Archive | September, 2008

Houston, we have a problem….or do we?

25 Sep
Wall Street distress is racking private equity, but venture plugs along

The credit crisis is racking private equity but venture capital might dodge this bullet

“To repay summer, they’re closing winter down…” Ask any frustrated writer and they’ll admit that they’ve got witty lines that they have been carrying around for years searching for a way to use them in print or polite conversation. With the dizzying news coming out of Washington and Wall Street on a daily basis, I got the rare chance to actually hit the trifecta in being able to deploy that obscure lyric from equally obscure ’90s-era pop band XTC in two news outlet interviews and in venture industry mixer cocktail banter in one 24-hour period. For a journeyman writer, that’s gold, Jerry. GOLD!

To me, the line is evocative: witty due to its illogic but also a bit sad and sobering. The notion of canceling winter due to the excesses of the previous summer is a clever turn of phrase. But, as we all know, winter is coming, regardless. It cannot be cancelled, nor postponed, nor have its length or ferocity negotiated away. Sunday was the first day of fall and that point was brought home to me vividly that afternoon as I enjoyed a spirited drive through Sonoma wine country and witnessed the amber hues amidst the rows and rows of grape vines that blanketed the valley hillsides. The metaphors of the season’s obvious change evident that afternoon juxtaposed with the steady stream of dour financial news and doomsday prognostications for our economy were not lost on me.

In the weeks to come we will no doubt hear every hackneyed and overwrought phrase or adjective used to describe the woes that currently face this country’s financial system. “Apocalyptic” and “catharsis” are my current favorites. That said, I don’t want to minimize or trivialize what is happening to US financial markets. Indeed, as exciting or terrifying as it sounds history is occurring before our very eyes, hundreds of books will be written on this subject in the months to come, and we will have many more years to divine what happened, how we all got here, and what kind of country and economy we will become in its aftermath. While I have been known to say that pendulums swing but one way — too much this way; too much the other; forever — I may have cause to reconsider that maxim when it comes to the changes afoot in how the US government and the financial system work and play together. For one thing, I doubt we will ever see the kind of deregulation free-for-all of the past 25 years again–certainly not in our lifetimes.

The venture markets, however, have thus far been spared the carnage and dislocation evident in other sectors of private equity. Some market participants will no doubt argue that point. However, while our financial markets are inextricably linked on many levels and while a long and deep recession will eventually extract its pound of flesh from all private equity market practitioners, the day-to-day functions of a typical, traditional venture capital firm have not changed all that much in the past year. More cautious investment philosophies? To be sure. Less froth and competition for most early stage deals? Most definitely. However, investing moves apace, certain fundamentals idiosyncratic to early stage venture capital remain sound, and most firms report strong deal flow and relatively consistent interest from existing and prospective limited partners. So, why the seeming contrast? Let me posit a few ideas.

1. Venture capital learned (some of) the lessons of the tech bust and did not “re-load.”  If you accept the axiom that what goes up must come down, then you must also accept that the fact that venture has been spared the carnage visited on other sectors of private equity has a lot to do with the notion that venture capital never really recovered from the tech bust earlier this decade. As such, while our hedge fund and buyout/LBO firm brethren were raking in massive remuneration over the last seven years (and getting a bit sloppy regarding overcompensation and managing LP relationships) most venture firms were relatively hunkered down. Additionally, there were few meaningful liquidity events sufficient to re-ignite the cash spigots from distributions of circa 1998-2000. (A lot of this has to do with the seized IPO market and dwindling M&A appetite, but more on that later. ) Even venture firms that went “all in” on the latest consumer internet/Web 2.0 boomlet beginning in 2004 still did not typically bring on platoons of new partners to chase and manage new deal flow; they typically elevated their own — many of whom were around during the tech bust and had the scar tissue to not repeat certain ill-conceived practices. If there is doubt on this last point, please ask any venture partner recruiter. Sad as it sounds, throw a rock through Palo Alto’s Il Fornaio on any given Friday happy hour and you will hit six former General Partners at marquee Sand Hill Road venture firms still “on the beach” all these years after the tech investing bubble burst.

