A Buyer's Market
Think the stock markets have been rough? Here’s a rare peek behind the scenes of the ravaged venture capital markets…where a shakeout at the institutional level has created a singular opportunity for individual investors. "Never before," suggests Karim Rahemtullah, "have the capital markets offered such a leveraged opportunity for the smaller VC investor."
The tanking global markets have left no stone unturned. Once the source of Hollywood screenplays and lavish launch parties, the venture capital market has all but dried up. Or has it?
Well, at first glance, you’d certainly think so. Ninety seven billion dollars streamed into 63 venture capital funds during the peak year of 2000. Through the 3rd quarter of 2002, the number of funds has been chopped in half to 33. And the amount of money raised has plummeted even farther to $5.5 billion. The number of deals on the table – averaging well above 2000 per quarter in 2000 – has now dropped to 832 in the first quarter of 2002, and 857 in the second quarter.
A perusal of mainstream press on the subject reveals headlines that read like more like a patient’s diagnoses than a financial assessment. "Poor economy and illiquidity continue to plague private equity returns" reads one… "Venture capital fundraising continues to decline as industry strives for equilibrium," reads another.
But, like so many things in the markets, it all depends on your vantage point. The "equilibrium" these headlines refer to indicates, in fact, that the market has been leaning in favor of investors in a way not seen for a long time…but not the type of investor you generally associate with behind-closed-doors venture deals. In fact, this carnage is actually good news if you are a small – but qualified – investor, looking for early- stage investment deals. Let me explain why.
Venture capitalists are no longer paying massive premiums to invest in growth companies like they did in the 90s. Instead, they’re finding bargain basement deals. The combination of a market collapse and a recession have created the perfect storm scenario for companies seeking capital. It used to be a sellers market, but not anymore.
In a recession, cash is king. And given the economy and the bear market, cash is scarce.
But contrary to popular opinion, a recession does not mean negative growth all around. And because the competition for VC money is getting fierce, the quality of deals available to new VC investors is getting dramatically better.
The simple fact is, there’s never a recession in the market for new companies with new ideas or patents that may prove profitable. According to The Venture Capital Journal, a trade journal published by Thomson Financial, the top ten VC deals in October included new offerings in biopharma, storage networks, data solutions and switching, and other telecom components…as well as a company with a patent for a wireless insulin pump.
These are some of the sectors getting the most abuse in the market. An industry analysis shows that VC activity in the software, telecom, networking and life sciences "sectors" has dropped anywhere from 10% for software to 34% for networking. But these industries still show some of the most dynamic innovation and product development. And at present, they’re a perfect hunting ground for early-stage investors.
As director of the Supper Club, a small, private group of early-stage investors founded by Bill Bonner, I’ve seen a dynamic turn in favor of individual investors. The number of new venture deals coming across my desk has not decreased over the past few months. Quite the opposite, in fact…and their quality is getting better. Good businesses are hungry for scarce cash.
We’ve seen companies with patents in a wide variety of industries, from medicine to transportation: a CT scanning unit that can perform virtual colonoscopies and non-invasive CT angiograms; a patented low-cost siding in the transportation industry; even an innovation in snowboard bindings making them safer and lighter… not bad for your kids, eh?
Good deals need cash. But at the institutional level, VCs have shut off the cash spigot. Losses from the dot- bomb era have come home to roost and the ‘players’ have either folded their cards or been scared out of the market. But that could mean an unusual opportunity…a buyer’s market, if you will. And the minimum required to get into this game has come down substantially.
There’s an old saying about companies seeking early stage capital: ‘beggars can’t be choosers.’ Two years ago – at the height of the VC frenzy in 2000 – dealmakers were restricting deals to those who could afford minimum investments of $100,000 or more. Those who wanted to invest "only" $10,000 or $50,000 into a series of deals were shown the exit door in a hurry…"maybe you should call your broker and see if you can get some shares in the IPO," they would say, knowing full well the IPOs were pre-scripted, too.
Fast-forward to today, after the bust. Companies with unique innovations and products ready for the marketplace are still looking for the heavy hitters. But the number of deals big VC funds are willing to look into has declined as steeply as the amount of capital they have to invest. More deals than ever before are now on the table for smaller investors. And smaller investors actually have an advantage they’ve never enjoyed. Because the VC well is drying up, you can often negotiate the best possible terms for your involvement in the deal directly with the principals of the company looking for capital.
