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

Something Ventured:
September 7th, 2007


By Brent Holliday
Greenstone Venture Partners

Economy Is Less Than Prime

 

Gotta keep moving,

Never gonna slow down.
You can have your funky world,

See you 'round.

But I got to ramble (ramblin' man)
Oh I got to gamble (gamblin' man)” – Bob Seger, RamblinGamblin’ Man

It’s been a good ride.  After four years of growth and jobs and profits and increased house prices, it looks as though we might finally have a real crisis on our hands.  At least from the point of view of our biggest trading partner’s economy, which seems to be lurching towards recession.  Like the proverbial butterfly flapping its wings in HG Wells’ novel, the impact of the actions of just a few unscrupulous mortgage lenders has rippled its way across the entire North American economy.

You’ve read about it already.  You hear the talking heads pointing fingers and analyzing the tea leaves.  I thought of a simpler metaphor for the sub-prime debacle in the form of a short story… I hope it fits:  What this whole mess is about is how one feels about risk. 

Six months ago, four folks walked into a casino, feeling good about life.  Interest rates were low, which means they all feel good about spending some cash.  The first guy is Pinstripe Pete, the banker.  He is the eldest and most conservative of the four.  He toddles off to play the nickel slots, which don’t have great odds, but what the heck, it’s peanuts to him.  The second guy is Ernie Equity.  He has been investing in big companies and doing buyouts. Life has been good because Pete has been lending him money to leverage up his deals.  He hits the craps table which has the best odds in the house, but he still sits at the $5 minimum table. The third guy is not a guy, its Corporate Carol and she’s dressed to kill.  She has been floating higher interest rate corporate debt, dabbled in “jumbo loans” and generally played fast and loose for a few years, which has been great because the rates are not really that high, historically speaking.  Carol goes straight to the blackjack table, $25 minimum bets and lets everyone know she’s there to win.  The last guy is Slick Dick.  Dick gave up his used car business in 2003 to start a mortgage brokerage outfit that offers people that should not qualify for a mortgage low up front rates and 100% mortgages.  Dick heads to the penthouse “high roller” poker room, where no-limit Texas holdem is happening at $1000 blinds.

They sit at their respective locations playing their games for a few months.  Then something happens.  The real estate bubble starts to burst as supply gets ahead of demand.  US bank rates have slowly climbed higher.  And Dick’s customers have blown past their “initial low rate” periods.  They are in trouble as they have much higher rates, make much higher payments and start defaulting.  I mean who couldn’t have seen this coming?

Dick’s cell phone rings.  Right in the middle of a $150,000 pot.  Dick answers and turns pale.  The FBI wants to talk to him.  All those mortgages he passed on are defaulting and people are pissed.  Dick’s appetite for risk disappears as quickly as his last martini.  He leaves the table and runs from the casino calling his lawyer as he goes. 

As Dick runs out, he passes Carol.  The “jumbo loan” business is tanking as the lenders higher up the food chain are not into the riskier debt all of a sudden.  Her corporate clients are not finding any buyers for their paper either. Her Blackberry starts buzzing like crazy and suddenly she feels like going back to her condo and hiding in a dark room.  Her swagger is gone.  Her job prospects dimming…  She leaves in a hurry passing Ernie at the craps table.

Ernie sees Dick and Carol leave the party.  He feels OK.  No need to panic.  After all, this is all about debt and he is an equity guy.  The companies are still doing well.  He leaves the tables and strolls the casino.  The higher risk tables are all eerily empty.  His confidence ebbs.  His Apple iPhone rings (“Killing Them Softly” ring tone, naturally).  It seems that deal flow is slowing… not much too look at without that 5 debt dollar to 1 equity dollar leverage all gone.  Yikes!  Does this mean that they have to invest all equity like venture capitalists?  Whoa!  Deals just got a lot smaller.  Ernie spins and heads out.  Time for a vacation in Cabo.

Now Pete has been watching all this nervously.  He still sits at the slot machine, but he hasn’t put a single nickel in the machine in weeks.  He has been observing.  His compatriots in big banking have stopped lending to Ernie or taking paper from Carol and Dick.  They have decided that the world has gotten far too risky.  They just let the casino owner know that they are shutting the whole thing down.  They are scared to death of bad loans and want nothing to do with this.  Pete sighs, lifts himself off the stool and shuffles out the door.

Over in the corner, Ravi the janitor chuckles and continues to clean the floor.  This North American casino is shutting down, but his friends at home in India and over in China are still rocking and rolling.  Time to head back to where the real action is…  Ravi turns out the lights and heads for the airport.

As a technology company in Canada, how does this cascading ripple effect affect you?  As of today, the issue is dependent on the almighty consumer in the US.  Can the consumption of goods and services by the end consumer stave off a recession.  Many experts think not.  This time, the extra money is not there because you can’t re-finance your home to buy the new car, do the renovation and get the 60” plasma TV.  The finance community is in massive de-risk mode, as per Pete in my story.  Capital will not flow as easily through the enterprise if debt is harder to get.  Will M&A slow down?  Will IPOs pick up (because equity financing is the only way to more capital)?  Will spending decrease in the enterprise?

Again, in North America, it might depend on the consumer.  Because if they stop buying, the whole economy slows and yes, enterprises batten the hatches.  Even if your company does not sell directly to a US consumer, you might get hit by them. 

What to do?  Follow Ravi.  Most experts are saying that those large US corporations that are a) not in finance, retail or housing and b) get at least 35% of revenue from outside America are OK.  In other words, the global market is doing fine and not as affected by the US over-exuberant debt market. Are you selling to Asia and Europe?  If you aren’t, you should be.  Now is the time to focus on global markets if you aren’t already.  The US may recover quickly and the global markets may still get sucked in (after all, one of the tenets of globalization is that the interconnectedness of capital markets either floats or sinks all boats a lot faster than it used to).  But for now, Ravi has the right idea.

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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