Secondary Market for Private Equity

Interesting post from Joanna Glanser at PEHUB about the number of private equity partnership shares trading hands. From the brief article:

The forecast released this week by secondary market maker NYPPEX predicts that sales of limited partner stakes in private equity partnerships will soar by 68% to $27 billion in 2009.

This highlights the stratosphere of markets that can and should exist to enhance market efficiency - allows one owner take possession of an asset that another is no longer willing or able to hold. Fred Wilson touched on that during his panel discussion at a recent conference. Marketplaces such as SecondMarket should exist to provide an exchange mechanism.

The Venture Capital Confidence Index - A Leading Indicator

Mark Cannice, Chair of the University of San Francisco Entrepreneurship Program, provided some great insight about how venture capital and venture capital activites may foreshadow overall financial market activity.

In his video interview on The Wall Street Journal Online, Mark pointed out that venture capital operates at the "intersection of public and private finance," providing an interesting future perspective regarding the health of the financial markets. If VCs are seeing fewer exit opportunities via IPOs or acquisition, that may serve as a leading indicator regarding the overall financial market.

The complete video interview on MarketWatch is available for public viewing (no logins/subscriptions required).

$236 million? Bear Stearns, Valuations, and Train Wrecks

An astonishing train wreck. That’s all that comes to mind in reading about Bear Stearns’ collapse and J.P. Morgan’s purchase of the Wall Street mainstay since 1923.

According to the Wall Street Journal – “J.P. Morgan Rescues Bear Stearns.” "Rescues?" Seems more like Cousin Vinny bailing out the “two youts” somewhere in Alabama after being charged for murder…

Part of me feels like the $236 million price tag might still subject J.P. Morgan to the “winner’s curse,” but seeing that no other bidders were evident, I guess not...

To put the $236 million number into perspective, the latest Bear Stearns balance sheet is showing over $600 million in Plant, Property, and Equipment, so at least J.P. Morgan can have a sidewalk sale to liquidate the remaining office equipment and cover the legal fees associated with the acquisition. And the $236 million would have been pocket change for the LBO equity firm about a year ago.

Or if you started with $200,000 in 1923, earning the market return of 8.66% per year would have yielded you $232 million by now.

The latest venture capital investment-based valuation of Yelp is somewhere around $200 million. So Web 2.0 companies with revenues at $10 million a year are worth more than Bear Stearns in its current state?

When I introduce the concept of fundamental analysis to my finance students at the University of San Francisco, we do an exercise to illustrate the difference between “market value” and “intrinsic value” of a firm. Guess I have a new company to use for next semester’s lecture.

Venture Capital - Moving up the Ladder

In an article earlier this month, I examined an interesting trend in venture capital based on data provided by PWCMoneyTree. In short, the data appears to indicate that venture capital is moving away from investments in the "Start-up/Seed stage" and more towards later stage companies - those companies in "Expansion" or "Later Stage."

A recent article by Joseph Bartlett on VC Experts seems to find similar observations, using Jensen's "Eclipse of the Public Corporation" for support to his argument. Bartlett refers to Rebecca Buckman's October 2007 article in The Wall Street Journal - "Venture Capital Goes Big" that discusses venture capital's increasing activity in the buyout arena of private equity.

While the private equity industry seemed to nicely partition itself in recent years - venture funds here, LBO/MBO firms there - a funny thing happened - the walls between participants in the private equity industry seem to have disintegrated to some degree. I referred to this in an article last summer based on Mark Boslet's article in the San Jose Mercury News.

The net result? Greater demand for LBO/MBO deals, causing valuations to rise and profit margins on these deals to fall, and in turn possibly contributing to private equity's troubles as the 2007 credit crunch hit the financial markets. Bartlett also discussess the increasing price of LBO activity due to this increased demand, more plainly referring to the "winner's curse" that haunts firms that overpay for acquisitions.

If this trends continues, the entrepreneur in her garage with next big thing will find that traditional venture funding may be more difficult to attain than ever, and start-up capital will likely to be better accessed through the increasing angel capital networks emerging throughout the country.

