In the early 1990s, venture capital and buyouts again parted ways. Venture financing had dropped to a nine-year low of $2 billion. By contrast, there was $30 billion floated in high-yield debt — until the junk bond market shut down for half a decade.
Venture capital was marked by a series of high-profile IPOs, once the World Wide Web took hold. Among them were Yahoo! and Amazon in 1994, and Netscape in 1995, which opened at $28 and closed at $71 on its first trading day. The latter half of the decade again saw an accelerating phase, famously, with massive overvaluations. “I told you that in 1983, venture capital companies went public at 19 or 20 times revenue and we thought that was big stuff. But in 1999, companies went public with no revenues.” Venture firms by now had a war chest of $56 billion.
By contrast, buyouts were more muted than they had been in their Drexel Burnham Lambert heyday, with leverage of between 20% and 40%.
Then came the 2000 market peak, with $105 billion chasing venture firms. When the new economy tanked, default rates went to all-time highs, and it took with it some buyout firms who, lured by the fantastic numbers in the venture space, shifted from investing in stable companies with cash flows. The accounting scandals at Global Crossing, Enron and WorldCom in turn prompted new legislation: the Sarbanes-Oxley Act that shut the tap on IPOs. “Going public became a very time-consuming, expensive, even prohibitive activity,” Zug says. Yet, as venture capital collapsed, buyouts were entering a “golden age” fuelled by cheap debt. Companies were being taken out at nine to 12 times EBITDA (earnings before interest, taxes, depreciation and amortization.) Almost $200 billion was chasing buyout deals, while, reflecting the “non-existent performance” of venture investing, only $25 billion was raised for new deals by 2007.
Today, “the venture window continues to be shut,” Zug says. But buyout firms are equally squeezed; “LBO debt has completely dried up and new deal activity has come to a virtual halt.”
Overshadowing both sectors is that, with the dramatic falls in public stocks, many institutional investors are now over-allocated to private equity. To get those ratios back to their policy portfolio, some investors are selling their stakes in the secondary market at discounts of 60% to 80%, even 100%, because they cannot afford to meet a capital call. In private equity, capital is committed at the beginning, but not drawn on all at once.
Fundraising averaged $400 billion over the past few years. Zug originally expected $200 billion to be raised this year, but is now predicting a record drop to as low as $100 billion.
What lessons can be drawn from these cycles? Assuming an investment with a top-quartile firm, an investor would have reaped 10% in the acceleration and free-fall phases of the cycle, compared to 26% in the bottoming and firming stages. The numbers are slightly higher for buyouts, at 17% and 30%.
Even so, the outlook is uncertain. While the general partners still think they will earn a 6% to 8% internal rate of return on their 2005, 2006 and 2007 vintage funds, Zug says “I think that’s high, myself. Those years are now of course etched in stone, to some degree, or at least the deals that were done in those years are etched in stone. Those were done at purchase-price multiples that we probably won’t see again in our lifetimes, or at least in the lifetimes of the fund.”
Those deals were done at nine or 10 times EBITDA, where Zug thinks in the current environment six times EBITDA is more likely. “To get out of those deals at anything close to what the investors got in with, in terms of pricing and to make money, they’re going to have to drive EBITDA up considerably, which seems a little challenging in this market environment,” he says.
If one buys the cycles, now would be the time for venture capital. But Zug also suggests “we could be in for a new paradigm in the buyout business; we could be in for a buyout business that is largely equity supported and half the price of what deals were done at three years ago.”
He adds, “I think there will be some debt available, but it won’t be at nearly the levels that were available before.” That puts the emphasis on pricing, for equity investing without leverage. Still, he warns, “I think it’s going to be a much, much tougher time in the buyout business. Despite all the talk of hands-on value creation, growing the companies, etc., the leverage in the buyout business — particularly the levels and the costs in the past few years — had to have fuelled significantly the performance in that industry. And it’s not going to be there for a while.”
 | Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com |