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A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

Something Ventured:
August 25th, 2006


By Brent Holliday
Greenstone Venture Partners

A Financial History Lesson

“Don’t know much about history…”
– Sam Cooke, Wonderful World

“History never looks like history when you are living through it.” – John W. Gardner

Some bubble-like activity is afoot in the financial world and I thought I would explain it in the context of “haven’t we seen this before”? 

The 1980’s were boom time for financial folks.  Remember Michael Milken, T.Boone Pickens and the rest of the corporate raiders?  Remember the Oliver Stone movie Wall Street?  Gobs of money and the resulting conspicuous consumption from the money made financial people evil… hence the portrayal of Gordon Gekko, played by Michael Douglas.  The money was made by folks who did leveraged buyouts, the process of buying a company using debt and then using the company cash flow to pay the interest.  More money was made by those who securitized that debt and created and traded the “junk bonds” that we all read about.  Even more money was made by the folks who were the intermediaries to all of these transactions… the investment bankers, lawyers and accounting firms that were involved.

But it all went bad when the economy turned south, the cash flow slowed and the debtors went collecting the collateral (the companies and their assets).  Those that were billionaires were having to “get by” with only a few million.  The house of cards, built on questionable levels of debt, even more questionable rationale for buying out companies (small to the very, very large) and the almost instant drying up “exits”, had collapsed.  In the aftermath, people pointed to greed and the herd mentality of financial folk who smelled money and all tried to mimic the success of the folks like Milken and Pickens.  Hey if they can do it, why can’t I?

I would argue that we are headed for a similar crash in the next few years in the financial world, only this time the bad words aren’t “leveraged buyout”, they are “private equity”.  And part of private equity is venture capital, which, along with hedge funds, are collectively known in the financial industry as “alternative assets”.

“Human history becomes more and more a race between education and catastrophe.” – H.G. Wells

Just like in the 80’s, when a good thing comes along, lots of folks start chasing it and pretty soon there is too much money chasing too few quality deals.  In 2005, private equity funds raised $111.4 Billion US with $25.2 Billion going to venture capital funds.  All of this in the United States alone.  This is 5X the 2002 level of $28 Billion US, when venture capital had its low of $3B raised.  In the mid 1990’s, before the dot-com bubble, private equity fundraising was about $15B US a year.  In the dot-com bubble, early stage venture capital was all the rage, now it is the later stage buyout funds that make up most of the money available.  Just like in venture capital, there are big “brand name” PE funds like Carlyle Group, Blackstone, Texas Pacific and Goldman-Sachs and many, many smaller regional players. The Economist has a great article from 18 months ago, when they crowned the PE firms as the new Kings of Capitalism and therefore, accurately predicting the very top of the market, in my humble opinion: http://www.economist.com/displaystory.cfm?story_id=3398496

So, what do they do with all of this money?  They buyout existing businesses, they take public companies private or they aggregate smaller companies into a larger whole.  Just like in the 80’s, some of this is done with debt.  Lululemon, of Vancouver, was bought by a private equity firm.  There is talk of Ford Motor Company going private with the help of PE money.  There has even been some wild speculation about how the biggest deal in PE history could see a buyout of Microsoft.

How do they make money?  They sell the companies back to the public in an IPO or an income trust format or they break up the parts and sell them off for a collective profit.  This scheme has been working well for the past couple of years… but with a soft IPO market, who buys the buyers’ deals?  Like the metaphor of the smaller fish being eaten by the bigger fish, being eaten by an even bigger fish, the private equity game is turning into the economic equivalent of a ponzi scheme…  it seems that more and more, they are buying each other’s companies.  How long can this last?

“If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.” – George Bernard Shaw. 

