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