they hold investments for around three to ten years before they sell the business on or, in the case of their larger holdings, float them on the stock market.

For example, earlier this year, venture capitalist CVC Capital Partners tripled its initial investment in IG Group (LSE: IGG) after the spread-betting firm was successfully floated. In July 2003, the private equity firm bought IG for just £143m after its chairman and largest shareholder Stuart Wheeler decided to sell. (Wheeler said he needed the cash to renovate a Scottish castle he had just bought!)

The deal was struck at a time when spread-betters were suffering from a downturn in market conditions. According to IG's chief executive Nat Le Roux, attempts to sell IG as a going concern to institutional investors failed miserably. That left the company with little option but to seek a management buyout with help from venture capitalists.

Interestingly, during its two years under venture capitalist control, IG introduced new products such as binary betting that allows punters to take or lay bets on financial and sports events. This side of the business now accounts for around 10% of group turnover and is growing rapidly. It is unclear if IG would have introduced this fast-growing product if not for the intervention of CVC. Nevertheless, the reinvigoration of IG partly explains why it now commands a much higher valuation than before.

Many companies such as IG Group have prospered whilst under the control of venture capitalists. Other examples include Premier Foods (LSE: PFD), Halfords (LSE: HFD) and Center Parcs (LSE: CPK). Venture capitalists prefer businesses with good cash flow, which can then be used to pay off the large amount of debt that they traditionally use to fund each deal. As businesses with good cash flow tend to make good stock market investments, it can be worth investigating further when previously venture capital backed company come to the market.

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