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BULLS & BEARS: What investors can learn from venture capital skid

March 26, 2007

I was watching a business program the other day, and one of the guests was an independent-thinking fellow who summarily dismissed the old saw, "They don't ring a bell at the top." He went on to say, "They do ring bells; it is just that nobody listens."

Remember the glory days for venture capital? It doesn't seem that long ago when an idea was worth a billion-dollar initial public offering. Back in the 1990s, the wizards of Silicon Valley were the icons of the "New Economy." Investors poured money into venture capital funds, and the riches flowed (in recent years, mainly to the managers of venture capital funds).

Then the bottom fell out. The late-tothe-party investors, who piled into venture capital funds at the peak-and, as always, the most money gets invested at the top-have since suffered through dismal investment performance. The average venture capital fund has lost 3.5 percent annually over the past five years, according to the National Venture Capital Association.

The institutions who piled money into venture capital funds at the turn of the millennium were "looking in the rearview mirror," seduced by the eye-popping returns of the mid-1990s and extrapolating them into the future.

Yet, the signs of a top in venture capital were visible by 1999 with a cacophony of bell-ringing IPOs that were floated on the market with little in business substance behind them.

Today, this look back in history provokes a more relevant question: Is this the unwritten future for venture capital's cousin, the private equity fund? Take a look at some of the things going on and see if your ears start ringing.

The flow of money into private equity is eerily reminiscent of the first quarter of 2000 when mutual fund inflows reached records, soon after the stock market bubble burst. At present, every consultant on the face of the Earth is urging a major shift in asset allocation into alternative assets. With all the money pouring in, private equity managers are paying record sums for acquisitions of public companies. Ding.

There is no shortage of lenders eager to provide the financing for private-equity acquisitions. As such, so-called "covenantlite" loans, or loans where the lenders are willingly forfeiting many of their legal protections, are being used to finance some private equity deals. Deals also are being financed with newly issued junk bonds that allow private equity managers to"toggle off" cash interest payments and instead make their payments by issuing more debt. Heaven knows who is lending them the money-oh, wait-it's hedge funds. Ding Dong.

Last, the venerable private equity firm the Blackstone Group is preparing to go public. Has anyone stopped to consider the irony? A firm that extols the virtues of removing your business from public markets is going to sell itself to the public? El kabong! We just cracked another Liberty Bell!

Investors sending their checks to private equity funds today won't know the return on their investments for several years. But our guess is they will not receive anything approaching the returns of recent years. For the contrarian alternative investor looking to "buy low," maybe it is time to revisit venture capital. Returns have been down, the competition is preoccupied with private equity and hedge funds, and the next big thing is alternative energy.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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