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Sunday, 07 June 2015 22:00

Filling the Funding Gap: More capital required to meet $1.3 billion need from existing Michigan companies

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The venture capital industry’s success over the last decade in Michigan has created a significant challenge as the demand for funding in the next few years far outpaces the availability of capital, requiring a broader approach by managers creating new funds.

The Michigan Venture Capital Association’s annual research report identified an estimated $1.3 billion need from existing portfolio companies for follow-up investments in the next few years. That compares to just $108 million presently held in reserve by venture capital funds.

Prospects to help fill that gap include deep-pocketed institutional investors that historically have not put a lot of money into state-based VC funds — the pension funds, endowments, foundations and family offices. But that could be changing as they now appear to have a greater willingness to invest their money in Michigan companies, sources said.

“There is much more interest by those kinds of institutional investors in getting exposure to this area,” said Loren Andrulis, a partner at Warner Norcross & Judd LLP in Grand Rapids who works with institutional investors. “I have seen an appetite for that increasing among those kind of institutional investors over the last year.”

Institutional investors in the state may have always had a degree of willingness to get more involved in Michigan-based funds, he said. With the industry’s growth in the last decade and the state’s economic rebound, “maybe there’s just a little bit more of an ability now,” Andrulis said.

“There’s a level of maturity locally that’s increasing that allows those kinds of institutions to make that investment now,” Andrulis said.

Jim Adox, chairman of the MVCA, recalls a recent meeting he had with more than 30 representatives from Michigan-based institutional investors “to bring them up to speed about what’s been going on in Michigan” with the growth in venture capital that’s been outpacing the nation. He found them at least willing to consider steering their investments as limited partners into venture funds in the state.

That interest reflects the growth of the industry, said Adox, managing director for Madison, Wisc.-based Venture Investors LLC’s Ann Arbor office.

“I heard people say that Michigan and venture capital could be at that tipping point where we’re experienced enough, successful enough and have good returns, that we’ll now look at investing in them,” said Adox, a 17-year veteran of the VC industry.

“They said, ‘Wow, there’s a lot more going on in Michigan than I recognized. We’re going to give you guys a look.’ They kind of opened the door,” he said. “I’ve been here a long time and this really is the first time that door has been opened.

A few of them were supportive and made investments in a couple of the funds (in the past). Now there’s more opportunity for that, and hopefully as things continue to grow, they’ll invest in more.”

RAISING CAPITAL

At the end of 2014, in-state and out-of-state venture firms in Michigan had $4.8 billion in capital under management, which compares with $4 billion in 2013 and is double the amount of five years earlier, according to the MVCA report.

Across Michigan, 12 firms based in the state were actively trying to raise $652 million in 2014, according to the MVCA. The organization expects nine firms to seek to raise $599 million in 2015. Thirteen firms will look to raise $676 million in 2016, the report states.

Part of the higher interest from institutional investors stems from the maturation of the state’s venture capital industry that has many firms now looking to form larger, successor funds in the next few years, said John Kerschen, co-managing director of Michigan Accelerator Fund I in Grand Rapids.

Michigan-based funds that formed in the last decade continue to progress with their initial investments and reached a level where they will “be generating returns to those investors that are attractive,” Kerschen said. “That will help draw more LPs that can contribute larger dollars into our next generation of funds.”

Institutional investors have been reluctant to put money into the small, first-time funds in Michigan that have formed over the last decade and first want to see a track record of success, he said.

“Institutional investors that can invest all over the country or all over the world aren’t going to entrust large sums of money to small, first-time, unproven fund managers — and most of us in the state are still in that early development,” Kerschen said. “The bulk of the Michigan-based venture organizations are still relatively young and we need to prove our capabilities via returns.”

Michigan Accelerator Fund I has so far invested $10 million in eight portfolio companies. The firm in time will begin to look at forming a second fund, Kerschen said.

GAINING SPEED

A record 51 startup companies collectively received $204 million in venture capital investments in Michigan in 2014, according to the MVCA. Locally, a dozen West Michigan companies received more than $29 million in venture capital funding last year.

MVCA Executive Director Maureen Miller Brosnan points to indicators that suggest the industry can maintain its momentum.

Michigan ranks seventh in the nation in the number of Ph.D. degree holders per capita and sixth in patents issued — two key areas for innovations that an entrepreneur can build a startup company around. However, the state rates poorly in VC invested per dollar of federal research funding, indicating plenty of opportunity for private capital to play a larger role and “creating a fertile ground for venture capital investment activity,” the MVCA report states.

The growth is not only predicated on attracting more institutional investors to Michigan but out-of-state money as well.

