FYI | Nov 24 2008
By Greg Peel
Back in June 2007, leading US private equity firm Blackstone listed on the NYSE amongst much fanfare. The shares were highly sought after, and the listed price of over US$35 represented a ridiculous premium to the IPO price despite Blackstone warning potential investors at the time that the company would likely not see positive returns for two years.
I commented at the time that Blackstone had probably “rung the bell” for the top of the market. I wasn’t far off as it turns out. The timing of the listing was either complete folly or a stroke of genius whichever way you look at it. The founding partners walked away with billions – at least on paper. Blackstone shares are now worth around US$4.
Clearly private equity has been an early victim of the credit crisis, being, as it is, traditionally funded on high levels of leverage. The junk bond buyout model will now return to hibernation for another twenty years. Not only will private equity funds suffer a lack of fresh interest as a result, there have already been some spectacular buyout collapses brought about by the credit crisis. Private equity moved in and bought viable companies using high levels of debt, and as such has been blown away. Linen ‘n’ Things was one of the first and better known to go under in the US, and in more recent times another large private equity firm – Texas Pacific – has seen its credibility shattered by having made a foray into US thrift Washington Mutual. WaMu has since been sold to JP Morgan for the peppercorn price of US$2 billion. From Australia’s point of view it is notable that Texas was one of the members of the consortium which tried to buy Qantas. Allco was another – now deceased. And in Australia we watch with interest as to whether CVC Capital will go down with the Nine Network.
But private equity does not rely purely on a leveraged buyout model. Believe or not, some private equity takeovers are completed on just equity. I have commented previously that last week’s Australian Mining Congress revealed there is plenty of high-net-worth money armed and ready to exploit opportunities in the junior mining sector. If private equity firms can provide a good chunk of the financing from its pooled funds, banks will be more willing to provide their share. Banks still need some form of business potential.
When we think of private equity takeovers we think of targets being well-established, listed firms such as Qantas. This may be the case in boom times such as we have experienced up to 2007, but the rest of the time private equity usually looks for unlisted opportunities. Taking over a listed entity at a 30% premium usually requires about a five-year horizon to streamline the company and then re-list for exit returns. Starting with an unlisted company just means getting that company to IPO for initial listing and exit returns for private equity investors.
When you enter the realm of the unlisted company, you also come across that private equity sub-set – venture capital. While the definition may be grey a venture capital-backed company is usually one with some bright idea, some innovation, something that stands out from the everyday that thus offers potentially enormous returns for those getting in on the ground floor. It is a “new venture”. Venture capital funds are thus a form of private equity fund offering investors a diversified pool of chosen projects in the hope one or two will come to fruition. Venture capital investment is the realm of the high-net-worth investor with some gambling money available. There are also tax incentives to be had.
One would be forgiven for thinking that venture capital as an investment class would now be as dead as a dodo as a result of the credit crisis. The world has turned extremely risk averse, and venture capital is right up there on the risk ladder. But one must remember that not everyone who had money in 2007 has subsequently become a pauper in 2008. There is, as is often noted, plenty of cash sitting on the sidelines waiting for an opportunity to re-invest. And given it is exchange traded assets which have suffered from the panic of the markets it is no great stretch to assume some investors will be looking to avoid the herd mentality, redemptions and margin calls and look to private, unlisted ventures as an investment opportunity out of the spotlight.
That is not to say venture capital has not suffered as an asset class during the credit crisis nor that it won’t find the going a lot tougher from here. The boom times brought about growth in venture capital investment, unsurprisingly, and such growth always means venture projects become more marginal and investment money less secure (read hedge funds) as everyone decides they want in on the game. Marginal venture projects and venture funds holding marginal investment pools have suffered and will continue to do so. This is actually good news.
At least it’s good news if you’re not one of those investors who have suffered or will likely suffer from here. As US investment firm SVB Capital suggests, the venture capital sector is now in for consolidation and rationalisation – like many a sector – meaning what is left when the dust settles will be quality projects backed by prime investment funds.
Indeed, SVB Capital suggests 2009 could be a “vintage year” for venture capitalists. By 2010, things should have returned to a level of stability.
In 2000, venture capital funds were averaging 30% per annum returns. That seems terrific, but it was also as a result of the tech boom. In the late nineties venture capital was all about telcos and dotcoms. Duly shattered thereafter, venture capital returns were able to average 18% up to 2007, suggesting a painful road back to boom times once more. In 2009, SVB expects the good venture capital funds to return an average 20%.
Emphasis is, however, on the “good”. Venture capital funds which will succeed in 2009 will be those with quality projects and secure funding.
Like every industry, venture capital will need to sit down and look hard at its portfolio of projects and decide which ones really do have legs in a post credit-crisis world and which do not. And which projects are not scuppered by possibly two years of global economic weakness and which are too vulnerable. Venture capital usually follows an A-B-C investment process, signifying initial investment and then two further rounds of investment top-up as projects come closer to success. It is likely that many marginal projects will now be stranded at the B or C phase and that venture funds will just write off initial investments.
This leads to a Darwinian attrition, and suggests that those projects still slated to receive B-C funding, as well as new projects tagged for A funding, will be those projects showing the greatest potential in a tough market. The pool will be smaller but the quality will be higher. The investment pool will also be smaller as hedge funds and other marginal investors are forced to abandon venture capital desires, but this also means remaining projects are less likely to see their funding collapse.
It is these factors that lead SVB Capital to suggest that a smart investor in venture capital has a good opportunity to see excellent returns in 2009, away from the torrid and volatile listed markets.
