Private equity, angel investors, deep pocketed media and IT firms are putting a squeeze on VCs, or so says the headline. Is any of this true?
It’s no secret, the venture capital landscape is changing: VCs like Fred Wilson offer a daily glimpse into how so and how much every day on their blogs (small is beautiful), while other venerable funds try to adapt and change with the times (Charles River offering debt financing).
The boom, bust and boom again in technology and new media circles has led to an influx of wealthy individuals acting like angel investors, with the ability to pony up six if not seven digit-sized investments.
Cheap debt translates to private equity firms scooping in and buying up assets at a torrid pace.
And, of course, IT and new media companies are flush with cash, boast high P/E multiples and can entice entrepreneurs to pursue the building of their dreams within their organization. While entrepreneurs and investors won’t say it in public, selling out to Yahoo!, Microsoft, Google, IAC - and increasingly the old media types News Corp., Viacom, Time Warner, etc. - is always an exit option.
Any way you dice it, venture capital is being attacked from all corners. Of course, VCs are not going away, either. For one, angels invest mainly in those they are close to - literally and figuratively - and have an affinity with. Tech firms and new media companies tend to invest in companies that offer them something unique and strategic, and tend to reduce the freedom and options of the smaller company down the road. And, private equity investing, while enormous, is generally limited to investing in publicly traded companies, meaning that startups can’t turn to them. While other hedge funds take positions in everything from stock, currencies and derivatives, they seldom - if ever - plunk down money in a startup.
So the fact remains that all of this talk about VCs being threatened is, well, simply untrue. If anything, we think that this is partially emanating from VCs who have a lot of capital under management but little places to invest it in. In other words, the more we look at the landscape, the more we think VCs are trying to step on PE firms’ toes.
Private equity, of course, is a growing business. A recent article in Business Week’s April 2nd 2007 issue had some interesting stats. John K. Castle, chairman and CEO of Castle Harlan, a private equity firm, broke down some numbers in an attempt to calm the concern over an ever-growing private equity appetite:
- US private equity firms raised $215.4 billion in 2006, according to the Dow Jones Private Equity Analyst.
- Private equity investors, mainly pension funds, endowments, other institutional investors, have committed $555 billion, with $322 billion remaining to be invested, according to Wachovia Securities.
Clearly, these are big numbers, but Mr. Kastle, who admittedly is biased, does a very good job to put them into perspective. How so? Read on.
- The $322 billion in private equity is slightly more than the market capitalization of MSFT ($302B) but less than that of Exxon Mobil ($425B) or GE ($$379B). The problem of course is that private equity leverages its bets with a lot of debt, so the $322 billion is actually much more, while Mr. Kastle says that it represents $800 billion purchasing power (or a ratio of 2.4, many hedge funds and private equity funds tend to be far more levered than that. At the extreme, former Salomon Bros. trader’s John Meriwhether’s infamous Long Term Capital Management was levered to the tune of 40 to 1.
Mr. Kastle goes on to argue that the $322B in private equity left to be invested is in fact representative of:
- 1.6% of the $20.1 trillion in total equity of all of the companies traded on the main US exchanges.
- the tiny $54.1 trillion net worth of US households and non-profit organizations (the organizations and individuals that own all financial, real estate and other assets).
Right or wrong, the point he is trying to make is that private equity is small in comparison to all of the money that is out there.
Of course, while VCs are sitting on a lot of money, the bottom line is that only a tiny fraction of that capital is invested:
Let’s take a look at the VC industry, mainly in the US.
According to the National Venture Capital Association, as of December 2005,
- the venture capital industry was managing approximately $259 billion.
- there are approximately 866 venture capital firms in the United States.
- the average venture fund size was $299.5 million.
- venture capitalists invested approximately $22 billion into 2,527 companies.
Simple math translates that only $22B of $259B was invested in 2005. If you break down the $22B by 866 VC firms, this means that each VC invested approximately $25M that year. In fact, considering that over 2,500 companies got VC money, this means that each investment was in the $8.7M range.
Last year, 2006, saw a rise in activity, but even then, VCs invested some $6.2 billion in 797 deals in U.S. during the third quarter of 2006, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association based on data by Thomson Financial.
In other words, even when you forget the fact that 9 out of 10 VC investments fail, the ones that succeed tend to have very little impact on a VC’s return on equity, because so little of it is actually invested. But indeed because so many traditional VC investments are speculative, that the next trend is for VCs to move progressively more and more towards areas that private equity companies currently invest in. Sure, a lot of VCs are embracing smaller deals, but that might be because it involves someone they have worked with previously or it presents an opportunity they really believe in. In other words, the numbers do not really seem to justify remaining in new ventures, the smart money has been following larger deals and VCs have seen the light.
The challenge is the massive amounts of capital under management combined with a risk/return profile that suggests that they are better off buying up established, less risky companies, spruce them up and then unload them at a profit.
Doubleclick was acquired by a private equity firm for $1.1B, they unloaded $535M in assets and now want to fetch $2B in a sale in less than one year. Say what you want about the plausibility of that happening, like we have here and here, the fact is: it’s a less risky proposition with much higher and certain absolute returns than the potential relative returns of pure play startups.
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