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. 

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? 

The credit crunch can help venture - One man’s ceiling is another man's floor

I believe the current credit crunch can actually help venture returns. Why?  Because it will help build momentum for the technology IPO market, which is what really drives venture returns.  Investors have finally demonstrated a willingness to buy technology IPOs. There were some 36 technology IPOs in 2006.  I expect to see that number roughly double in 2007. 

In the middle of the liquidity crisis, VMWare went public, traded up sharply and stayed there. 

Why do tech stocks now look better?  Because alternative investments don't look as attractive.  Investors shied away from tech stocks for years, fearing the post-bubble risks.  Leveraged investing strategies were perceived as less risky. For the last five years, I’ve watched the skyrocketing returns from hedge funds and buyout funds with jealousy, wondering if I was missing something.  I believe we have just witnessed a sharp shift in perception of the risk for those leveraged investing strategies. 

I have taken a long-term view on the positive potential for venture returns, but admit it’s been a bit tiring to be in the less loved asset class.  I have assumed that much of the returns from hedge funds and buyout funds have often simply been a function of magnifying small fundamental returns with significant leverage.  Of course, there are some great managers in each class who deliver strong fundamental returns, but that seems to have been the exception.  Less credit and/or more expensive credit will hurt these asset classes.

Fortunately, venture is not dependent on credit. I do not see a sustained credit panic and public market meltdown.  I believe the financial markets will recover, albeit with tighter credit.  The current environment could prove ideal for venture returns.  My key assumption is that technology IPOs become more attractive as public market investors look for investment returns from growth, not leverage.   

All this reminded me of Paul Simon's song.  As hedge funds and buyout funds may have hit their ceiling, there is a good floor under technology venture today. 

Fighting The Sarbox Monster

There is an excellent editorial in today's Wall Street Journal by Robert Grady of Carlyle.  The Sarbox Monster provides a well organized list of reasons why the IPO market remains largely unreachable the the downstream cost to the U.S. in terms of job creation and innovation.  The article is light on recommendations, but puts the problem is a constructive context.  I view the article as a sign of a more receptive climate to Sarbox reform and other regulatory changes to correct prior political short-sightedness.  Bob reminds us that essentially all of the value creation from venture has occurred through the growth of companies after an IPO.  Fortunately, public market buyers can remember that these winners outweighed the losers, even after the bubble, as evidenced by recent buying of smaller technology IPOs.  It appears that both politicians and buyers may be finally positioned to facilitate positive changes.

Sarbox reform will be necessary as a first step to get companies public, but it will not solve the underlying problem of providing research for small cap stocks. The best solution I've seen is the National Research Exchange (NRE) www.ResearchExchange.com.  Founded by Wall Street veteran David Weild IV, the NRE is working on ways to pay for ongoing research coverage. The basic idea is to carve out a portion of the 7% underwriting fee and put it into an escrow account to pay for research over the first two or three years.  The pool could be used to attract research from firms outside of the main underwriting group.  If an analyst left an investment bank and coverage was dropped, the remaining money in escrow could be used to find another firm to cover the stock.  There would be no promise on recommendation, to avoid the obvious potential conflict.  While NRE is still in process of structuring and rolling out the service, I like the idea of effectively guaranteeing coverage by spreading out the economics. 

AIM Gaining Share

According to investment bank, McNamee Lawrence & Co., more money was raised through IPOs on AIM than Nasdaq from January through July this year.  AIM raised $9.2 billion and Nasdaq only $8.2 billion.  There were 9 software IPOs on AIM compared to 7 on Nasdaq.  That’s a dramatic shift of market share.  We could hope that U.S. politicians and regulators would wake up, but our expectations for Nasdaq reform remain low. 

While more dollars are being raised, we have still not seen data of U.S. venture-backed IPOs performing well in the AIM aftermarket.  Another investment bank, Innovation Advisors notes aftermarket performance on AIM has lagged Nasdaq.  Our observation is that AIM has mostly attracted smaller companies. 

In conversations with various U.S. and London bankers, there appear to be a greater number of larger, potentially better performing companies in the AIM IPO pipeline.  We continue to look for positive case studies. 

Good Article On IPO Market

Mark Boslet of Dow Jones just wrote a good overview of IPO prospects. He notes that some U.S. venture-backed companies are considering listing on London's AIM Exchange.  It provides both perspective and hope for the IPO market. 

Download ipo_drought_in_us_leading_vcs_abroad.doc  

After a decade of greed, we’re living in a decade of fear…

The 90s were driven by greed as we chased technology stocks to temporary wealth.  The mood was good while it lasted.  Aggressive investing was addictive. 

The crash shocked the investment community.  If that wasn’t bad enough, 9/11 caused us to be concerned for our personal safety.  This sustained period of panic and pessimism has created the equivalent of a low-grade fever that infects our attitudes and actions. 

While yesterday the NASDAQ Index just reached a 4-year high, it’s still 50% below its peak in March 2000. 

