Déjà Vu: How the PE Bubble Mirrors the VC Bubble

It’s only natural to compare and contrast the dotcom bubble of the late ‘90s and the PE bubble of recent years, especially since the latter has more than officially burst.

So, with some input help from Dan, I’ve broken down a few of the similarities. It’s anecdotal, it’s unscientific, it’s subjective, and it’s full of sweeping generalizations, but something tells me it’s not too far off the mark.

Rock Stars

Venture capital wasn’t invented in the late ‘90s, much like private equity wasn’t invented in the mid ‘00s, but neither industry got much attention from the mainstream media before their respective bubbles. Think Bob Davoli of Sigma Partners on the cover of BusinessWeek, or Steve Schwarzman as Fortune’s “Wall Street’s man of the moment.”

Fund Sizes, Valuations and Pace of Investments Increased

The size of funds, and therefore, the size of investments, grew exponentially. Or maybe it was the other way around…

They Each Dabbled

Plenty of PE firms lusted after startups in the late 90s, when venture capital was all the rage. And most of them lost their shirts (or shingles). It’s comparable to the rash of venture firms that have crept up into the land of buyouts in recent years, doing recaps, carveouts, and traditional LBOs. I don’t think the VC firms will retreat nearly so fast, however…

The Crappy Returns and Toxic Portfolios

In both up cycles, VCs and PE firms had a few years of massive returns, often from deals with short investment cycles. VC firms taking two-year-olds public in an “irrationally exuberant” market, and PE firms making hay with dividend recaps or sponsor-to-sponsor sales. But, since then, it’s been downhill. As of last year, the average return on 1999 vintage VC funds is about $0.95 on the dollar, according to a peHUB post by Bill Burnham (and that doesn’t even take into account the miserable post-bubble years). Its too early to tell what 2006 vintage PE firms will look like, but judging by last year’s spike in LBO-backed bankruptcies, and discounts to the public debt of those still in business, it won’t be pretty. Talk to me in two years when the debt on ’06 deals hits maturity.

Deep Discounts on Secondary Market as LPs Flee the Asset Class

For proof that history is repeating itself, look no further than this NY Times article from 2001, which quotes David Park of Paul Capital saying, ”This is the largest opportunity the secondary market has seen in a decade.” Sound familiar?

In Need of Some LP Relations

When VCs realized their funds weren’t going to post a return, they tried to salvage relationships with their LPs. They shrunk away from two and 20, and firms like Battery Ventures issued voluntary, pre-emptive clawbacks on carry taken from early wins. Many firms also shrunk their fund sizes and allowed LP to take back commitments. It remains one of the differences between the two bubbles. At the PEA conference an LP remarked, “LPs in the venture bubble hated their GPs. That hasn’t happened in private equity…. Yet.”

Fund Shakeout
In the aftermath of the venture bubble, VC funds talked a lot about “returning to our knitting,” going “back to basics,” and raising “intentionally more disciplined” funds of smaller sizes. It should be no surprise that pundits predict private equity will emerge from this bubble smaller and with less players. Firms are already cutting fundraising targets left and right. One LP put it, “If you aren’t one of the big players, or a true niche player, there’s a good chance you won’t survive.”

The Real Question

Will PE survive, and in what form? It can be argued that VC has never really recovered from the bubble, and that the model is fundamentally broken. Dan recently brought it up in a column titled, “Radically Reinventing Venture Capital,” where he suggests LPs “create a series of loosely-affiliated evergreen “funds,” with each fund to contain just a single VC. In other words, cherrypick the cream of the crop.” (Click here to read the many detailed responses.)

I think it’s safe to say this kind of model simply does not translate to even a middle market private equity-sized scale, much less a mega-buyout one. In fact, I’d say most PE firms are relatively lean as it is (moreso as layoffs continue). They work on fewer, larger deals, and therefore have less zeros that allow the blame to be passed around.

So are there other ways to fundamentally change the model of private equity? We’re already seeing the asset class evolve away from financial engineering and toward that whole “operational expertise” thing (I know, you never really left, blah blah blah)… But so many people pay lip service to the idea that it’s hard to tell how many can actually do it. (Adding the word “real” in front of “operational expertise” doesn’t make your argument any stronger. I’m talking to you, Cerberus.) And anyways, Ebitda growth has always been a fundamental part of a LBO, which you can now just refer to as “BO.” It remains to be seen if private equity and venture capital come up with anything more revolutionary.