Private equity: Start up or buy out?

There seem to be cycles in private company investing. Those with long memories will remember Michael Milken and junk bonds. In recent memory, there were the venture firms of the Silicon Valley that went bust at the beginning of the decade, or more recently still, buyouts whose coda was supplied by the failure of the Ontario Teachers’ Pension Plan to take Bell Canada private.

But how regular are these cycles, and what do they portend? It’s a question veteran private equity investor Brooks Zug has been asking himself for a while now. Zug, senior managing director and founder of HarbourVest Partners, initially wondered whether there were commonalities between venture capital and buyouts, and thought he had an answer three years ago.

He did, but it wasn’t the right answer.

“I was wrong in trying to have the venture cycle follow the buyout cycle and assume that they both follow the same cycle,” he admits. “The venture cycles and the buyout cycles have been almost directly opposite one another.” He made his remarks earlier this week at a private equity symposium, sponsored by the Canadian Institute of Chartered Business Valuators, the Canadian Venture Capital Association, Financial Executives International-Canada and the Toronto CFA Society.

Zug examined fundraising and returns in private equity over the past forty years, charting a four-part cycle that ends plateaus with a peak and then goes into free fall before bottoming into a trough. Then investments start to firm up before accelerating into a peak again. “If you invested in venture in the 1970s, for example, you made a lot of money; if you invested in venture in the 1980s, you didn’t make too much money. But if you invested in buyouts in the 1980s, you did well; if you invested in buyouts in the 1990s, you didn’t do so well.”

In the late 1960s, venture capital peaked in 1969, at the same time as the stock market. There was $373 million in capital raised, centred on the fledgling solid-state microprocessor industry. Intel was formed in that period, and Arpanet, the forerunner of the Internet, went live. But by 1974, the amount of new fundraising had contracted to $60 million, just as public stocks were bottoming.

The next half of the decade was a firming period. By 1980, there was $1 billion raised primarily for disk drive and portable computer companies. “Along with enthusiasm for that segment of the market, which had just developed out of the founding of Intel and Microsoft, we saw venture capital valuations rising tremendously,” Zug recalls. Indeed, by 1983 — the first year with more than 100 initial public offerings, which included Intel, Lotus and Miniscribe — valuations reached all-times highs, at roughly 20 times revenues.

At the same time, the leveraged buyout industry was in its initial stages, with the first large leveraged buyout occurring in 1979. In the early 1980s, there was perhaps $1 billion committed to the sector, compared to over $3 billion for venture firms.

Since that time, the cycle has been radically different for venture capital and buyout firms. Venture capital went into free fall in the 1980s, a descent that was hastened by the publication of the first benchmark data in 1988 by Venture Economics. That dispelled anecdotal notions of success, or as Zug notes, “the people who were raising money told us nothing but the best stories.”

But buyouts were in a firming cycle, with Kohlberg Kravis Roberts (KKR) raising the first billion-dollar buyout fund. By the second half of the decade, the buyout cycle had reached the acceleration phase, boosted by the ability to deduct debt against taxes and the increasing availability of high-yield, or junk bonds. Buyout firms raised $13.9 billion, while KKR made a $31.1 billion bid for RJR Nabisco — still one of the top-five leveraged acquisitions ever. It was financed with only 5% equity; the other 95% was debt.

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.”

(03/06/09)