Venture capital investors are going to school on the education sector, hoping to help drive changes in the primary, secondary and post-secondary systems.
According to a July analysis done by Chicago education-focused advisory shop GSV Advisors LLC, there were 168 venture and growth placements in the education sector in 2012, as compared to 80 two years earlier. And the MoneyTree Report, an analysis of Thomson Reuters Corp. data by PricewaterhouseCoopers LLP and the National Venture Capital Alliance, venture capital investment in education businesses has grown 80% since 2005 to more than $632 million in 2012.
"Education technology is a hot space. Many VC funds are active here," said partner Emilio Ragosa of law firm Morgan, Lewis & Bockius LLP. He cites Union Square Ventures, First Round Capital and FirstMark Capital as particularly energetic participants.
The investment activity comes with the education sector undergoing a technological revolution of sorts. Computers and the Internet allow for instantaneous delivery of content, and venture capitalists and traditional publishers have established business that are helping to drive these changes.
But the industry presents some peculiar challenges. For one thing, most of the edtech startups' customers are school districts, which have temporal and fiscal budgetary constraints. For another, the length of time necessary to develop an education business will not meet many VC firms' requirements.
And some of the technological innovations that draw VC investments are not universally popular. For example, the expansion of broadband Internet access has enabled the development of so-called massive open online courses -- essentially huge classes conducted on the Web -- that proponents claim will upend the traditional higher education regime. But critics of MOOCs point to statistics showing low completion rates and question the quality of instruction provided. So while several major universities have adopted MOOC offerings, a pedagogical backlash could slow the growth of the concept.
Nonetheless, VC investors continue to pour money into the education space at an ever-increasing clip, and have nearly tripled the amount over the past decade. Investments in edtech companies nationwide rose to $429 million in 2011, the latest year with available data, from $146 million in 2002, according to statistics from the National Venture Capital Association.
Why the rush? And why now? Education industry banker Peter Yoon, managing director at New York's Berkery, Noyes & Co., rattles off a few reasons. "First, the size of the sector. In terms of percentage of [gross domestic product], it's No. 2 behind healthcare," he said. "In the K-12 space alone it's about $700 billion. I think investors at venture capital firms have seen that education and training has outperformed other sectors and GDP in general during the Great Recession."
Students in the U.S. educational system are increasingly acclimated to digital communication and content delivery in several other aspects of their lives, and technology proponents believe the school system must adapt both to more effectively disseminate information and cut costs, particularly when the value of a traditional education program is being seriously questioned.
"Education is going through a period of tremendous transition, transformation, disruption," said Yoon, adding that entrepreneurs and investors in edtech see opportunity amid all the technological dislocation.
ONE SUCH INVESTOR is Ted Mitchell, president and CEO of Oakland, Calif.-based NewSchools Venture Fund, founded in 1998. "Our inbox is pretty full all the time. We probably look at between 50 and 75 operations over the course of a [month], probably advance four or five into diligence and we'll [invest] in one. So our pipeline is pretty robust," he said.
Mitchell said NewSchools is structured as a nonprofit organization that allows the shop to invest in both for-profit and nonprofit institutions. "When we secure a return, the money stays in our funds, we don't return capital to investors."
NewSchools has a $10 million fund dedicated solely to education technology investments, and a second related fund of about $15 million. The latter fund focuses on ventures that work to change how teachers are trained administratively -- how they deliver lesson material through lectures and administer classwork or homework assignments. It funds ventures that work to foster professional development. Technological concepts like distance learning play a big role here.
"When you've got the kids and the teachers demanding the technology, it's a demand hole equation, rather than a supply push equation that's changing the market."
Mitchell described several of NewSchools' investments and related how the companies in question took advantage of the firm's backing. "Usually it's about hiring people, maybe more engineers, maybe it's an operations person, maybe even a sales and marketing person," said Mitchell.
He cited an October 2011 investment in San Carlos, Calif.-based Education Elements Inc. The company sells a software platform that manages plug-ins to synthesize and aggregate curriculum content and data.
