Is small still beautiful?

Are small businesses less attractive investments these days? Well, it depends on whom you ask. The answer given by a well-established private equity house is likely to be different to the one from a business angel actively backing innovative young companies.

Once upon a time, there were much clearer divisions between the levels of funding provided by different types of equity providers. Business angels (high net-worth individuals) invested lump sums in early-stage companies, venture capitalists (VCs) provided development capital for particularly risky ventures and private equity firms were happy to muck in once profits were rolling.

Mark Wignall, chief executive of Matrix Private Equity Partners, recalls the days when, ‘people were falling over themselves to invest in young, early-stage companies.’ It wasn’t that long ago, he says, that venture capital group 3i dominated the market with, ‘a high-street presence a bit like a bank, so you could pop in during a trip into town and pick up your risk capital!

‘Then 3i shifted its focus and diversified into other areas and started making much larger investments, leaving a gap for small investments into which a host of other equity providers moved.’

However, many of those now concede, in private if not in public, that market forces in the last five years have inevitably precipitated a move by VCs and private equity backers away from small, risky investments towards larger, later-stage deals. This trend is what James Steward at private equity group ECI Partners calls ‘the flight to quality.’

‘We make a judgement based on the balance between how risky and time-consuming it is to invest in the company in question and what the rewards are likely to be if the gamble pays off. This risk-reward ratio is at the heart of any investment,’ he counsels.
‘Private equity providers are therefore leaning towards conducting fewer transactions, but ones of larger value, because this spreads risk more evenly and brings greater returns.’

Chris Clothier of business angel group MMC Ventures has witnessed the same trend, pointing out that, ‘many equity firms – Advent International is one example – have moved away from providing risk capital and now predominantly back buyouts. Levels of liquidity in the market are still high, so they have large amounts to spend and it’s just not economical to do small deals.’

Laurence Garrett, a partner at 3i’s venture team and director of the group’s Cambridge office, has been conducting venture technology investments for 12 years. He believes, ‘This upward trend has been happening for some time, but it’s a bit of a chicken and egg scenario. Deal sizes are going up because the costs of building substantial businesses are moving up.

‘When I first started in venture capital, you could build successful companies for £5 million. I haven’t seen a business that’s exited for substantial money in the last five years that’s been built on £5 million. Add to that the fact that investors want to work on fewer deals because they don’t want to spread themselves too thinly and you can see that the average deal size is bound to move north.’

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