More venture firms have been setting up an office or seeking to invest in Michigan in recent years. Of the total capital under management in 2014, $1.7 billion came from firms headquartered in Michigan, up from $1.2 billion in 2010.

Meanwhile, $3.7 billion was from out-of-state firms with a presence or office in the state, which compares to $1.4 billion at the start of the decade.

The present state of the VC industry in Michigan is far different from when Adox began his career. At that time, there were just four venture funds in Michigan and a handful of investment professionals.

“There was no industry. It was just kind of individual fund efforts,” Adox said. “It was tough sledding, especially if you were doing early-stage companies that are a lot of work. Now … it’s a totally different world.”

Today, there are 37 venture firms — both Michigan-based firms and out-of-state firms with an office in the state — doing business in Michigan, up from 33 in 2013 and 25 in 2010. The number of investment professionals nearly doubled in the same period to 102 last year.

GROWING ANGELS

As venture capital grew in Michigan over the years, so did angel investing.

The MCVA did not track the number of deals or the dollar value of angel investments in 2014, but it did note in the annual research report that the nine angel groups in Michigan had 257 investors, a 37-percent increase from five years earlier.

There are 210 startup companies in Michigan now backed by angel money, up 200 percent from 2009, according to the MVCA.

“This is a sustainable industry now in our state,” said Jody Vanderwel, president of Holland-based Grand Angels and a director at the MVCA.

Entrepreneurs today are much more aware of angel investors as a potential source of startup capital and have more options to consider, she said.

Likewise, it’s become a more attractive option for high-net-worth individuals who are seeking an alternative investment, which in turn helps the state’s overall entrepreneurial climate, Vanderwel said.

“This is a great place to make investments,” she said. “That increases the amount of capital available and increases how attractive the state is to entrepreneurs, because if one angel or VC group turns you down, there are others to turn to who might be a better fit for your company.”

In the 10 years since it formed, Grand Angels alone has put $16.2 million into 32 companies through 77 financing rounds. The group in 2014 invested $2.5 million in 12 deals, four of which were new and eight of which were follow-on investments in existing portfolio companies. Grand Angels has a 2015 goal of doing 15 deals for a collective $1.5 million.

INCREASING AWARENESS

As venture and angel investing grew over the years, private equity has also remained on a steady growth trajectory.

As of 2013, Michigan had 386 private equity-backed companies that collectively employed more than 52,000 people and generated sales of $6.83 billion, according to growtheconomy.org, a website maintained by the national Association for Corporate Growth.

That compares to 321 companies with 37,860 employees and $5.15 billion in sales a decade earlier. While the growth in private equity in Michigan slowed during the worst of the state’s downturn from 2007 to 2009, research indicates that PE-backed companies performed better than their peers.

In the Grand Rapids area, for instance, 24 PE-backed companies from 2000 to 2013 grew jobs by 13.9 percent, versus a decline of 9.1 percent for all other companies, according to ACG Western Michigan. They grew sales by 29.7 percent in the same period, compared to a 16.5-percent decline at all other companies.

In the Kalamazoo area, eight companies backed with private equity grew jobs by 72 percent from 2000 to 2013 and saw sales increase by 68.9 percent. All other companies had a collective job loss of 3 percent and a 1.4-percent sales decline, according to growtheconomy.org.

Jason Byrd, a managing director at Charter Capital Partners in Grand Rapids and a member of ACG’s global board of directors, said private equity has become an increasingly viable option for business owners seeking growth capital or who are willing to part with a majority stake, although more deals are occurring that involve minority investments.

Still, he said, private equity can do a better job of promoting itself. The ACG organization has been making a “big push” to create more awareness of private equity and its role in the economy, Byrd said.

“There’s certainly more awareness, but I still believe there is more room for improvement, and maybe a little bit outside of the business community as well,” Byrd said. “We want to get more business owners comfortable that aren’t comfortable with it, and then it’s that next layer of legislators and regulators that need to understand our market as well as they do other industries.”

Michigan is a lower- to middle-market state for private equity, with transactions typically ranging from $10 million on the low end to $250 million at the top, Byrd said. More funds are getting started in the state, more funds outside of Michigan are looking to invest here, and family offices are increasingly looking to make direct investments, Byrd said.

Private equity funds could find a potential match in companies whose owners are ready to exit, including those who want to stay on and continue running the business. Many private equity firms like to retain management and prior ownership to maintain continuity, Byrd said.

The retirement of business owners from the baby boomer generation who lack a next generation to sell to or to turn over the company to should drive a good number of private-equity deals in the years ahead, he said.

“You’re just going to see this consistent process of private capital coming into what has historically been family-owned business,” he said.

 

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