SF Venture

A Very Dry Q2

Public market skittishness again impacted exit activity, with NO venture-backed IPOs in the second quarter.  There were 56 M&A deals for venture-backed companies, down from 89 in the second quarter of 2007.  Average M&A pricing did rise to $171 million, up from $110 million. 

Taking a longer view, there were only 385 venture-backed IPOs from 2001-2007, compared to 1353 from 1991-1997. 

 

We don't expect the IPO market will recover until after the election.  This could be postponed depending upon how long it takes for the bad news to become fully reflected in the public markets.  I do not believe that we have seen the full impact of credit/real estate problems combined with higher energy/food prices on the consumer.  We may see capitulation before the election, but we may need to see data for the fourth quarter.  If there is an IPO market in the fourth quarter, I'd expect it would be highly selective. 

This should set us up for a reasonably sharp rebound for IPOs in 2009, albeit from depressed levels.

Looking to venture exits for the remainder of 2008, we would still expect modest volumes of acquisitions.  We were surprised that the average price of M&A deals increased in the second quarter, which does not seem sustainable. 

This appears to be creating attractive opportunities for new investing.  I have not yet seen data for pricing of venture rounds, although anecdotally we're heard that pricing has started to soften.

In my view, this is just part of the natural cycle for venture.  The difference is that the negative part of this cycle has been extended.  It's clearly taking longer to make money from venture investing.  In 2007, the median age of a venture-backed IPO was 8.6 years.  This should still allow positive venture returns looking out over the next 5-10 years, particularly relative to other asset classes.  The winners of the last 5-10 years were buyout and hedge funds that depended on leverage.  Venture provides returns without leverage.  We saw public start to appreciate growth stocks in 2007 and I believe it is inevitable that they will again, fueling the next window for venture-backed IPOs. 

Exit Data Dark For First Quarter - Another Cycle Begins

The credit-related traumas impacted exit activity in the first quarter, with only 5 IPOs and 56 M&A deals for venture-backed companies, down sharply from recent levels. 

We don't expect the IPO market will recover until after the election.  We would still expect modest volumes of acquisitions, albeit at lower prices.  Clearly, this is bad for existing venture investments,  stretching out returns. 

Anecdotally, we have not seen pricing of venture rounds come down to reflect these market conditions.  In some areas, like new media, where pricing has appeared excessive, there should be a meaningful correction.  Later stage valuations are also ripe for adjustment.  Generally, we expect pricing of venture rounds to come down over the next few quarters. 

This data marks a turn in the typical cycle.  We saw a similar price correction at the beginning of the decade after the combination of the bursting bubble and 9/11.  We made some of our best investments during that recovery period.  Prices were reasonable and companies needed to find more compelling marketing opportunities while maintaining capital efficiency.  We see the same circumstance starting in 2008, where lower pricing will provide a good start for new investments. 

Spitzer's Fall - Opportunity To Correct His Mistakes

I cannot restrain from rejoicing at Eliot Spitzer's resignation today.  For years, I have been distressed by the damage he has done to Wall Street.  Now that his credibility has been destroyed, I hope we can revisit his actions against Wall Street and consider at least partial corrections.

The public markets have never fully recovered from the combination of Spitzer's crusade and the layers of bureaucracy now burdening public companies courtesy of Sarbanes & Oxley. 

What did Spitzer do wrong?  He was successful at bringing cases that created headlines and furthered his political career at the expense of others.   He claimed that because of a structure that allowed communications between bankers and analysts, investment recommendations suffered because of a perceived conflict of interests between issuers and investors.  He needed to blame somebody and create rules, even if those rules to hamper banker/analyst communications didn’t provide any benefits.  Clearly, bad recommendations were made in the 90s.  However, the vast majority of market participants were honestly trying to make money for both issuers and investors.  In fact, it was constructive to have bankers and analysts share perspectives on companies.  The reality is that capital markets are naturally self correcting and did not need his help.  When bankers or analysts lose money for clients, they eventually lose their jobs.  Communication between them is irrelevant.  The bursting of the bubble naturally weeded out many positions.  Have the new rules created any benefit for investors?  No. We’ve still seen IPOs succeed and fail, with analysts being right and wrong. 

Spitzer and others have only succeeded in hampering the IPO process.  At the beginning of the process, the separation of bankers and analysts creates inefficiencies and often miscommunications to investors.  The auditors are so afraid of making a mistake and still confused by evolving accounting rules that they force slow and costly processes.  Sarbanes Oxley preparation layers on even more paperwork with questionable benefits.  Once public, the full disclosure rules hamper communication between companies and investors.  Companies need to be so careful that they are pushed to say less to everybody.  All of this leads investors to remain cautious on IPOs, particularly technology IPOs. 

Political interference with the public markets has exaggerated volatile conditions.  Despite all of the structural challenges to going public, we finally had a receptive year for technology IPOs in 2007.  At the end of last year, I’d hoped to see a continuation of positive conditions.  I underestimated the market’s volatility and the unraveling credit crisis.  We’ve seen the class of 2007 technology IPOs has been generally guiding estimates down, scaring investors away quickly.  It may take reports from both the first and second quarters to find a bottom.  With some market confusion possible around the elections, it may take until the end of 2008 to see a recovery in the IPO market. 

Is it too late to correct these structural problems?  We’ve seen attempts to soften Sarbanes Oxley, which may be possible with the next administration.  Similarly, why not also soften the rules around investment banks?