Venture Capital Investment Trends since 1995 (Deals by Stage)

Doing some research about Venture Capital trends, I came across some interesting data provided by PWCMoneyTree.showing convergence in the number of venture capital deals between Early Stage, Expansion, and Later Stage deals, while the Start-up/Seed Stage dropped considerably over the past 12-13 years:

Reading nothing more than the data presented in these graphs, I'm hypothesizing that this decline was a function of a number of factors:

1. Venture Capital followed itself.

If there were a plethora of start-ups in the mid-1990s at the start of the internet/tech bubble, then it would make sense that targets that received venture capital in the "Start-up/Seed Stage" would then receive subsequent rounds of funding while in their "Early Stage" and "Expansion Stages", then eventually as "Late Stage" investments. Seems there may be some evidence of this effect as you examine the decrease of Start-up/Seed Stage funding with increases (and then decreases) in Early Stage and Expansion targets. These Early Stage and Expansion investment targets then became targets for Late Stage funding.

2. Venture Capital has become more risk averse.

Following the fallout of the last tech bubble in the late 1990's, venture capitalists turned their attention to firms that were past the start-up stage and had a better chance of survival. This would certainly explain the dramatic rise in the percentage of deals in Later Stage companies from approximately 10% to 30% of investments.

3. Venture Capital has become more selective

Certainly there was not a drastic decrease in the number of firms seeking Start-up/Seed Stage funding during the past 12-13 years - just the number of venture capitalists willing and able to fund these start-ups.

4. The ongoing emergence of Angel Capital

As angel capital groups continue their emergence, they may be filling the void - funding Start-up/Seed Stage companies instead of traditional Venture Capital.

I am actively researching these thoughts to support with further evidence, but this certainly provides some interesting fodder for discussion. I'm interested in your feedback on this thought process.

Venture Capital is not the end goal

It’s interesting when talking to start-up CEOs and entrepreneurs how often they are enamored with landing venture capital, as if receiving the funding itself is their main business objective. Venture capital is the beginning of any start-up's journey- a vehicle to speed product development, expand market reach, and grow the firm more rapidly than what would be possible through self-funding from revenues. Venture capital is never the destination.

Just remember the VC's rough equation:

10 investments = 7 failures + 2 breakevens + 1 successful exit

You're one of ten - there's a better chance that you're one of the future failures in this model than the successful exit.

Just as bankers provide small business loans to firms that meet their expected rate of return hurdles, venture capitalists invest in start-ups that offer the opportunity for them to meet their own capital growth goals. This is not philanthropy. One rarely hears an entrepreneur express delight for their pending small business loan from their banker, yet closing a round of venture capital is met with valedictory celebration.

In many ways, it would seem logical that the bank loan should be the capital event to spark celebration at a small business, since the bank only wishes to be compensated with interest payments, instead of preferred shares. Of course, most start-ups don't fit the lending criteria of most banks - this is illustration is meant to offer some perspective.

Certainly venture funding is vitally important to fill the investment gap between angel investors, private equity, and traditional lenders. The start-up entreneur should just remember that there are two sides to any transaction. If a VC is willing to invest $5, $10, $15+ million in your biotech, software, or patented technology, that money will come at a cost. Be sure to weigh the cost/benefit of the transaction before considering venture capital funding to be the end game.

(There's some solid reading and perspective on venture capital and angel investing at The Smart Startup).

Company Value = Benefit to Customers

A common way to value a company is to look at the company’s total revenues and then take a some multiple such as “1x” or “2x” in conservative industries, with “10x” as an acceptable standard in the technology industry, and an incredible “100x” as witnessed in Microsoft’s valuation of Facebook. We’ll call this the “Revenue Multiple Approach” (RMA).

What’s interesting to me is that you never read about why we use "revenue" (or a multiple of revenue) to establish a firm’s valuation.

I was considering company valuations last week from an economic perspective - thinking more about how and why companies are valuable and how they fit into the broader economy and less about the plug-and-chug, back-of-the-envelope modeling that is common in finance. It made sense that a firm’s value solely should be based on the benefit that its customers receive from purchasing the firm’s products and services.

The outcome of this explanation is to show how we can generate the value of a firm (“Supplier") based on its sales to its customer(s) (“Purchasing Firm”)

In general economic theory, we know that consumers will consume a good as long as price of good is less than (or equal to) the benefit received by the firm. Consumers consume based on personal utility and firms consume production inputs to minimize cost (or maximize profit). It is possible to calculate the contribution of consuming this input to total profit.

Mathematically, this is means that a transaction to purchase a good or service will occur only if:

Price of a Good ≤ Value

So, if the value of a good is expressed in its price, then the value of a product is equal to the maximum price that the good’s consumer is willing and able to pay.

