Cheap dollar may help slow exit market

Late last year, the exit outlook didn’t look that bad. While U.S. markets sputtered, venture and private equity firms were still seeing some lucrative exits in emerging markets. On the domestic front, investors were wary but hopeful that the credit-crunch would be short-lived.

Optimists were wrong. So far, 2008 has been a crummy year for venture-backed IPOs and deathly slow for M&A. Investors are glum, entrepreneurs cash-strapped, and the confidence levels of venture capitalists are running at multi-year lows.

The first quarter was particularly bleak. Only five venture-backed companies went public on U.S. exchanges and raised just $283 million—the lowest volume of new issues in nearly five years. M&A was equally lethargic, with only 56 deals—one of the lowest quarterly levels in the past decade. The Silicon Valley Venture Capitalist Confidence Index, a quarterly survey of regional investors, found optimism running at the lowest levels in its four-year history.

For a while, IPOs in emerging markets offered some consolation. Venture and private equity firms scored some big wins with initial public offerings on Hong Kong and Bombay exchanges. And with the weakened U.S. dollar, overseas exits brought the added reward of currency gains. Now that exit window may be closing, too.

Major emerging market stock indexes are down sharply this year, hampering new offerings. And fans of creative liquidity strategies are struggling to find new alternatives to their old alternative exit strategies. With the weak U.S. dollar, cross-border dealmakers say one exit strategy that looks poised for an upturn is international M&A. As market leaders in emerging economies in particular seek to broaden their global reach, cross-border investors predict they’ll snap up more U.S. assets. If, that is, their own domestic economies don’t follow the lead of the United States.

Softening in emerging markets

Decoupling. It sounds like something married people do when they tire of each other’s company. In private equity circles, the term describes the view that emerging markets are better equipped today to withstand a downturn in the world’s largest economy. With rapid growth in domestic consumption, so the theory goes, emerging economies can continue to thrive.

Last summer, when troubles in the subprime mortgage market signaled the beginning of a U.S. credit crunch, emerging markets investors remained unscathed.

Over the course of 2007, the Bombay Stock Exchange’s Sensex index scaled to a record high. In China, the benchmark Shanghai Composite Index more than doubled last year, and Hong Kong Stock Exchange’s Hang Seng index reached its zenith last fall.

Venture and strategic investors landed some nice returns during the run-up. For public market exits overseas, no recent deal compares in instant market capitalization to last fall’s offering by online business-to-business network Alibaba, whose stakeholders included Fidelity Ventures, Softbank and Yahoo. Shares of the Hangzhou, China-based company nearly tripled in its November debut, garnering the company a first-day market value of $25 billion. The market’s recent plunge, however, has wiped out most of those gains, leaving Alibaba with a market cap of about $10 billion.

VCs logged other gains, too, on Chinese and Indian exchanges. Another China-based hit was online game developer and operator NetDragon, an IDGVC Partners portfolio company that raised about $200 million in a November public offering on Hong Kong’s Growth Enterprise Market. Like Alibaba, NetDragon fared badly in aftermarket trading: Shares have shed nearly half their value since the start of the year.

In India, Shriram EPC, a provider of engineering and management services for energy and waste treatment plants, went public on the Bombay exchange in February. The IPO looked promising, with Shriram sporting a market cap of around $360 million. But after hitting a peak in first-day trading, the company’s shares have since fallen by nearly 20 percent.

Shriram had previously raised $33 million in two rounds from Bessemer Venture Partners and Bangalore-based UTI Venture Funds and $37 million in pre-IPO capital from Galleon Group, Argonaut Partners, and New Vernon Private Equity.

The dollar is so low at this point that there are bargains to be picked up by foreign investors.”

Gary Benton

Venture-backed OnMobile fared a bit better with its February debut on the Bombay exchange. The developer of software for mobile devices is trading above its first-day closing price, with a market cap exceeding $800 million. OnMobile had previously raised $15 million in 2000 from JP Morgan, Satwik Ventures and Telesystem-Argo Global Capital.

In recent weeks, prospects for exits in emerging markets have darkened considerably. The Shanghai Composite Index has shed more than one-third of its value in 2008, and the Sensex has dipped sharply after reaching a record high in January. Fans of the decoupling hypothesis, meanwhile, are finding that breaking ties is hard to do, particularly where the world’s largest economy is concerned.

“In India for the last two years there’s been this euphoria over domestic consumption,” says Ramanan Raghavendran, managing partner at cross-border private equity investor Kubera Partners, who divides his time between Mumbai and New York. “What’s slowly dawned is that the global economy is notoriously intertwined—and so you’ve seen a fairly dramatic drop in indexes in the last couple of months.”

Kubera has seen one of its portfolio companies go public on the Bombay exchange this year: IT outsourcing service provider GSS America Infotech. Kubera bought a 10% stake in the company in January, two months before GSS went public on the Bombay exchange, and Kubera has not yet sold its shares.

But while he considers GSS a successful offering, Raghavendran says the Indian market for IPOs has gotten bleaker over the past three months. That has greater impact on venture and private equity returns in India than in other regions, he notes, since a public offering, rather than an acquisition, is the preferred exit route for most Indian entrepreneurs.

Credit crunch-fueled gloom has also put a damper on debuts on the London Stock Exchange’s Alternative Investment Market (AIM), which for the past few years has been touting itself as a liquidity route for small companies. In the first quarter, only 30 companies went public on AIM, foreshadowing a sharp year-over-year slowdown. In 2007, 284 companies went public on AIM, and 462 did so in 2006.

“It goes without saying that the current macro trends are not easy,” says Richard Webster-Smith, business development manager for the London Stock Exchange. “You’ve seen quite high degrees of market volatility, and that quite naturally has impacted short-term IPO activity.”