Today, any risk feels bad.  Individuals run quickly from stocks that show volatility.  Investors have generally moved have far away from risk as possible.  Venture capitalists are still taking risks, but returns continue to suffer a shortage of rich exits, with some improved liquidity from M&A.  Hedge funds and buyout funds are attracting massive amounts of money with the promise of beating mediocre returns for taking long positions in public equities.  Real estate looks so safe that it feels like another bubble. 

Consumers are borrowing heavily and spending on new toys from iPods to retro hot rod Mustangs.  This may provide some comfort in contrast with disturbing world news and slower career progress at home. 

Corporations are still shy of spending on new technologies.  Fear continues to drive purchases of security tools to deal with persistent threats.  For technology designed to boost productivity, CIOs are less likely to start big projects and more likely to allow individual professionals and/or departments to buy hosted applications. 

The London bombs are yet another reminder of the ongoing battle between worldviews.  We are also being forced to take sides on domestic issues.  Last year’s election started the showdown between red/blue, conservative/liberal, and the religious right/left.   This week’s forum is the Supreme Court.  The scary part of these debates is that there does not seem to be room for moderation.  Great leaders in the past have brought the country together.  We appear to be dividing ourselves from the rest of the world and each other. 

With these serious distractions, no wonder it’s difficult to get excited about the next new technology.  Fortunately, the web is working again with a second wave of economic activity with more personalized commerce.  The rapid rate of blog creation is also providing a healthy outlet.

While the U.S. may be suffering through a decade of fear, emerging markets around China are starting to enjoy a decade of greed with the help of positive demographic and political trends.  This is attracting more U.S. VCs to head east for this cycle.    

Can the next decade provide an easier path for life, liberty and the pursuit of happiness back home?  I don’t yet see the catalysts to support another decade of greed.  My nature remains to be naturally optimistic, but I’ve been training myself to keep expectations low enough to appreciate whatever happens. 

Where’s The Wind?

The combination of springtime in San Francisco and positive sales momentum in our venture portfolio should be lifting my spirits.  Strangely, it’s not.  The venture market feels better, but somehow stuck.  While we’re past the storms and there’s some wind blowing on the bay, the fleets of venture boats still require a lot of tacking to get anywhere.  When will the winds return behind venture to turn it back into a money-making category? 

The financial news highlights that that investors are still making more money by trading than making long-term bets. As a venture capitalist, I stubbornly believe that long-term investing can still be profitable.  This article in the New York Times, If I Only Had A Hedge Fund? surprised me.  While the article makes some debatable points, there is no arguing that there is a flood of money going into hedge funds.  Maybe I’m just jealous, but waves of new capital should force returns to converge towards the index averages for equity. 

We’ve seen a similar surge of new money into buyout funds.  My prior post questioned whether or not competition from LBO funds would drive up prices and lower returns.  I’m wondering now whether or not both shifts are a function of fear of buying and holding stocks.  The recently announced $11 billion SunGard Data Systems deal is notable for its size.  LBOs of even larger companies would allow them to hide from the distractions and regulatory expenses of the public markets, theoretically allowing growth.  However, in order to make money on the investments, there would still need to be an exit.  LBOs may end up being exercises in hibernation, not in creating attractive investment returns. 

So where does that leave venture?  Even if the IPO market remains picky, M&A can provide profitable exits.  According to VentureOne, M&A prices rose again in the first quarter of 2005 to a median amount of $60 million, which compares to $24.4 million invested prior to acquisition.

The venture markets still offer a hospitable environment for buyers of long-term growth.  As hedge and LBO fund returns wane, the whims and winds will return to favor venture.  We’d look for more evidence of this shift through the end of this year. 

MarketWatch Interview On 5-Year Anniversary of Market Peak

This week, Bambi Francisco interviewed me on MarketWatch. We discussed valuation justification for the surviving public companies. The show ran on the five-year anniversary of the market’s peak in March of 2000. In the more than five years since I have been a full-time venture capitalist, public market investing has become even more challenging. As I note in the interview, I am seeing an increase in attractive private investment opportunities, including Internet companies.

MarketWatch - 2/28/2005 5:45:00 PM
Internet stocks five years after the bubble burst

It's been five years since the Nasdaq peaked in March 2000. Keith Benjamin, former analyst with Robertson Stephens, says Internet companies that survived the bust deserve current healthy valuations.

Link to Video Clip on MarketWatch Site

Download marketwatch_interview_keith_benjamin.wmv

The LBO Bubble

During the last five years, Leveraged Buyout Funds, LBO funds have boasted favorable returns compared to public and venture market returns. This has caused a flood of new capital into large, mid and small market LBO firms. According to Venture Economics, LBO funds raised $46 billion in 2004, compared to Venture funds raising $18 billion. Given the run up in public market prices and this glut of new capital, it’s hard to imagine how LBO can go in any direction but down.