VC firms, tech startups face growing pressure for liquidity. Enter private equity

Investors are demanding to extract returns from VC firms and startups even though the IPO market is still in a state of recovery, reflecting lingering economic anxieties and other factors. IPOs in 2024 have outpaced last year, but activity remains below normal levels, the law firm Ropes & Gray said in an October report.

Those dynamics are driving VCs and more mature startups to create liquidity by selling to private equity, even though the rewards often aren’t nearly as dazzling as in a public offering.

Meanwhile, PE activity in the tech sector is picking up.

Tech as a percentage of total PE deal value was 28.3% in the third quarter, up from 18.7% in the second, as buyers and sellers had an easier time agreeing on prices, according to Pitchbook private equity analyst Garrett Hinds. Capital was cheaper, and PE buyers could pay a little more. “Some of the VC-backed companies that have been private for longer and have sufficient scale have been in the radar of private equity," Hinds said.

Looking forward, he said, private-equity buyers may broaden their interests beyond the highest-quality targets that were evident in the third quarter.

Notable private-equity acquisitions this year include KKR and Dragoneer Investment’s $4.8 billion deal for educational tech company Instructure Holdings and Bain Capital’s $4.5 billion acquisition of financial tech company Envestnet.

Private equity’s interest in tech has been on the rise for years. Tech accounted for 43.3% of PE deal value in the second quarter of 2022, according to Pitchbook.

The 2022 spike reflected Elon Musk’s acquisition of Twitter, now X, according to Hinds. A large PE-backed take-private of a tech company could occur again, given historic levels of dry powder. “It could happen with a PE-backed consortium, like multiple firms split up the equity, and potentially a consortium of private credit lenders back the debt financing," Hinds said.

But PE companies are also highly selective when it comes to acquiring tech companies. Where venture capital firms place lots of bets and hope that a few turn out to be huge winners, PE buyers look for companies with a reliable business model they believe they can take to the next level.

PE firms are particularly drawn to software companies with subscription business models and stable, recurring revenues, although they will look for growth opportunities in other sectors such as AI-supportive data infrastructure deals too, according to Ropes & Gray partner Kate Withers.

All of which means PE can be picky, and isn’t prone to overpaying.

Lane Bess, chief executive of cybersecurity startup Deep Instinct, said his family office, Bess Ventures, invested in companies he thought were going to have a shot at going public in the two to five year range—and many of them have aged beyond that timeframe, according to Bess.

“And now we’re going into 2025 and they’re saying, ‘We hope the window will be open in the next year,’ " said billionaire Bess. He previously was president and CEO of Palo Alto Networks and chief operating officer of Zscaler.

Three years ago, many startups in cybersecurity and other areas of tech were valued at 12 to 15 times forward revenue, he said. Now those valuations are in the revenue multiple range of six to 12 times, in many areas, with the exception of a few areas such as AI and some software-as-a-service players, according to Bess.

A private-equity exit may not be as lucrative or satisfying as ringing the bell at the stock exchange to celebrate a successful IPO. And measured realism feels alien in the tech world, synonymous with a go-big-or-go-home mentality.

But it could have a positive side effect for tech startups, by discouraging marginal companies and investors from contributing to endemic bubbles.

Still, the idea is a hard sell for some, including Bess.

“Personally, selling my company to private equity would be my last choice," he said. “That’s because they’re likely to cut costs to the bone, and they’re likely to let the company sit for a while until they can find some other way to combine the company or manufacture a strategic valuation or re-entry into the public markets."

Others may not share his sentiment.

“A lot of this does come down to investor and board dynamics, to get liquidity," Bess said. “There is a lot of impatience. Investors are now saying, ‘Listen, you know, my money’s been tied up in that company long enough. I’d be happy to see an exit.’ "

Write to Steven Rosenbush at steven.rosenbush@wsj.com