Total Value of a Good = Max Price Paid by Purchaser

(This sort of reinforces what we said above about a transaction taking place only if the price of a good is less than or equal to its value to the consumer.)

In a perfectly competitive market, firms produce to a point where their marginal cost of producing a product is equal to the marginal benefit gained from its sale. This is represented by the marginal cost/marginal benefit curves, also more commonly known as “Supply” (marginal cost curve) and “Demand” (marginal benefit curve).

If a firm produces to the point where MC = MB, then the costs to the Purchasing Firm for the good will be equal to the revenue of the Supplier. Conversely, the revenue of the Supplier will be equal to the marginal costs of the Purchasing Firm, which happens to be equal to the marginal benefit received by the purchasing firm.

So if we want to determine the Supplier’s value, then we can assume that its value is equal to the total marginal benefit experienced by all Purchasing Firms, which we’ve said happens to be equal to our Supplier firm's revenue.

Simply put:

Value of a Firm = Total Marginal Benefit Received by its customers = Total Revenue of Firm

Instead of using the Revenue Multiple Approach, we could call our company valuation model method the “Marginal Benefit Valuation” (MBV) because when we’re using revenues to determine a firm’s value, we’re really just calculating the firm’s total marginal benefit to its customers.

Finally, the last step in this process would be to take some reasonable time period, project revenues each year over that time horizon, use a discount rate that correctly assumes risk level or opportunity cost, and calculate a firm's value based on the discounted revenue streams during this time. And there's the basis for firm valuation using revenues to make the determination.

As an extension to the discussion ---

Which multiple to use (1x, 2x, 10x, 100x…)?

Much of that decision is subjective based on brand recognition, future company growth, the industry, and pure subjectivity. (We all remember the dotcoms where business valuations were based on which venture capital firm was willing to bid the highest.) This is another article in itself….

Why use multiples of revenues?

Well, as a part-time academic (I teach Finance at the University of San Francisco), I’ve personally never been able to get my head around using the RMA. If revenues are the choice for determining a company’s value (because they represent the Marginal Benefit received by their customers), it seems that it is far more logical to calculate the present value of future revenues. If one is particularly bullish on a company’s future prospects and would like to reflect this attitude in a company’s value, just adjust the discount rate downward and adjust the growth rate upward to yield higher present value (or higher company value). But of course, then you’re infusing significant subjectivity to the equation, but this approach offers a more sound theoretical modeling technique.

Market Value vs. Intrinsic Value

I'd like to tackle the issue of firm valuation. Determining a firm's value is especially important for start-up firms under consideration for venture funding. Establishing, maintaining, and increasing a start-up's value is central to the reason the firm was founded and for utilizing venture capital and investment provided to it.

This introduces an item that requires further clarification - the definition of "value." Value can be generally defined as "a fair price" or as "utility" or "worth" (courtesy of the American Heritage Dictionary...).

In the financial world, it's common to differentiate among types of "value." Specifically, there is a difference between an asset's "market value" and its "intrinsic value." Market value is the value that someone else places on an asset - what that asset is worth to some other market participant. Intrinsic value is the actual value or worth of a firm.

This fundamental difference in values supports the argument that the true value of a company is not necessarily reflected in the market valuations given to them by other market participants. The case I referred to was Microsoft's $15 billion valuation of Facebook. Valuations generated by venture capitalists or other related suitors nearly always tend to be market values, and not a reflection of a firm's intrinsic value.

If a VC values a company at $100 mln, and makes a $10 mln investment, that means that they have purchased 10% of the company. That initial $10 mln investment may be (or at least should be) entirely necessary for the target company to propel itself for product development, sales, and eventually profit. However, given that VCs are wrong on their company valuations 90% of the time, the $100 mln valuation is solely based on the market value - what the VCs are willing and able to pay for some asset.

In this case, they are willing and able to pay $10 mln for 10% of the company. Surely they would be willing to pay less that $10 mlm for 10% of the company, and alternately, the company owner would surely be willing to sell less than 10% of the company for $10 mln. But assuming that the VC and the company operate in a competitive market, this $10 mln investment for 10% of the company represents the market equilibrium price for the asset (the asset being 10% of the start-up).

This market price doesn't necessarily mean, and in most cases, does not mean that the intrinsic value of the start-up is $100 mln, only that the market value of the start-up is $100 mln. In fact, with the 90% failure rate of the VC industry, it stands to reason that the market valuation of the company is quite overpriced, but because there is a willing buyer and seller, a market for the 10% of the company is created.