"We put in $250,000 into Education Elements initially and that was really sort of [startup] phase. They used it to hire engineers to help build out the platform," Mitchell said. "Subsequently we put another $250,000 in and they used that to help hire people on their design team who are out talking with districts, consulting with them about how to incorporate technology into the classroom."
Another venture the firm backed is online video library, practice exercise and assessment business Khan Academy. The firm put $200,000 so that the business could hire more engineers.
NewSchool's two major exits were News Corp.'s acquisition of 90% of Wireless Generation for about $360 million in cash in November 2010 and the August 2011 sale of Pittsburgh math textbook and software publisher Carnegie Learning Inc. to for-profit college operator Apollo Group. He couldn't give specific return figures.
THOSE DEALS DEMONSTRATE the main exit strategy for edtech investors: M&A. Both the larger strategics and private equity-backed companies like McGraw-Hill Education Inc. are using M&A to build out their adaptive learning and content delivery capabilities. "I think if we had our whole portfolio here and asked them to raise hands ... about an exit, my guess is that the IPO side would be the smallest and acquisitions the largest," Mitchell said.
"It's often that the innovations come from these small companies," explained Morgan Lewis partner Robert W. Dickey. "They come up with some new technology for distance learning or a mobile application, and the larger strategics see these as opportunities [to] buy a technology they couldn't build as efficiently and then scale it out into their own business model."
Many of the targets they look for initially start out as venture-backed business. "Education in general is probably a middle-market sector, probably a little lower. If you got a company that is getting in the range of $40 million to $50 million in Ebitda or so, then you are quickly gobbled up by another strategic or you're thinking about going public," said Yoon.
In addition, education-focused publishers, among them Pearson plc, have themselves invested in the venture firms that help grow the types of companies that they may eventually acquire.
For instance, NewSchools Venture Fund counts Pearson as a limited partner. And New York-based Macmillan Ventures serves as the VC arm of Macmillan Publishers Ltd., a publishing house controlled by Verlagsgruppe Georg von Holtzbrinck GmbH. The VC business was founded in September 2010 and is headed by Troy Williams, former CEO of early e-book company Questia Media Inc.
"We have seven portfolio companies now," Williams said. "Typically the companies are somewhere between $1 million and $10 million in revenue. We don't release deal size per se but most things are trades somewhere between 3 and 4 times sales and 8 to 12 times earnings."
The publishing giant initially gave Williams more than $100 million -- he won't say exactly how much -- to acquire edtech startups that will eventually be the future of Macmillan. The plan is to let them exist autonomously like startups within the organization, as Macmillan transitions out of the content business and into educational software and services industry. Williams looks to do around 10 to 15 deals over the course of the next four years or so.
"We have about 300 people in all the businesses in the portfolio. On the investment side, it's a small time of about two to four people depending on the deal. Once we get one deal to the table, we kind of shut down parallel tracks," he said.
Over the past 18 months, the firm's portfolio expanded to seven businesses from two. Williams said the firm is big on helping edtech startups sell and market their product and also upgrade the technology involved when possible.
"We'll surround the founder with senior marketing and senior sales people and obviously professional IT product development and engineering [talent]," Williams said. "In edtech, it's the sales and marketing that's a challenge, and it's hard to get to that first million in revenue until you get some progress on this."
Macmillan New Ventures' investments include adaptive learning and classroom quizzing engine PrepU, one of the initial platform companies; Austin, Texas-based online homework and gradebook company Sapling Learning Inc., bought in November 2012; and virtual science lab business Late Nite Labs of New York, acquired in March 2013.
Ryan Craig founded University Ventures in early 2010. The firm focuses on the higher education market to avoid some of the policy entanglements that come with doing education deals.
Craig started his career in education in 1999 working for the president of Columbia University as vice president of strategic development for Fathom, Columbia's online education company, before taking a post at PE shop Warburg Pincus LLC, working on developing education investments. The companies he worked with between 2001 and 2004 while at Warburg included San Diego college operator Bridgepoint Education Inc. Warburg seeded Bridgepoint in January 2004 and took the company public five years later; the firm remains a majority shareholder. Craig had left Warburg by 2011 because he had developed an interest in wanting to develop education technology more independently.