America, the bargain bin

With public offerings foundering, cross-border investors say the weak U.S. dollar could open up another exit avenue—the sale of U.S. startups to strategic acquirers overseas, including those in emerging markets—and India in particular.

“The dollar is so low at this point that there are bargains to be picked up by foreign investors,” says Gary Benton, a partner who specializes in international transactions for law firm Pillsbury Winthrop Shaw Pittman. Benton says funds controlled by high net worth individuals and families in India, Europe and other distant locales are eyeing the assets of venture and private equity firms in the United States.

The trend mimics what’s already occurring on public markets, as foreign acquirers, including many in emerging markets, snap up seemingly undervalued assets. Tata Motors’ $2.3 billion purchase of Ford’s Jaguar and Land Rover divisions in March is the most high profile example to date. Other mega deals include Tata Chemical’s planned purchase of East Hanover, N.J.-based chemical company General Chemical Industrial Products for $1 billion, announced in February, and Hyderabad-based Rain Calcining’s acquisition of Kingwood, Texas-based CII Carbon for $595 million, which closed last July.

Are venture-backed assets attractive to emerging market acquirers? Raghavendran thinks so. One of his portfolio companies, Hyderabad-based Ocimum Biosolutions, in December acquired the genomics division of GeneLogic, a publicly traded company in Maryland that previously raised funding from backers including Oxford Bioscience Partners and Cross Atlantic Partners.

Private equity investors have already profited in some transactions. For example, Indian outsourcing service provider Wipro last year acquired New Jersey-based outsourcer Infocrossing for $559 million. In 2002, PE firm Camden Partners invested $10 million in Infocrossing at a $70 million valuation, according to Thomson Financial (publisher of VCJ).

What we are increasingly seeing is a number of India-based companies spreading their wings and looking to make acquisitions overseas.”

Ramanan Raghavendran

Another large deal involving a private equity player was Mumbai-based business process outsourcer Firstsource’s acquisition of Louisville-based MedAssist for $330 million last year. Private equity firm RoundTable Healthcare Partners had bought a majority stake in MedAssist, a provider of health care accounting services, for an undisclosed sum in 2003.

Recently, IT-related deals have accounted for a larger share of Indian companies’ U.S. acquisitions—a trend that bodes well for technology venture exits. While the number of transactions in the first two months of 2008 remained the same as last year (10), 70% were IT-related, compared to only 40% last year, according to a March report by Virtus Global Partners, a boutique investment banking firm that focuses on U.S. and Indian transactions.

Raghavendran predicts purchases of U.S. tech startups by Indian companies will become more frequent. He says when he is in Bombay he talks to several Indian entrepreneurs every week who have their eye on startups in the United States, noting: “What we are increasingly seeing is a number of India-based companies spreading their wings and looking to make acquisitions overseas.”

SIDEBAR: Moving backward

In yet another indication that all is not well in exit-land, reverse mergers are nearly outpacing regular IPOs as a means to go public on U.S. exchanges.

In the first quarter, a half-dozen venture- and angel-funded companies announced or completed reverse mergers, with most incorporating a concurrent stock sale to institutional investors. Judging by short-term returns, it’s unlikely any of the companies’ private investors chose the reverse merger route for its profitability.

This backdoor approach to an IPO—in which a private company merges with a publicly traded shell—commonly produces a thinly traded stock that sells on a second-tier exchange for a couple of dollars a share. Research coverage and fast liquidity are seldom part of the deal.

Despite their shortcomings, however, reverse mergers have gained traction with investors as demand for traditional IPOs shrivels. Wall Street types who in a prior era might’ve peddled tech stocks or mortgage-backed securities are today keeping busy raising capital for special-purpose acquisition companies (SPACs), the shell corporations used to consummate reverse mergers.

“Reverse mergers are not such unusual, bizarre transactions as they seem,” says Alan Donenfeld, a general partner at Paragon Capital, a New York-based hedge fund raising a fund targeting reverse mergers and private investments in public equities (PIPEs). Paragon plans to focus on private businesses that face difficulty raising capital on public markets.

In 2007, SPACs raised $12 billion in proceeds from 66 offerings on U.S. markets, according to SPAC Analytics, a research firm. So far this year, 12 SPACs have raised $3.4 billion, with the average deal size surging to $285 million this year, up from $183 million in 2007.

Venture-, angel- and PE-backed companies are factoring into a number of planned and recently consummated SPAC transactions. Among the largest recent debuts was that of MiMedx, a medical device company that had acquired PE-backed spinal implant developer SpineMedia. The company announced in February that it merged into Alynx, a publicly traded shell company listed on the Over the Counter Bulletin Board. Alynx currently has a market cap around $108 million. SpineMedia had previously raised $10.6 million from Clayton Associates and Trelys Funds. The only venture investor listed on MiMedx’s merger proxy statement is FCA Venture Partners, with a 3% stake.

Another big offering on the horizon comes from Raven Biotechnologies, a developer of monoclonal antibodies that raised $112 million from more than a dozen venture investors between 1999 and 2007. The company—whose backers include CMEA Ventures, Milepost Ventures and U.S. Venture Partners—is currently completing a reverse merger with VaxGen, which sells on the sparsely traded Pink Sheets. None of the VCs is listed as a beneficial owner on the merger proxy.

Such deals are the exception, however. Most reverse mergers are substantially smaller, such as that of angel-funded College Tonight, a social networking site that recently completed a reverse merger with Pink Sheet-traded Simex Technologies. The newly public company, which posted $6,000 in revenue last year, has a market value around $12 million. —Joanna Glasner