Friday, July 4, 2008

Venture Cap in a "State of Crisis", PE Not Far Behind

Let me begin this post where I left off yesterday because it is important to hammer in the point that the subprime crisis was just the tip of the iceberg of the credit crisis.

The past few weeks have brought a chorus of proclamations from Wall Street cheerleaders that the "credit crunch is ending". But there are reasons to believe that the credit crunch is moving beyond its subprime mortgage origins into other loan sectors. According to Richard Suttmeier, chief market strategist of, the top five problem loan sectors to watch now are:

  • Credit card debt
  • Home equity loans
  • Commercial real estate loans
  • Commercial and development loans
  • Derivatives generally ($182 trillion notional value)

Suttmeier notes that each of these potentially bad loan categories are rising among FDIC insured institutions. Rather than pulling back, he says borrowers are tapping outstanding lines of credit while banks are using "tricks" (like making payments on behalf of debtors) in order to keep the loans in the "current" category. You can watch Suttmeier's interview here (click to watch interview).

It is worth noting that the credit crisis is spreading to other important areas of the capital markets. This week, the National Venture Capital Association (NVCA) declared that venture capital is in a "state of crisis" I quote the following from their press release (click here to read it all):

"For the first time since 1978, there were no venture backed Initial Public Offerings (IPOs) in the second quarter of 2008 according to the Exit Poll report by the National Venture Capital Association (NVCA) and Thomson Reuters. The absence of any offerings this quarter follows an exceptionally slow first quarter when only 5 venture-backed companies went public. This number is a fraction of the first half of 2007 when 43 companies went public. According to the NVCA, the situation is concerning enough to be characterized as a capital markets crisis for the start-up community."

Moreover the NVCA survey found that:

  • 81 percent of venture capitalists do not see the IPO window opening in 2008.
  • Two-thirds of venture capitalists believe that venture-backed companies are less likely to want to go public today than they were 3 years ago.
  • The three largest factors to which venture capitalists attribute the current IPO drought are:
    • Skittish investors (77 percent)
    • Credit crunch/mortgage crisis (64 percent)
    • Sarbanes Oxley regulation (57 percent)
  • Only 8 percent of venture capitalists characterize the current IPO drought as “not critical” to the future health of the venture capital and entrepreneurial communities."
You can click on the chart above to enlarge the image and download the whole NVCA Powerpoint presentation by clicking here.

The liquidity crisis has also spread to the private equity market, which has been in a moribund state this year. According to the, buyout firms face some serious challenges everywhere except distressed debt:

"It's been a tough first six months for buyout sponsors, as both financing and fundraising markets remain a challenge.

In the U.S., buyouts in the first two quarters of 2008 were smaller and fewer. They totaled $37.9 billion (296 deals), plunging 88% from $306.5 billion (424 deals) in the first half of last year, according to Dealogic.

While dealflow was still raging in the first half of 2007, it was at the tail end of the leveraged buyouts boom, followed by a severe credit crunch last summer.

Since then, top private equity firms have put their money to work in ways other than the traditional LBO. For example, they began making noncontrol investments and bought distressed loans from ailing Wall Street banks.

Certainly, megabuyouts have disappeared. Globally, the first half of 2008 saw no deals over $10 billion, Dealogic said. There were seven in the same period last year. The average deal size, meanwhile, shrunk to $234 million from $806 million.

Meanwhile, fundraising has fallen off as well. Buyout funds focusing on the U.S. raised just $38.4 billion in the first half of this year, a hefty 56% drop from the $87.4 billion raised last year, according to London-based Private Equity Intelligence Ltd.

On a global basis, buyout fundraising decreased 21% to $108 million from $136 million.

But investors see opportunity in adversity. Distressed debt funds raised 38% more capital globally, raking in a total $33 billion in the first half of this year, PEI said.

The global pool of mezzanine capital doubled to $20 billion."

There's no clearer symptom of private equity's dismal state than Thursday's prominently placed piece in The Wall Street Journal's C section that Kohlberg Kravis Roberts & Co. (KKR) hasn't given up on the notion of going public. I quote the following from the

"It's been one year since the leveraged buyout giant announced plans for an IPO.

But that was before the credit markets collapsed, before big-cap leverage buyout activity of the kind KKR specializes in evaporated and before KKR's revenues and cash flows dwindled to a trickle. (This last point is a guess, since KKR hasn't updated its financials since last November, when it issued its last amended IPO prospectus. But unless KKR has secretly scored a killing in pork bellies or energy futures, it's safe to surmise that recent results have been anemic.)

Nonetheless, the mere fact that KKR is "still keen on becoming a public company," as the Journal reports, qualifies as news of a sort.

Of course, actually moving forward with an IPO is another matter entirely. The shares of LBO players who beat KKR to the public market, the Blackstone Group LP and Fortress Investment Group LLC, continue to perform dismally. Given current market conditions, it's doubtful their shares will perk up in the near future."

Finally, investors should understand the renumeration structure of PE dealmakers, which according to the Bank of International Settlements, promotes excessive risk taking:

Dealmakers receive a fixed management fee for their funds, while paying lower tax rates on their investment profits, which encourages them to raise more money and pursue larger targets, the Basel, Switzerland-based bank said in a report today. LBO dealmakers themselves typically only have a stake of up to 3 percent in a fund, the BIS added.

``These factors point to incentive structures that encourage excessive risk-taking by general partners in the private equity market,'' the BIS said in the report. ``After periods of high returns, the private equity market might be characterized by a situation in which too much money is chasing too few deals.''

Investors should take note of these significant developments in venture capital and private equity. The contagion effects of the subprime crisis are hitting private markets as well as public markets. Given the illiquidity of private asset classes, pension funds need to reduce their exposure to these assets and diversify their portfolios, focusing on top-performing distressed debt funds in private equity and real estate (the next big shoe to drop!). They should also make sure they are not paying fee structures that promote excessive risk taking.

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