University Ventures has about $150 million under management and strategic partnerships with German media conglomerate Bertelsmann AG and London's Pearson. It has about eight investments in its portfolio; one is an edtech holding the firm helped form in December 2012 called UV Labs. It partners with schools to build new online learning products. Craig said UV Labs is to be considered very early stage.
"We're focused on creating [an alternate] mechanism by which learning experiences can be given," Craig said. "It's a project that involves the same type of natural language processing and semantic Web work that's gone on in technology companies, it's just applied to education."
ALONG WITH POTENTIAL GROWTH, the education sector presents some unique challenges for investors. "A venture capitalist, you know, they'll have a five-year horizon, and a lot of education companies take a lot longer to gain momentum," said Williams. There is also a limited sales window for education companies, especially those that sell to schools and districts in the K-12 segment. Usually there are only one or two sales cycles per year.
"Every education company has a huge pipeline of potential clients in K-12. But in any school district you probably need 15 or 20 people to all say yes and any one of them can say no and will lose their job if they say yes," noted Craig. He and other investors agree that the policy issues that come into play while making deals or operating tech companies in the education space cannot be overemphasized.
"In one sense a school district is like any other customer, but there's a sort of reality [check], you see it written into some of these contracts, that it's subject to being funded by the state, and if there's a budget cut, the contract goes away," explained Morgan Lewis' Dickey.
"In K-12 especially there is constraint on where dollars flow," added Deborah Quazzo, founder and managing partner of education and business services boutique GSV Advisors LLC.
Ted Mitchell's firm has a unique advantage in working with school districts because another arm of NewSchool's operations deals with funding charter schools. NewSchools supports 331 schools with 130,500 students, mostly in Boston, Newark, N.J., and Washington.
"So what this means is we're able to introduce new technologies and products into a marketplace," said Mitchell. "Say you've just started an edtech company, you learn a heck of a lot from early adoption, improve the product, plus you get a little bit of revenue into the system and you have a referral when you go [pitch] to a public school system."
STILL, LARGE STRATEGIC BUYERS are likely to keep the M&A wheels turning. "Bertelsmann has made a public statement that they want to build a large, higher education offering division as a leg of their growth strategy going forward," Craig said. "Pearson has obviously made a transformation."
University Ventures hasn't made any exits but Craig said sales to some of the larger publishers would be one of the obvious routes. "I would expect some of our companies to be sold to strategics, some of them maybe to our own LP's like Bertelsmann, others may go public."
Indeed, the larger education companies such as Pearson and McGraw-Hill Education have aggressively pushed to acquire companies in the edtech space focused on adaptive learning and online content delivery spaces, and a few were VC-backed.
Two deals that fit this category for Pearson included its May 2012 acquisition of Brisbane, Calif., cloud-based language learning business GlobalEnglish Corp. for $90 million in cash from management, and the purchase of online course and educational services company EmbanetCompass LLC for $650 million from Technology Crossover Ventures and other investors.
"They're hungry for data on student learning pathways," said Mitchell, referring to deals by Pearson and others in adaptive learning and online course content.
"They've paid up and now they need to execute," added Craig.
McGraw-Hill, meanwhile, bought ability assessment technology company Aleks Corp. of Irvine, Calif., in July 2012, a 20% stake in Danish educational software maker Area9 Aps in January 2012 and Bookette Software Co., of Monterey, Calif., for undisclosed terms.
Yoon expects more deals from McGraw now that it's privately held; McGraw-Hill Education was acquired by Apollo Global Management LLC for $2.5 billion in November.
"Obviously the uncertainty of direction with what the education side was going to do has now been lifted and now they can focus [on] building the business and they have the backing of a tremendous sponsor, focus on organic growth, as well as acquisitions."
According to Yoon, Ebitda multiples in the space have been robust. "High single to low double-digit multiples," he said.
Rapid change was also likely to continue. "These technologies are going to significantly impact education as we go forward, things like distance learning and MOOCS," said Dickey. Venture capitalists see funding education technologies as investments in the human capital making its way though the school system, and they hope to streamline the process. "There is a lot of money going into edtech, it's a great thing. It's warranted, I absolutely think it's warranted," said Williams.
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