2. Better teams, better ideas, less journeymen. This point has been echoed elsewhere. This is also probably because it’s accurate. Soft markets do a lot of wacky things. One of things they do is weed out a lot of mediocre folks with mediocre ideas who really should stay at their jobs at Big Tech Company or Impressive Consulting Firm and leave the funding landscape to talented people who actually have a technology or a compelling business idea that has real potential. In frothy markets, everyone feels emboldened to go for that brass ring and try out their crazy ideas. That’s great. It’s part of what makes the industry so rewarding in many ways. However, when markets soften those same people are more concerned about keeping their jobs, thus clearing the way for people who need to start exciting new companies because, frankly, they have no other choice. Those are the kinds of people I like to meet with.

3. Soft markets allow start-ups more time to get it right.The day-to-day blocking and tackling of building a company has little to do with exogenous economic factors. Whether markets are heated or cooled, the mechanics of building a product, recruiting partners and employees, sealing partnership deals, and taking a product to market remain unaltered. Frothy markets are often a negative because they distract founding teams and force them to spend much more time competing with other companies for talent, trying to get the attention of their over-worked attorneys and advisors, cutting partnership deals, locking up building and equipment leases, etc. There is also the annoyance of having to continually reassure early investors and employees about the company’s prospects each time a new market entrant raises a venture round and carpet-bombs the community with press releases. A softer market slows things down, re-establishes more stable equilibrium for costs and expectations, and reduces the likelihood that other would-be founding teams will get funded. The upshot? More time for you and your team to focus on building a great company.

4. The Last Man Standing concept. OK, this is a bit controversial but here goes. To many limited partner investors, venture capital was the ugly girl at the Ball in the aftermath of the tech bust. The star for Hedge funds and private equity firms was ascendant once venture capital fell on difficult times. For complex reasons too involved to go into on this forum, hedge and buyout firms were able to attract enormous amounts of money and, for a time at least, brought some impressive returns for that money. The venture capital model could not really compete with those returns. In short order, LP allocations for traditional venture capital funds were cut. Poorly performing venture firms closed shop, fund sizes were cut, and new realities were beginning to become adopted in the community to cope with longer hold times, a dry IPO window and intermittent M&A cycles. Now that hedge funds and buyout firms are struggling with their own challenges in the current financial crisis, venture firms have become more palatable for limited partners again.

In short, the venture capital story is a compelling one. Kleiner Perkins’ Ted Schlein has been an impassioned ambassador for the industry and has worked tirelessly to distinguish for the limited partner community what it is venture capitalists do and how they differ from the activities of buyout and hedge fund professionals. As terms like “financial engineering” and “complex derivatives” become derogatory in the current credit crisis, the notions of building great companies and innovating ideas that can change the world and how we live in it will continue to gain power. That allure will continue to draw in new investors from the institutional class who wish to play a part in this next chapter. Venture capital is ideally positioned to leverage that renewed interest better than any other asset class. While there remain myriad problems — the lack of an IPO window is a serious problem and the dwindling numbers of M&A acquirers is an increasing concern — venture investors seem unified and motivated to address these issues and implement viable long term solutions.

The Hedge Fund bubble finally pops

5 Sep
Tough times at hedge funds could be helpful to VC firms raising capital

Tough times at hedge funds could be helpful to VC firms raising capital

As if the old adage about Main Street coughing and Wall Street catching pneumonia wasn’t tired enough already, new kindling was added to the fire in recent days in the form of abysmal performance numbers put up by some of the industry’s best known hedge funds as well as word that certain marquee portfolio managers were packing it in. Dan Benton, who made his name at Pequot and Andor Capital Management, announced he would be shutting down his fund in October. Former CNBC financial news commentator Ron Insana‘s advisory fund-of-fund vehicle told it’s investors that it would cease operations shortly as well.

