Credit Crunch Impact - Entrepreneurs & Investors

7 May 2008

This GP Bullhound report, commissioned by BBAA, looks at some of the questions raised  by entrepreneurs and investors. Extracts from the report are presented below, to see the full report go to: http://www.bbaa.org.uk/portal/images/stories/sector_report_credit_crunch_april_2008.pdf

People and businesses across Europe and the US are experiencing a harsher
economic climate following the meltdown in the US sub-prime mortgage market
and subsequent liquidity crisis in financial markets – widely referred to as “the
Credit Crunch”.  Consumer and business confidence levels have been declining alongside stock and real estate markets, and some economists believe that the US is now in a recession.

State of the Market
Anecdotal evidence from transactions we (GP Bullhound) have insight into, as well as entrepreneurs and investors that we talk to, suggest that the economic
turbulence started to affect technology transactions in November 2007 and
that deal activity has slowed down significantly since.

How does this impact venture fund raisings?
Private equity valuations follow the public markets
There has been a strong correlation historically between public and private
equity market valuations. The report contains a graph tracking public vs. private equity market valuations during the past peak / trough period in 1997 – 2002 which suggests that private equity markets closely followed public valuations, but with a slight time-lag.

Private placement activity has slowed down
New venture investment activity has slowed down over the past few quarters
but the Information Technology sector has performed relatively well.

Prolonged venture investment cycles are likely to continue until markets and asset prices stabilize
The General Partner Dilemma
The traditional ‘General Partner Dilemma’ suggests that venture fund
managers (GPs) are best able to raise their funds in bullish market climates
but then come under pressure from their Limited Partners (investors) to make
investments in potentially overheated / overvalued markets, whereas when
markets are bearish – and asset prices typically low / attractive – GPs are
often unable to raise funds and/or under pressure not to make investments.
Frustrated entrepreneurs will argue that investors are generally driven by the
herd mentality with a seemingly uncanny agreement when to invest or not.
Whereas the herd mentality could partly be explained by the GPs’ dilemma
and other psychological factors including peer pressure, it is also a function
of how funds are structured including governance rules and compensation
systems. Such rules make it very easy for investment committees to say no
in uncertain times, and individuals are not rewarded for making ‘bold’
decisions.

Plenty of capital to deploy
As the market stabilizes, VCs are likely to quickly return to a highly active
investment mode in order to deploy the vast amounts of capital that sit within
funds – early signs of increased activity already point in this direction.
The private equity industry as a whole has continued to raise significant
amounts of capital into 2008 with an estimated US$176bn being raised in the
first quarter alone – albeit that Q1 closings will relate to fund raising activities
in earlier periods, many before the credit crunch. Private equity and venture
fund raising is becoming increasingly polarized however as the major
established funds continue to raise ever larger funds while small and nobrand
/ start-ups are finding it increasingly difficult to succeed.
Consistently in the venture end of private equity, venture funds raised as
much money in the first quarter 2008 as in 2007 (~US$6.3bn), but the
number of funds that raised capital was down from 83 funds to 57.

Conclusions
We (GP Bullhound) believe that we will continue to see pro-longed venture investment cycles over the next few months as public equity markets continue its recovery and investors are comforted that valuations have reached a floor (public stock markets have been trading in a stable range for the past month, possibly indicating that we’re at the floor already).

With valuation multiples reaching all-time-lows however, smart money is
starting to come back. We notice a higher than normal sensitivity to
valuations and investors seeking better downside protection in terms as well
as an increased willingness to syndicate. We (GP Bullhound) continue to see strong deal activity in many sectors; digital media companies with developed revenue models and distribution channels being one; Semiconductor/systems companies targeting large consumer markets (or bottlenecks therein) are also getting attention and software businesses with true SaaS offerings continue to be very well received.

While the pace of technology acquisitions remains intact, deals in many
cases are taking slightly longer to close with valuation levels coming down
from levels we saw last year. Finding the right internal sponsor, or
“champion”, for the deal within the acquiring entity can be complicated and
challenging in any market environment, but particularly so in today’s market
as internal dealmakers attempt to be more selective and critical of potential
acquisitions.

A key factor is that many buyers price in dollars, independent of which
currency the target is trading in (or have received investment in), and this
‘discount’ may have to be accepted.

Regional strength in Europe might make it attractive for Euro zone VCs to
use their strong currency to make investments in start-ups that are exposed
to $ or £ costs as part of their expansion.

From a valuation standpoint, while it is true that we are in a “buyer’s market”,
competition for leading properties and technologies with scale remains
strong, both for financings and M&A deals.