The private equity bubble, and what it means for startups

There are storm clouds gathering in the buyout world, which could see a big retrenchment. In the long-run, this could be good for the Silicon Valley start-ups.

The amount of money raised by U.S. leveraged buyout funds in 2006 is staggering when you compare this to two years ago (see graphic).

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Some forecasts suggest 2007 will be another record year.
Many institutional investors are worried that the LBO funds are “writing checks like crazy” and that “…this may be a great time to sell companies, not a great time to buy,” Kelly DePonte of Probitas Partners, a highly respected placement agent active in the LBO space, told Reuters last month.

The argument used by those raising large LBO funds sounds familiar • “the opportunities for LBO deals are very strong,” — and hence they say larger funds can be put to work. But if the opportunities are so good, why not raise the bar for investments • selecting only the best ones — to reap the largest returns possible? That would mean discipline, something that is rare in a market where investors, en masse, swing between fear and unrealistic expectations.

The staggering amount of money being raised by LBO funds brings back memories of 2000 with over $100B raised by venture funds. Can the LBO funds responsibly deploy the money they have raised, given their investors’ expectations for returns and the competition for deals? Or, just as importantly, will there be a robust enough “exit” environment to allow the kind of returns the Limited Partners have come to expect?

The current environment would suggest not. LBO funds generally invest in mature companies with substantial cash flows and revenue • and so can be patient and bide their time for a liquidity event. But those longer time horizons eat into effective returns. An investment that takes a decade to bare fruit is less valuable than one that takes four or five years. The sheer amount of money that has flowed into LBO funds in the last two years creates its own challenge. Generating a 20% return over five years requires doubling the invested capital, so over the next 3 to 4 years, the LBO funds have to generate over $750B (and that’s not counting the debt used to leverage the majority of deals) • but there was only $43 billion last year in IPOs. The math doesn’t add up.

The inevitable conclusion is that LBO returns are headed lower • much lower.

It took VC funds five years to recover from the fund raising excesses of 2000. That correction was precipitated by the collapse of the Internet bubble and has been very painful. The venture industry has been much more careful in the size of funds being raised as a result and I suspect we haven’t seen the end of next generation funds being driven smaller as more VC funds come back to the market.

As the VC funds proved in 2000, there are limits to the amount of capital that can be deployed in a particular investment strategy. What will spark the correction for the LBO funds?

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Increasing competition for LBO deals will lower returns and make it harder to deploy the larger funds. The 2000 correction in VC fund sizes started with the larger funds being cut in size, as it became clear money couldn’t be invested in a reasonable timeframe. Will 2007 see some of the larger LBO funds take the same action?

If this happens, will it spill over to the related hedge-fund industry? And will this, in turn, lead to public markets that values fast-growing venture-backed start-ups instead • because of their long-term potential?

For those of us here in early stage investing, it’s time to paraphrase Mel Brooks’ “It’s good to be da King” in his movie History of the World, Part I.

“It’s good to be an early stage investor!”

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(See Stu Phillips’ blog, at Soaring on Ridgelift.)