High-return investing can be divided into two camps. In the US, we label these ‘Venture Capital’ (VC) and ‘Private Equity’ (PE). VCs invest in new, small companies who use the funds to essentially create something out of nothing. PE funds invest in established companies that could use a little care. Both are seeking outsized returns, but the nature of their targets dictate very different capital structures.
VCs buy equity in companies hoping to capture a big piece of that enormous growth. Invest $2 in a company and then sell that stake for $12. By contrast, PE funds seek their returns through the use of leverage, or borrowed money. Buy a company for $10, borrow $8, sell the company for $20, then pay back the loan, and yields a $12 return. This structure dictates the types of companies each side can invest in. VC funds have to be very good at identifying high growth potential – new markets, hot trends, etc. PE funds look for companies that have recurring revenue, those that can afford to pay the interest on those loans.
As a result of all this, PE funds have largely stayed out of tech. By its nature, tech is very risky with significant technology risk on top of just normal execution risk. If some over-the-horizon technology comes along and obsoletes a product category, incumbent companies cannot maintain their loan payments and puts the PE investment at risk.
Could this change? Private Equity funds like predictable, stable businesses with long-term recurring cash flows. After two decades of consolidation there are a lot of of semis companies operating in near-monopoly positions. While high-performance, leading edge chips can quickly become obsolete, there are plenty of chips that were designed 20 years ago and are still selling well today. As we noted a few weeks back, over 80% of semis industry output takes place on trailing edge fabs, and most of those chips are old designs. We recently caught up with a friend who designed a product 15 years ago that is still selling tens of millions a year. It is nothing fancy, it is just that no one has bothered to replace that status quo. Those cash flows sound pretty stable and long-term.
This means that a lot of semis companies could become ideal targets for private equity. At the moment, most semis companies are in good health, flush with cash. So they do not need PE investments, but the markets are fickle. There is the possibility that the Street overshoots in the current downturn with overblown fears of inventory overhangs and other terrors of the dark. This force alone could push many semis companies, especially those in un-glamorous markets, into perfect range for a PE buyout.
There is also likely still room for further consolidation. Someone could come along and buy up a handful of mid-sized semis companies, combine them into one, squeeze out some costs and end up with a healthy return. Of course, there are not a lot of targets left, and a big part of the reason for that is that someone has already run this playbook. For years, Broadcom has essentially been run as a private equity fund, with backing from an actual PE fund – Silver Lake. Broadcom proved the model, and we suspect that there is room in the industry for someone to replicate it with a bunch of companies that are now too small to hit Broadcom’s radar (to say nothing of the fact that Broadcom seems to have moved permanently into software).
A bit more pressure on semis stocks and an ambitious semis CEO or two, could very well mean that Private Equity joins the semis party.