Private Equity: Start Up or Buy Out?

But how regular are these cycles, and what do they portend? It’s a question veteran private equity investor Brooks Zug has been asking himself for a while now. Zug, senior managing director and founder of HarbourVest Partners, initially wondered whether there were commonalities between venture capital and buyouts, and thought he had an answer three years ago.

He did, but it wasn’t the right answer.

“I was wrong in trying to have the venture cycle follow the buyout cycle and assume that they both follow the same cycle,” he admits. “The venture cycles and the buyout cycles have been almost directly opposite one another.” He made his remarks earlier this week at a private equity symposium, sponsored by the Canadian Institute of Chartered Business Valuators, the Canadian Venture Capital Association, Financial Executives International-Canada and the Toronto CFA Society.

Zug examined fundraising and returns in private equity over the past forty years, charting a four-part cycle that ends plateaus with a peak and then goes into free fall before bottoming into a trough. Then investments start to firm up before accelerating into a peak again. “If you invested in venture in the 1970s, for example, you made a lot of money; if you invested in venture in the 1980s, you didn’t make too much money. But if you invested in buyouts in the 1980s, you did well; if you invested in buyouts in the 1990s, you didn’t do so well.”

In the late 1960s, venture capital peaked in 1969, at the same time as the stock market. There was $373 million in capital raised, centred on the fledgling solid-state microprocessor industry. Intel was formed in that period, and Arpanet, the forerunner of the Internet, went live. But by 1974, the amount of new fundraising had contracted to $60 million, just as public stocks were bottoming.

The next half of the decade was a firming period. By 1980, there was $1 billion raised primarily for disk drive and portable computer companies. “Along with enthusiasm for that segment of the market, which had just developed out of the founding of Intel and Microsoft, we saw venture capital valuations rising tremendously,” Zug recalls. Indeed, by 1983 — the first year with more than 100 initial public offerings, which included Intel, Lotus and Miniscribe — valuations reached all-times highs, at roughly 20 times revenues.

At the same time, the leveraged buyout industry was in its initial stages, with the first large leveraged buyout occurring in 1979. In the early 1980s, there was perhaps $1 billion committed to the sector, compared to over $3 billion for venture firms.

Since that time, the cycle has been radically different for venture capital and buyout firms. Venture capital went into free fall in the 1980s, a descent that was hastened by the publication of the first benchmark data in 1988 by Venture Economics. That dispelled anecdotal notions of success, or as Zug notes, “the people who were raising money told us nothing but the best stories.”

But buyouts were in a firming cycle, with Kohlberg Kravis Roberts (KKR) raising the first billion-dollar buyout fund. By the second half of the decade, the buyout cycle had reached the acceleration phase, boosted by the ability to deduct debt against taxes and the increasing availability of high-yield, or junk bonds. Buyout firms raised $13.9 billion, while KKR made a $31.1 billion bid for RJR Nabisco — still one of the top-five leveraged acquisitions ever. It was financed with only 5% equity; the other 95% was debt.