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

Tech Wreck - Dell, Apple and HP: A Developing Story

Technology based firms like HP (transformational M&A), Dell (Management led LBO) and Apple (huge cash reserves) have generated plenty of recent headlines. What they have in common is a maturing industry, slower growth and increasing over capacity that is common to the creative destructive process is dynamic economies. The consequences of these developments are pressured margins and falling stock prices. This has created a strategy-value gap. Essentially, the current strategy no longer creates the highest and best results because it no longer fits evolving market opportunities. This presents a huge governance challenge for boards facing management teams unable or unwilling to change.

The competitive advantage period these firms previously enjoyed has shrunk to zero as their markets and products became commoditized. Thus, the source of value has shifted from growth opportunities to assets in place. The emphasis is no longer growth but returns and profitability. This shift gives rise to the following fundamental changes:

1) Increased emphasis on capital allocation as free cash flows rise due to falling investment requirements. This produces significant agency issues as management may be tempted to waste resources in over-priced acquisitions as occurred at HP.

2) Ownership and management changes in the areas of consolidation based M&A, LBOs by frustrated management and spin-offs and divestment of SBUs that no longer fit.

3) Increased shareholder distribution thru dividends and stock repurchases of excess free cash flow.

4) Higher leverage to maximize tax benefits and increase managerial discipline over cash flows and balances.

5) Improved focus reflected in the reduced number of SBUs. This reduces cross subsidies and improves capital allocation.

6) New incentives added to improve accountability.

7) Enhanced governance through new more active and experienced board members.

All of the above will be driven by heightened shareholder activism by investors,such as Einhorn at Apple, seeking to improve shareholder value. Some of this will be ugly-proxy fights, litigation, transaction challenges, and ultimately possible hostile take-over attempts.

The net result will be the tech industry as the new hotbed of deal activity going forward. Firms, management and boards will struggle to adapt to an evolving industry environment. Not everyone can succeed, but for those who can the rewards will huge. In the meantime, investment bankers, lawyers and bloggers will be busy. Much more to follow.

J