Just a few short months ago, Henry Kravis boldly proclaimed that the “private equity world is in its golden era.” Since then, we’ve seen the sub-prime mortgage market implode, the dollar hit record lows, and corporate debt get ravaged. Oh yes, and some high-profile hedge fund failures and bailouts. So what does this mean to financial institutions who invest in the private equity asset class? For one thing, future allocations will likely swing away from mega buyouts and towards other asset classes, including venture capital. Oh how the winds have shifted.
Bye-bye mega buyouts
What started out as the sub-prime mortgage flu earlier this summer has quickly become a much broader credit infection, and now threatens to turn into a pandemic. While the pundits debate if pending buyout deals will get done (they will) and as partners at buyout firms like KKR, Blackstone, and Carlyle offer much more generous debt terms on these deals (which is why they will get done), two things have become apparent.
First, the LP community has finally decided to take a breather from its multi-year party at the buyout bacchanalia while the debt market sorts itself out. And second, there will be far fewer big buyout deals with accompanying junk debt in the foreseeable future.
As a top Wall Street pro said in a front page Wall Street Journal story on Sept. 6: “It’s become nearly impossible to finance a PE transaction of over $1 billion.” The mega buyout guys are about to go through their bubble correction just like venture guys did in 2002. Maybe not as bad, maybe worse. We’ll see. Bubbles always look so obvious with the benefit of 20/20 hindsight.
Canaries in coal mines
Few could have predicted that John and Jane Doe, defaulting on mortgages they never should have gotten in the first place, could cause a global contagion to spread so quickly. Still, did LPs stay too long at the buyout party? Were there warning signs that were overlooked? Yes, in fact, there were many:
Blackstone IPO. Maybe Steve Schwarzman, chairman and CEO of Blackstone, really is smart enough to go public at the top of the market (although the 35% drop post-IPO has to crimp). The firm’s prospectus gave one clear warning sign when it disclosed that Blackstone had recently passed on a number of deals because they were too competitive and it thought the winners overpaid.
Mega buyout mania. The race to create the biggest buyout fund—$20 billion just wasn’t big enough—smacked of the VC arms race during the tech bubble to raise billion-dollar venture funds. Perhaps the phrase “I can raise a bigger fund than that” will join the list of immortal famous last words along with “Hey, watch me” and “How could we possibly lose?”
The LP community has finally decided to take a breather from its multi-year party at the buyout bacchanalia while the debt market sorts itself out.”
Jim Huston and Richard Yen, Blueprint Ventures
Increasing debt-to-cash-flow ratio. As early as January 2005, David Hamilton, Moody’s director of corporate bond research, told the New York Times: “This percentage of really risky debt is unprecedented.” As Business Week reported in May 2007: “In 2004, the average buyout was funded with $4.50 of debt for every dollar of a target’s cash flow. No longer. Now average debt levels are a record 5.9 times cash flow, and debt multiples of eight or nine times are common.” With debt now even tougher to obtain, it is truly time to batten down the hatches.
Public markets—a leading indicator?
There is another key indicator of private equity performance that is readily available and has been apparent for quite a while: the relative valuations of value stocks to growth stocks in the public markets. The run-up in large cap value stocks over the last several years has been eerily similar to the run-up of large cap growth stocks during the tech bubble of the ‘90s, when growth stocks were much more expensive than value stocks.
Just like the Nasdaq bubble drove “hot money” into growth mutual funds such as Janus in that bubble, so too did money flow into value mutual funds over the last several years. No doubt a lot of this money was chasing the expectation that the mega buyout funds were going to take out these cash-flow-rich companies at a premium—the value version of a Nasdaq IPO.
From mid-1998 through mid-2000, growth stocks substantially outperformed value stocks. But since then, it has been a different story—until just recently. From 2004 through 2006, the Russell 1000 Value Index had over twice the return of the Russell 1000 Growth Index (41.9% vs. 18.4%, respectively). But in 2007, much of that gap has been closed. As of Aug. 31, the Russell 1000 Growth Index is up 7.3% for the year, while the Russell 1000 Value Index is up just 0.8 percent. And most of this divergence occurred since mid-June, right about the time the sub-prime mortgage market began to tank.
Not coincidentally, institutional alternative asset investments have tended to mirror the public markets. Just as LP money poured into venture funds in 1999 and 2000, LPs have poured capital into mega buyout funds over the last several years. And while LPs have not completely abandoned the venture asset class over the last several years, LP inflows into venture have been flat during this time period.
Are we now experiencing the first stages of a full blown bubble correction in value stocks and mega buyout funds, or is this just a temporary blip? Only time will tell, but it is definitely caveat emptor for the brave soul investing in a mega buyout fund today.
Don’t look back
Buyout stalwarts will point out that venture has been a woefully underperforming asset class over the last several years. That’s true. Data from Thomson Financial and Cambridge Associates show that you could have earned a better return with risk-free U.S. Treasury bills over the last few years than in venture. In contrast, large buyout funds have delivered 20%+ IRR over the same period.
Strong performance of technology growth stocks will likely pull institutional money back to the venture asset class in the short term.”
Jim Huston and Richard Yen, Blueprint Ventures
Part of the problem in venture was the lack of IPO exits. It’s difficult to generate attractive returns when venture firms invest $50 million to $75 million into companies whose only exit option is a $75 million to $100 million acquisition.
In buyout land, they could raise debt and quickly dividend back most or all of their original equity investment—and further leverage their companies’ balance sheets—to pump up their IRRs.
But this party appears to be over, at least for a while. And with corporate spinout VMware’s red hot IPO drawing comparisons to Google, perhaps the tech IPO window is reopening at the same time the debt-fueled buyout exits are drying up.
The public market’s tide is also turning in favor of the growth asset class. Tech bellwethers such as Cisco, Amazon and Intel have been the stars of late, while financial services and REITs (the darlings of the last five years) have sagged. Expect these tech titans to use their appreciated stock as currency for future acquisitions. That’s music to venture capitalists’ ears.
Venture forth, young man
Strong performance of technology growth stocks will likely pull institutional money back to the venture asset class in the short term. To keep funds flowing into the asset class in the long term, venture firms must prove they can deliver IRR numbers closer to the historical norms of 15% to 20 percent.
Expect venture investors to be up to the challenge. Today’s VCs are battle survivors who made a multi-year forced march through the desert in the last venture cycle. Those who don’t like the new rules of the game are leaving the playing field to those who can create venture-style returns in the post-bubble environment.
One lesson we all learned in college, but we always seem to forget, is that the party is a lot more fun than the hangover. It seems there are some lessons we have to just keep relearning. Venture has been schooled on this over the last five years. The buyout guys first learned this in the post-Michael Milken meltdown almost two decades ago, and it appears they are going to have to learn it once again. Oh yes, we should have seen this coming.
Jim Huston is a managing director and Richard Yen is a principal with Blueprint Ventures, an investment firm that focuses on capital efficient technology startups and Corporate IP Spinouts. They may be reached at email@example.com and firstname.lastname@example.org.