Investment rules

I was speaking with a friend working in Turkey’s private equity (PE) industry recently. We were talking about the upcoming financing rounds of our startups, and specifically looking to see which companies could be a fit for the PE fund.

As is often the case in our discussions with PE investors, we hit a roadblock when we started talking about the earnings before interest, taxes, depreciation and amortization (EBITDA) figures of our companies. PE investors traditionally look for companies with positive EBITDA.

They do so for two reasons. The first is that they’re less risky than companies with negative EBITDA, and the second (related reason) is that it makes it easier for them to finance the company’s growth through debt which can then be paid down using the free cash flow generated by the business. While free cash flow isn’t the same as EBITDA, companies with negative EBITDA are also likely to have negative free cash flow.

Since our startups are investing in their future growth, they rarely have positive EBITDA and this brings discussions to an end.

While PE investors’ desire to look for positive EBITDA companies is fully understandable, it’s interesting how such criteria can quickly be overlooked when investors are driven by a fear of missing out on the next big deal. For example, PE investors have started actively participating in the rounds of tech companies with negative EBITDA in the US. Examples include FanDuel and Artivest where KKR invested in the Series E and Series A respectively, and Zenefits where TPG invested in the Series C. Granted, with the exception of Artivest, these companies are approaching late stage territory. However, they still have negative EBITDA.

We have yet to see how the returns of these investments play out. Maybe PE investors will achieve great returns on their EBITDA negative venture investments, or maybe they’ll regret bending their rules. But they show that investment rules can be bent in environments where there’s excess capital in the market.