Cash is truly king. And if you’ve still got some, the time may be fast approaching to put it to use. A news release issued by the National Venture Capital Association, albeit an organization with a vested interest in releasing good news about the industry, showed that "in an unprecedented trend, venture capital funds returned more money to their limited partners (LPs) than they raised in new funds in the second quarter of 2002."
The release goes on to state that "recognizing it was unlikely venture firms could effectively invest billion- dollar funds in the current uncertain and volatile environment and reap the stellar results investors expect, seven firms gave back $2.7 billion to their LPs." Seeing the writing on the wall, these VC funds are actually returning investor capital!
If that’s the trend in place, the number and quality of private companies seeking cash from investors with smaller entry positions will increase – and the pot for the small-time investor will be getting ever richer in the months (perhaps years) to come.
for The Daily Reckoning
November 5, 2002
P.S. The implosion of the VC market is good news for Supper Club members. It’s a ‘buyer’s market.’ When you’re in the club, it goes something like this: "Who’s got the money?" the moderator/host asks the members in attendance. The reply: "we do!"
And…"who wants the money?" The reply: "They do."
"They" are the companies coming to us with ideas and their hats in their hands. And with that, the VC reality is quite clear.
In this market, investors are in the driver’s seat. And businesses looking for VC money must make lucrative concessions to get what they want. Investing, at least at the venture round, is finally "back to normal" after nearly a decade of irrational exuberance.
Editor’s note: Dubbed a "Market Maven" by CNBC, Karim Rahemtulla was educated in England, Canada and the U.S. and speaks five languages. He travels the world extensively to research investment opportunities for his readers. For more than a decade, Mr. Rahemtulla has been studying, investing and teaching about the world’s most profitable investment markets. Today, Mr. Rahemtullah is investment director at The Supper Club.
Tomorrow’s the big day.
"Fed may lower rates," says Bloomberg.
"Economists fear rate cut won’t help," says USA Today.
Wouldn’t it be nice if the Fed really could make us all richer? How? By lowering the cost of money – just by setting short term rates where the economy needs them. How could charging less than the going rate for credit help? After all, there is only so much money available. How could the Fed know better than the market itself how it should be priced? We don’t know. But after 11 rate cuts, people are beginning to wonder about the 12th.
If that’s all there is to it, why doesn’t the Fed give struggling nations like Japan and Argentina a hand? Why don’t they tell the foreigners what rates would work magic for their economies?
We never could understand what was the matter with the Japanese. They cut rates, just like it says in the Fed instruction manual. Rates went all the way down to zero. And what did they get for it? Nothing. It was as if they had dumped a pile of money on the street and offered to lend it to anyone at no interest. But who took them up? Only desperate zombie companies who needed the money to stay afloat and now can’t pay it back.
And now, we read in yesterday’s news, it’s the night of the living dead in the U.S., too. Dozens of huge companies are either in bankruptcy or close to it. They keep going… thanks largely to credit that was priced too low and was too easy to get. Sooner or later, as in Japan, this mis-priced debt will have to be reckoned with.
The U.S. is not Japan, they keep telling us. But the ways in which it is not Japan seem as alarming as the ways it is. In Japan, the credit went mostly to big corporate borrowers who now can’t pay their bills. In America, we may have fewer big corporate deadbeats, but we have a lot more consumers on the edge of insolvency. And just recently, it looks like the consumers are running into trouble. Auto sales dropped sharply last month…leaving only housing, as the last stud standing.
We don’t know what the Fed will do tomorrow. But we doubt it will be a good day for the stock market. Whether the fed cuts rates or leaves them unchanged, in either case, investors are likely to ask: what difference does it make?
Over to you, Eric…
Eric Fry in New York…
– Like some of the fatigued runners I observed last Sunday in the New York City Marathon, the stock market stumbled across the finish line yesterday. Sure, the Dow still managed to gain 54 points to 8,571, but the blue chips had raced ahead more than 200 points earlier in the session. The Nasdaq also surrendered much of its morning lead, but still added 2.5% to 1,396.
