When Numbers Get Serious

As the Paul Simon song goes “… when times are mysterious serious numbers will always be heard…after all is said and done… two becomes one.” This may explain what is happening in the Venture Capital driven tech world with its current nose bleed valuations/pricing. Venture Capital, like its related deal market cousins-Real Estate and Private Equity, is cyclical. Venture Investing is based on funding capacity not fundamentals as investors, especially limited partners, chase past yields.

The cycle runs as follows:

1)     High returns from successful exits triggers more fund raising

2)     Funds scammer to invest raised funds leading to increased deal competition and pricing

3)     Higher pricing producers lower returns and accidents which reduces fund raising

4)     Less funding capacity leads to reduced pricing, better deals and higher returns

5)     Repeat cycle

Funds are unable to resist due the Prisoner's Dilemma problem. We last saw this in the 1990s with the dotcom boom and bust. The bust lasted until 2012 as funds worked thru their problems and investor memories dissipated. In 2013, Venture Capital enjoyed its highest return since 1999 according to Cambridge Assoc due to some highly successful IPOs. Investors rushed in to invest and fund raising exploded. Tech pricings have followed suit.

Venture funds have developed a new approach to invest this embarrassment of riches accelerated funding. It follows from the observation that the highest returns (note-NOT risk adjusted) are from the largest exits. In this winner- take- all environment (first mover advantage?) it pays to identify winners (start-ups on the verge of breaking out) early and bet/invest heavily in them regardless of current prices. This, of course pre-supposes you can identify those winners before anyone else. This seems like a stretch given the hundreds of firms looking for such winners.

Essentially what is happening, in my view, given the lack of a fundamentals based valuation anchor, is the former series A seed capital financing round is morphing into a hybrid series B growth financing round. Series B, however, had required an externally based proof of concept with a viable revenue model. This seems to missing in the application of the accelerated funding model.  The impact of this development is pricing for IPOs and related M&A is skyrocketing as no one wants to avoid missing the next Facebook. This assumes Facebook ‘s success is based on repeatable skill not luck. The result is great for founders, but scary for investors.

Eventually, prices fall and IPOs fail - leading to a quick re pricing when serious numbers return leading to 2 becoming 1. Paul Simon was very perceptive and may offer some cautionary lessons for tech investors. Venture Capitalist must be attentive of cycles and beware extrapolating recent positive trends.

Sorry to rain on the parade.

j

Exit Strategies for Private Equity: US and European Evidence

Last week we outlined exit strategies for private equity investments.  One strategy that we didn't feature is a 'write-off'.  Obviously, write-offs can represent a failed investment and are (generally) undesirable. However, the ability to cut losses early is a healthy trait in any investment strategy.  The article below highlights exit strategies for US and European buyouts over the 1990-2005 period, revealing many interesting aspects of the exit process.  The importance of market sentiment is also noted, making it imperative to ascertain current and projected market conditions in any analysis.

 Exit Strategies of Buyout Investments – An Empirical Analysis 

Daniel Schmidt Sascha Steffen Franziska Szabó 

June 1, 2009 

(Abstract) 

"We analyze the three main exit routes for exiting buyout investments, initial public offerings (IPO), sales and write-offs on, using a unique data set for US and European buyout transactions for the 1990 to 2005 period. We examine the determinants influencing the choice of an exit channel employing a multinomial logit model. The results strongly support the view that private equity investors write-off investments that turn out to be non-performing early, showing their ability to filter out good from bad investments. We further find evidence that exits of buyout investments tend to be driven by market sentiment. We further analyze as to how the internal rate of return (IRR) influences which exit route is chosen. We find supporting results that only the most profitable ventures are taken public. Our results have implications for exiting buyout investments during the current financial crisis. "

The complete paper can be downloaded here.

All the best,

Ralph

PS We are approaching the next offering of our Acquisition Finance Course in Amsterdam and that also means approaching the deadline to sign up.

Dynamic Capital Structure: A Long and Winding Road

How you fund an acquisition can have an important value impact. Usually, an acquirer has a static target capital structure tied to a ratings goal. For example, an industrial firm with a BBB ratings goal will keep its Debt to Capital ratio below 40%. Thus, it would either use excess liquidity or seek to raise capital for an acquisition in roughly that proportion to maintain its target.

This is largely the case for large, public, infrequent, strategic acquirers. More aggressive firms with concentrated ownership use transitory or dynamic capital structure which fits their short term needs and market conditions. They deliberately, but temporarily, deviate from their long term capital structure target to fund a particular action. Then, they rebalance to meet their long term target. Basically, debt is used as a plug to meet unanticipated funding needs. This allows them to avoid issuing possibly costly undervalued equity or maintaining extensive cash balances.

We saw this with Hudson Bay (SKS) , which leveraged up to high initial 5.7X FD/EBITDA leverage level to fund the SKS purchase. The expectation is they will rapidly refinance the debt from a REIT/Sale-Leaseback. Private Equity (PE) firms use a similar technique. They use high initial leverage and then rapidly retire the debt through operating cash flow. That is why most LBO related bank loans never go to maturity. They are either refinanced at a lower rate if they work according to projections or are restructured is they do not.

PE also uses capital structure changes as a substitute for an exit. Current weak M&A and IPO markets have complicated PE exits from portfolio companies. The average age of portfolio investments has reached a record 5+ years due to the financial crisis. This hurts IRRs and their limited partner investors (LPs). Thus, PE has re-leveraged portfolio companies to fund recapitalizations-special dividends to return capital to their LPs. The level of recaps is running at record levels. It is likely to exceed the record 2012 level this year. In fact, many deals are being rushed to market before the expected Federal (Fed) Reserve tapering begins.

Firms also deviate from capital structure targets based on market timing considerations. For example, firms will fund acquisitions with equity when they feel their shares are overvalued. Perhaps the best example of this is when AOL used its inflated shares as the acquisition currency in the Time Warner transaction. More recent examples are the MB Financial and PACW transactions (MB). 

IPOs exhibit market timing as well. They tend to occur when valuations are high, as reflected in elevated market-to-book ratios. This is the reason why IPO returns a year after the issuance tend to disappoint (e.g. Facebook).

Market timing related capital structure decisions affect debt as well. Debt issuance is favored when both rates and spreads are low. Post crisis Fed actions kept rates low. They also compressed spreads as investors are searching for yield. Equity costs, as reflected in the equity risk premium, have remained relatively high given macro-economic uncertainty. Thus, many firms engage in debt financed share repurchases whereby,”cheap” debt replaces more “expensive” equity.

Bottom line- the capital structure decision is more complicated than the widely held static view. Managers may have a long term target, but how they get there is a function of unanticipated investment and financing opportunities they encounter along the way. Thus, reaching their capital structure target can be a long and winding road.

J