KUHN CAPITAL Monday, March 19, 2018
Dispatches from the front

The Velvet VC Trap

We recently came across some statistics that clarify what being a venture capitalist feels like today. VentureOne has released a compilation of VC investments and their disposition (Cashed Out, Dead or in the Holding Tank) from 1992 through to last August. That is, they identified, year by year, whether VC’s had sold off -- either through an IPO or M&A transaction -- a portfolio company, had written it off, or were still locked into the portfolio company’s equity.

It’s not a pretty picture, and the data are eloquent on the subject of what’s on most VC’s minds today – how to get out. Blocking the exit, of course, are a shuttered IPO window and rock-bottom M&A values, in many cases values much less than the VC invested, even assuming the property can be sold.

Two recent deals give a foretaste of this new reality: content management software vendor Vignette purchased for $32 million Epicentric, a similar vendor that had earlier attracted $81 million in VC money; and Pinnacor (formerly ScreamingMedia), vendor of information and analytical applications for financial services companies, announced it will acquire the operating assets of Inlumen, a similar vendor, for $2.6 million. Inlumen had taken more than $60 million from VC’s.

The Chart’s the Thing
We manipulated the VentureOne year-by-year data to give us a clearer, cumulative picture of how the status of VC investments has evolved over time, producing the chart below.

The first thing that strikes us about the chart is its overall “S-curve” shape, the classic picture of a matured industry or technology. Based only on this impression, any MBA student would observe that the VC business is likely to stay flat or even decline further in number of deals consummated unless or until a new model emerges (or when the economy offers greater exit opportunities).

The second thing that we notice is the speed of change. Industries normally demonstrate S-curves over a span of several decades, not several years. Of course, hi-tech businesses move through their cycles faster than, say, tire manufacturers, but the rate of VC deal deceleration has been breathtaking, braking from 2,657 in 2000 to an annualized rate of 540 in 2002.

A third observation is the ballooning proportion of Holding Tank investments, today representing 58% of all investments since 1992, way up from 19% in 1992. These stagnant Holding Tank positions are the key to understanding the VC industry’s immediate future.

How the Trap Was Sprung
Since it has traditionally taken three to five years for a portfolio company to mature, VC’s must wait this long before they know how effective their investments decisions have been. In other words, to some degree they must keep an eye on the rearview mirror while making investments for the future.

What was that rearview picture like when the industry kicked off its unprecedented spending spree in 1998? Well, things looked rosy then: the 1995 proportion of companies in the Cash Out, Holding Tank and Dead categories seemed about average: Cash Outs may have been slightly lower than usual and Holding Tankers slightly higher, but not by much. After all, investments had been steadily marching upward and it’s natural to expect Holding Tanks to increase as the rising number of new companies awaited maturation. See the table below.

So in 1998, with the public market’s appetite for IPO’s accelerating, inspired VC’s upped their number of investments that year to 980 from 836 the year before.

In 1999, IPO’s and overpriced M&A transactions were roaring, causing VC’s to nearly double their deal volume to 1,842. Wiser heads may have noted however that – despite all those Cash Out transactions – the cumulative proportion of 1996 Cash Outs declined for the fifth year in a row to 57% while Holding Tankers increased, also for the fifth year in a row, to 28%. Only gradually increasing indigestion, but a nagging trend.

In 2000, VC’s hit what will probably be regarded as an all-time yearly deal high of 2,657, gasoline thrown on the fire by VC-funded companies cashing out at grossly inflated prices, some well before their three-to-five year maturity. But the rearview mirror now looked downright suspicious: 1997 cumulative performance continued, even accelerated, its deterioration in Cash Out and Holding Tank proportions, 53% and 32% respectively. Why weren’t these indicators improving? Maybe older companies weren’t operating the sorts of trendy business models in demand for newer dotcoms? Anyway, would-be limited partners were pounding down the VC's doors with cash in hand, and valuations for the “right” sort of companies were stunning. Ah, but the velvet trap had already sprung.

By 2001, two facts had became suddenly, depressingly clear. At the same time that portfolio company exits burned off like a morning mist, the rearview message became unavoidable: 1998 cumulative performance was showing its seventh straight year of declines with only 48% of all investments Cashed Out and 37% in the Holding Tank, this despite two years of frantic portfolio company exit action.

What’s remarkable about all this is the fact that the percentage of companies declared Dead has remained rather constant through the intervening 10 years, holding at about 16% of the cumulative total, even in the valuation bloodbath of the last several years. This rock-steady proportion, with its “business as usual” implications, is the elephant in the room. Perhaps VC’s are understandably reluctant to classify some proportion of their Holding Tankers as, in fact, Dead, or to sell them off?

In fact, based on historical data, perhaps half of Holding Tank companies should be sold or declared Dead, a total of about 3,000 companies. More precisely, one would expect about 1,400 to be put down, with 1,600 sold. That ratio assumes, however, that VC’s applied their usual stringent investment criteria to recent portfolio company class years, and that the exit markets for these companies are clearing as effectively as in the past – both doubtful assumptions. It may be that as many as 2,000 of all Holding Tank businesses are actually, if not walking, Dead.

What’s Next
So what’s a VC to do? No choice is palatable, but one is inevitable. At some point, they have to swallow bitter medicine and move on. That is, they will eventually be forced to divest or close down some substantial portion of their oversized Holding Tank positions, almost certainly in the next few years, with resultant large-scale damage to their funds’ book values. And they’ll have to redefine their investment philosophies and criteria. Some will not be able to argue convincingly to future limited partners that they are flexible or experienced enough to make the transition.

But for now, most are playing a waiting game, hoping that exit opportunities improve, and that their Holding Tankers -- at least those that continue to demand time and money -- don’t force decisions to write them off. To buy more time, we see three maneuvers:

* Announcements of funds freezing new investments and going into maintenance mode, trying to keep their investment powder dry for future Holding Tank demands.

* Mergers of portfolio companies to gain economies of scale in equity transactions that avoid a declaration of absolute market value. Instead, such deals may be consummated in relative terms (see our earlier Dispatch on this subject).

* A unique phenomena, mergers of VC's or fund portfolios made in an effort to reduce fixed overhead while staving off valuation Armaggedon.

The final act will be a rising tide of VC portfolio company and whole portfolio sales, and mercy killings, with the subsequent shuttering of many a VC, and accelerating industry consolidation. To avoid walking into a soon-be-glutted buyer's market for Holding Tankers, some courageous VC's are already discretely exploring mass M&A exit opportunities.

We all lose from this spectacular industry supernova: the neutron star that emerges from it will be much smaller, more risk-averse and gimlet-eyed, less remunerative and creative, and not nearly as much fun.

Ryan Kuhn

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