– Despite the gains on Wall Street, the dollar failed to rally once again. The feeble greenback slipped slightly against the euro. Gold dipped 50 cents to $318.70 an ounce. Microsoft – a major component of both the Dow and the Nasdaq – sparked the frenzied stock-buying on Monday morning. Shares of the software giant jumped 6% after a Federal judge upheld the main provisions of the company’s antitrust settlement with the Justice Department, casting aside calls by nine states for more stringent penalties.
– Investors reacted giddily to the ruling by doing what they always do when they’re feeling giddy – they bought stocks, especially tech stocks. But the party atmosphere quickly turned dark after Defense Secretary Donald Rumsfeld announced that National Guard troops and reserves would be called up in the near future. Rumor has it that Rumsfeld promised his commanders more than 100,000 troops for a possible campaign against Iraq. Suddenly, war with Iraq is back on the front burner, and no one is feeling very giddy about that.
– Meanwhile, the economy continues to muddle along. Factory orders dropped 2.3% in September compared to the month before, and durable goods orders tumbled 4.9%…See what happens when Mr. and Mrs. Consumer stop consuming and start saving? The economy simply can’t tolerate that sort of prudence.
– Meanwhile, the job losses continue to mount. According to Challenger, Gray & Christmas, the monthly tally of announced layoffs rose to 176,010 in October, the second highest total of the year. "There are more negative economic reports now than when the recession officially began," said John Challenger, CEO of the outplacement firm. "Companies are simply unwilling to take risks at this point."
– The economy is slipping, yet shares prices are rising. Doesn’t this combination seem a little unstable? All in all, the pieces do not seem to be in place for a sustainable bull market in stocks.
– "I am not convinced that this rally is the beginning of a new bull-run," says Karim Rahemtulla. "The uncertainty surrounding a possible war with Iraq, further terrorist action and general global political unease can play havoc with the market. It would not be out of the realm of possibility for us to easily retest the September lows.
– "In fact," Karim continues, "I think we could yet see a 1,000-point down day in the Dow…Try as I might, I cannot see the world returning to a state of Utopia any time soon. For now we will continue with our strategy to take a bearish bent to making money." Given Karim’s cautious remarks, I was a bit surprised at his optimism in other areas of the market – namely venture capital…more about which below…
– Americans are flocking to the polling booths this morning to vote for their favorite scallywags.
– No matter whose names receive the most hole-punches, you can be sure that these newly elected representatives will spend the next four years trying to figure out how to take more of our money. In the 2001 fiscal year, the U.S. Treasury enjoyed a $127 billion surplus. In fiscal 2002, the government will run up a $150 billion-plus deficit.
– The era of budget surpluses is over. The new era of deficits has begun… we doubt it will be nearly as much fun.
Back in…West Virginia…
*** There were three major bull markets in America during the last century, Richard Russell explained yesterday. There was the 1921-’29 boom, the ’49-’66 bull market, and the most recent one, which he figures began in 1974 and lasted until ’99. The shortest of these last 8 years. The longest took 25 years to reach its apogee. During this time, it took stock prices up 20 times from where they started, making it the greatest bull market in history.
Each big bull market, however, was followed by an "extended, very complex bear market." Russell puts the bear market following the ’29 crash as the biggest – lasting 20 years, until 1949.
These bear markets can take a long time to get where they are going. Sooner or later they get there – down to levels where stocks finally bottom out at 5-10 times earnings.
The saving grace of previous bear markets was that stocks paid dividends. But now, the average dividend is barely a quarter of what it used to be.
The Trade of the Decade, we still believe, will be to sell stocks and buy gold. Even if gold goes nowhere…when stocks finally hit bottom, gold will look like it’s up from there.
*** "I love New York," said my model daughter. I met her at the airport. The two of us boarded another plane to visit my other daughter at her college in West Virginia. So, we’re on the road.
"New York is great. People are so much more friendly than they are in Paris. They say ‘Hi’ to me…people I don’t know.
"But the way they eat is awful. Of course, you can get a good meal. But those are the expensive restaurants. Everybody else eats terrible sandwiches, washed down with coke…"
Americans are not as serious about food as the French. The waiters are college students or out-of-work actors. The chefs are often former day-traders.
"The special of the day is a piece of beef," said our young Asian waiter, gazing down at his notes. We had turned into the Hyatt in a Northern Virginia suburb and decided to try the cuisine. "It’s like breaded and cooked in a beer glaze…you know, in its own juices."
We had no idea what he meant. But it wasn’t a bad meal.