The venture capital business has its own issues.  As I have mentioned here in this space before, the days of the big technology IPO are seemingly gone.  The “exits” for VCs have become merger and acquisition (M&A) only.  Generally speaking, the M&A returns for VCs are 5-7x less than IPO returns.  On top of that, technology companies are looking at a rapidly dwindling list of companies to sell to… at least those with enough cash or attractive stock.  If the companies have cash flow and decent growth prospects, then the private equity guys might be interested in taking companies off the VC’s hands… but that is part of the smaller fish to bigger fish problem.  And as a sure sign that private equity folks are getting desperate to find places to put their hundreds of billions, they are starting to look at younger and younger companies and smaller companies to buyout or take controlling positions in.  And this is not the 10x exit that VCs will be looking for…

The old VC math might need to be re-evaluated.  The idea of getting enough cash from the winners in your portfolio to more than compensate for the zeros in your basket of companies is becoming harder to do. 

“Those who do not read and understand history are doomed to repeat it.” – Harry S. Truman

In the aforementioned Economist article, the first graph shows the peaks of capital being raised for private equity/venture capital.  The first peak is in the 80’s and it was fuelled by the greedy herd heading for buyout funds.  The huge peak at the end of the 90’s was fuelled by the greedy herd running after early stage venture capital due to the overheated IPO market.  Now the third peak (not visible on the graph because they don’t show the huge 2004, 2005 and now 2006 PE capital being raised) is mainly the greedy herd after the buyout money again.  Last time, it ended badly because the stock market was a house of cards.  The time before that (in the 80’s) it ended badly because the economy turned south worldwide and the high leverage of most of the acquired companies crashed under its own weight.  What will happen this time?

The bulls are talking globalization and the fact that China, Eastern Europe and India will help fuel more and more deals and more and more good companies to acquire.  I don’t buy it… at least not completely.  The economics don’t work when too many people are paying too high prices for too few quality companies.  If the economy slows and the stock market does not ignite, the private equity bubble will collapse in a heap of miserable returns.  It’s not a question of will it happen, it is simply when.

If you managed to read this far, perhaps you are wondering how this affects you here in BC and in the technology space.  The capital markets all intertwine and your company’s options for growth, acquisition and going public are tied to these capital markets.  Now, your company specifically might be in a space that is hot and not affected as much.  Your company specifically might have found a niche and is doing very well so that lots of people are interested in fuelling your growth or offering you retirement kind of money.  This is more about the big picture and helping you understand the crazy world of high finance.

“History is the version of past events that people have decided to agree upon.” - Napoleon

If Michael Milken was the poster boy for the 1980’s bubble and Mark Cuban was the poster boy for the dot-com bubble, then the poster boy for the current bubble will be written into history only after we have had time to digest the downturn and see who best represents how we choose to remember it.  One version of history that people will always agree on: The finance business is fuelled by greed and the very good times are necessary to see excessive returns that will fuel the next generation, even though the bubble always bursts.

Letters From Last Time:

I left the story of Convedia and the Newbridge Affiliates up for a month to make sure everyone read it, partially because of comments like this from the principal and his wife:

Excellent story!!  Great insight into the whole story of this company. I feel that a group of highly talented people came together and created something special in the face of great odds. That includes the Executive, the Board, the Investors and all of the employees. My team and I look forward to the next phase of this business with our new partner Radisys.

Peter B

Hi Brent,

My name is Fran Briscoe and I'm Peter Briscoe's wife. Thank you for the wonderful article about Peter and Convedia. It's been a hard slog to get here and Peter has done it with integrity. Although I'm somewhat biased, I have always been proud of the way he conducted business and treated his employees. Now he has finally seen some reward for his hard work!

Thanks again!

Cheers,

Fran 

What Do You Think? Talk Back To Brent Holliday

 



Something Ventured
is a bi-weekly column designed to supplement the T-Net British Columbia web site with some timely, relevant and possibly irreverent insight into the industry. I hope to share some of the perspective and trends that I see in my role as a VC. The column is always followed by feedback (if its positive or constructive. I'll keep the flames to myself, thanks).

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