With a couple of fundamentals definitions, we can begin to see how the market valuations for start-ups and new media companies may be incorrect a high percentage of the time, with these errors tending to overvalue a firm rather than undervalue a firm.

It's a point of frustration to see artificially high market values placed on firms (whether they be start-ups or publicly-traded) when it is clear the economic or intrinsic value of a firm can be clearly argued to be much lower.

Venture Capital - late vs. early stage

An interesting article in the San Jose Mercury News by Mark Boslet discusses the higher valuations of venture capital deals – “Venture capital funding, valuations rise.” (links to PDF file of the article on the Saints Capital website).

Some thoughts on the article to consider:

1. The investors that compose the continuum of private equity, ranging from LBOs to traditional venture capital to angel networks, are growing individually, and as a result, are creeping into each other’s territory. Look at the investment parameters of many “Private Equity” companies and you’ll see a growing number targeting later-stage companies (not the traditional LBO/MBO private equity model of 10 years ago), creating competition for the market. The article states that “too much money [is] chasing too few late-stage deals.” The result is the increased valuations.

2. Angel networks are becoming more and more sophisticated - what used to be the territory of the traditional VC companies. “Angels” used to mean people like your Uncle Bill who did well in the market before retiring and could afford to throw $10K your way. Now angel groups are targeting investments up to the $2 mln range (and higher in some cases). Even organizations like the Angel Capital Association now exist that did not 5 years ago.

The article also states that early-stage companies are forced to suffer. I disagree to some extent.

Firstly, good companies with good ideas, good products, and good managers will get funded. The market works. There may be fewer investments and funding events at the early stage, but perhaps that is better to better information availability about markets, products, and strategies.

Secondly, the wave of VC capital that was thrown at Web 1.0 companies was often spent on outrageous marketing campaigns (i.e. $1 mln for Super Bowl ads) to build brand recognition.

Take a moment to consider where we are with Web 2.0 and marketing:

• Long-tail marketing
• Viral Marketing
• Blogging
• User-generated content
• Google Ads

I don’t have any hard statistics to back this, but I suspect that marketing costs for start-ups are relatively lower as measured by capital than they were 7 years ago. With decreased capital costs for marketing, a significant chunk of the demand for early-stage VC capital infusion diminishes. Start-ups can focus resources on technology and product development and launch their products to market by effectively utilizing a Web 2.0 marketing strategy.

Private Equity in Education?

Laureate Education accepted a $3.5+ bln offer from an investor group that includes KKR.

With regard to Laureate, I am curious to see if and how private equity begins to creep into the public education arena - private equity is already purchasing mega-sized infrastructure projects such as toll roads and bridges. It is not much of a stretch to think that the private equity model of efficiency gains and increased organizational effectiveness would be a solution to attritting school performance acorss the US. The demands of taxpayers are constantly increasing. The competition for entrance to colleges and universities is cutthroat. Creeping into the for-profit education sector could be the first step into a foray to public education sector.

Private Equity & the Publishing Industry

Apax acquired Thomson Learning for over $7+ billion - nearly the same sale price as Chrysler!

Pearson plc recently acquired eCollege for approximately $500 mln., despite Pearson’s strategic partnership with Blackboard, Inc., a direct competitor to eCollege. Additionally, this price reflects a value nearly equal to eight times revenue and 20 times EBITDA.

I am closely monitoring the current and proposed transactions in the publishing industry. With over seven years of experience in this industry, I believe that there are significant inefficiencies that exist within the market participants. The major publishing houses maintain internal brand and production silos within their organizations, often duplicating product development, sales, and distribution services. In these cases, there are opportunities to divest these brand silos individually, with the sum of parts worth more than the whole and thus providing an opportunity for an experienced private equity fund to execute these transactions profitably.

In addition, traditional publishing companies have been challenged by an increasing number of distribution competitors, such as used books sellers overseas and new technology companies offering customizable, user-generated content. Companies with modernized distribution channels versus traditional publishers (such as the relationship of News Corporation and Dow Jones) will be able to leverage these channels to better meet market demands, and again give rise to a profitable outcome.

These industry conditions present an interesting value proposition for private equity firms experienced in capitalizing on these types of market inefficiencies, resulting in more effective and profitable companies. I suspect that this may be a main proponent of Apax Partners’ cash purchase for Thomson Learning, a price considered to be exorbitant by some executives within the publishing industry.