Predictably, the schadenfreude has already begun. There are some within the venture ranks that have maintained that hedge funds and private equity groups had effectively sucked all the oxygen out of the room for venture firms these past six years in terms of attracting limited partner capital. While there is anecdotal evidence that one could argue supports that claim, I remain unconvinced. The principal rationale for venture firms imploding, at least as far as I have witnessed, has had very little to do with competition for investor dollars by hedge and private equity funds and has been largely the result of mediocre returns from mediocre venture outfits, persistent legacy issues, partner infighting, a dreadful dot-com/tech meltdown that took longer than anyone expected to work its way through the system, and a host of other ills. In almost all the cases that I have heard of, blaming hedge funds and private equity groups for draining the capital flows from venture groups has really been about sour grapes and about finding a convenient straw man to punch. Add to that the caricature that the popular media has provided of hedge fund and private equity players throwing themselves lavish birthday parties, buying robber baron-esque country estates, and indulging in over-the-top spending sprees, and you have a convenient whipping boy that is begging for a pile-on and a great story line for glossy magazines about the imminent bursting of the hedge fund bubble.

Sure, it makes for great copy, but not so fast. In its own Oscar Wilde-ian way, the demise of the hedge fund is being greatly exaggerated.

I don’t pretend that my crystal ball is any clearer than most in these matters, but I have been wondering aloud for years how the mathematically unsustainable lofty hedge fund returns could be, well, sustained. The hedge fund industry did not grow inasmuch as it exploded. From 800 active firms to 6,000 firms a few years later, to some 20,000 funds some time after that. If one accepts the premise that markets are efficient, it becomes pretty clear very quickly that returns must normalize over time as the market becomes ever more crowded with hedge funds all trying to beat the market. The inelegant image it conjures up is that of Miami Beach retirees all walking a small sandy beach with their metal detector wands in hand looking for that lost Rolex or wedding band. One guy will probably make a bundle. If there are 10 retirees out there, perhaps two will enjoy “outsize returns” for their time investment while the remaining 8 will cover costs and eke out a living. What we have come to — to push this metaphor to its logical conclusion — is 500 people on the beach…and it’s bedlam.

Ok, perhaps not a great analogy, but you get my point. Everyone in venture (and, I suspect, in the hedge fund business) loves to talk about finding the “white spaces” — those elusive regions no one has discovered yet. [i.e. That patch of sand no one has yet tilled with their metal finder.] Raw, exciting areas of opportunity where other investors aren’t breathing down your neck (yet) and there is time to roll up one’s sleeves and make a go of things. As more and more people pile into these sectors, incentives get perverted, valuations go haywire, and it’s almost impossible to get to a positive outcome. Typically, only a handful of smart investors find a way to eke out a couple good deal exits and everyone else licks their wounds and moans about the sector getting “overfunded.”

As tough as this is in venture, it’s just dreadful in the hedge fund world because of the mechanics of that business. Like in a sailing regatta, everyone is tacking off everyone else. Show a little success and you will find entire platoons of me-too copycat hedge funds mimicking your every trade. Pretty soon, you need to go further out on the risk profile to chase that elusive outsize return and then, like Icarus and his wings of wax, things don’t turn out so well. Now I know why there are almost always empty bottles of Tums strewn on every desk I walk by on the times I find myself at a hedge fund’s offices – especially lately. 

In the weeks and months to come expect more meltdowns, write-offs, and litigation as this bubble continues to deflate. Financial markets simply don’t operate this way for long. The impact this will have on venture fundraising will be interesting to follow. I am already getting anecdotal evidence from my friends at other venture funds that are actively raising funds that the funding environment has improved, in part because limited partners are cutting allocations to hedge funds and private equity and taking another look at venture.

While I do not cheer at the knowledge that some of my friends on the hedge fund/buyout fund side of things are in crisis right now, such a development could be good news for venture. Pendulums swing in only one way — too much this way, and then too much the other. Forever.

As for the hedge fund business, it will survive and prosper. Of that, let there be no doubt. But it will be leaner and more differentiated that it has become in recent years. This is in large part because in order to provide “outsize returns” hedge funds really need to get back to their entrepreneurial roots and eschew the temptation to raise excess capital and become like the bloated, glorified asset managers that they seek to best in terms of market returns. As the saying goes, one starts out in both life and business trying to break the mold; pretty soon, you are the mold.

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