Saturday, July 14, 2007

Private Equity & Venture Capital: Friends or Foes?

3000 Sand Hill Road

A number of recent events, combined with having many separate discussions with VCs, executives and people whose opinions I trust, have got me thinking about how private equity (PE) will fare over the coming years, and whether or not there's a connection between those trends and how VCs currently operate here in the Valley.

PE funds have been hitting the headlines of late as they do seemingly ever larger and riskier deals. Debt ratios in those buy-outs have also climbed (i.e. more debt as a percentage of total buy-out value), doubtless in consort with the rising tide of the market. With the Dow Jones now knocking on the door of 14,000, it's clear that there are very few bargains left to be had for all those hungry shoppers looking to do PE deals, something that in itself makes it harder to see how the deals that are being done now can have much upside.

However, there's another problem in the offing too: rising interest rates. In deals where, say, 80% of the funding is debt based, a not unusual figure in the case of some of the larger buy-outs of late, the payments to service that debt are obviously tied to the prevailing interest rates. As rates rise, so does the amount of cash consumed on a quarterly basis just to service that debt.

As governments systematically increase the cost of borrowing, ostensibly to cool down the economy, leveraged companies face the twin perils of lowering market demand combined with higher interest payments hitting them with a one-two punch. How that all gets played out if we have a recession (when profits fall far faster than interest rates can) doesn't bear thinking about.

However, PE funds have more money committed to them now than at any point in history. In 2006 just in the USA they raised $217 billion, ten-times the amount VCs raked-in over 2005. So if it is indeed harder to make all those dollars work on the US public markets, where will they show-up next?

Obviously, one option is to head overseas, and that trend is already well established. (Boots in the U.K. anyone?) However, there may be another outlet: emerging markets.

One of the changes since the heady days of 2000 here in Silicon Valley is that it's now a damn site harder to build a profitable software/infrastructure/tools business perhaps than ever it was. (And some might argue it was hard then, too, but no one cared since valuations weren't in any way tied to actual business results, oh dear me no!)

A big piece of the puzzle is how long, and at what cost, is required for a market for some new tool, platform or capability to reach critical mass, i.e. sufficient and growing revenues, valuable enough to fund two or three players to profitability, and sustained enough to ensure general market acceptance of this new way of doing things?

Here's the rub: I'm not sure the answer isn't "infinity". Or at least, longer than the VC model is designed to sustain.

EDA companies, for example, saw gestation periods of up to a decade before some of their tools in that space were standalone viable; more general business tools, like visual modelling, also took years to become mainstream, and even then the market wasn't built on just tools alone.

My point here is that if you are trying to define and catalyse a new market, you better have deep pockets, a lot of patience and boundless staying power. And even then, this might not be enough. To make this real, other competitors will have to exist, and such is the nature of competition that this fact alone may well delay markets reaching critical mass rather than accelerate them.

How, then, do all these things potentially tie together?

What if there was a way to accelerate market development and new product acceptance? Suppose you could push a market from being seen as early stage, fragmented, unproven and a niche opportunity over the chasm to a place on the other side where it's mainstream, adopted, proven and broad?

Here's where PE can make a difference. Suppose one of those funds chose to take a slug of money - say, $100m - and instead of leveraging it into an existing company, applied it instead directly to a market? By pulling together two or three early-stage players and forging one larger company that could offer both economies of scale and have enough presence and clout that they could actively drive a market forwards, then is there a way here to make everybody happy?

The clear implication is that for B/C stage venture companies, there would now be another option for a way forwards or an exit: consolidation. The PE firm would buy a controlling share in the two or three companies they would need to get a nascent market to critical mass, giving the VCs who had funded things that far some level of immediate return as well as still having a minority share of the combined entity. The partner driving this would have to make some hard - but hopefully well-informed - choices around what the on-going company would look like, both in terms of the market being built and who ends up in key operational roles, but if they have the insight and ability to pull it off then the results could be very interesting indeed.

As with all things, however, timing is everything, and timing in these situations requires a deep understanding of the dynamics and value-propositions of the market you are working on. Relying solely on their core skills of financial management simply won't get the job done.

To make this work, therefore, PE will have to hire a new breed of player: someone who can combine a real appreciation of market dynamics; be willing to take ownership of a strategy to play a market out; and have enough operational depth to pull-off a multi-way merger and subsequent creation of a real, thriving company.

But what of the rewards? Get this right, and the upside could be huge. We can all see nascent opportunities out there that, if the above formula could work, would result in a handful of strong, capable players, operating in key new markets, with enough mass and momentum to once again drive a raft of valuable IPOs.

New paradigm for a brave new Silicon Valley world? We'll see, but it may be the only chance we all have to reinvent ourselves in the software and infrastructure space.


I said...

It's going to end in tears for some. Those in early will do ok. It's the late entrants that are taking on too much debt and too high a cost that i'm concerned about. As you say the govt is tightening the belt with increases in interest rates. We are seeing various companies go belly-up as cash flow becomes an issue. Question is will it be a soft or a hard landing? Small part of me hopes that interest rates rise as i will get more interest on my savings. Flipside though is companies fail, people lose their jobs, economy stalls, etc etc Could get ugly.

J said...

... and don't forget the dreaded house price crash! Course, it's also true that those funds are actually spending our hard-earned retirement dolalrs too, so we may lose out three different ways in one go-round!

I said...

Absolutely. In the UK there are stories appearing on the media where folks are saying they are struggling to sell apartments. One example in surrey the girl had dropped 3 times and the latest price is lower than she paid for it 3 yrs ago. Too much supply and the cost of borrow is getting higher. Its not a good sign.

Don't start me on the pensions!