1999 vintage Venture Capital funds are infamous for being some of the worst performing private investment funds of recent memory with the average 1999 Venture Capital fund returning only about $0.95 on the dollar through 6/30/08. The poor returns of these 1999 funds are a result of two main factors:
- These funds were raised at or near the height of the tech bubble.
- These funds were often fully invested within 12 months of closing.
The result was a ton of money invested very quickly at very high valuations.
During the 3 year market correction that followed the tech bubble, venture capital lost favor with many institutional investors. Many of these same investors instead plowed their investment dollars into private equity funds. These funds enjoyed huge returns early in the decade as an extremely loose credit market combined with very low risk premiums and declining loan underwriting standards gave rise to such as wonders as dividend recaps, PIK toggles, and covenant light loans. By late 2006, private equity firms were raising absolutely gigantic funds with terms and fees that would make many VCs blush. Part of the private equity pitch at the time was that because they were buying well established firms with ample cash flows and “fundamental value”, private equity would never see the same kind of market collapse that cratered 1999 and 2000 vintage VC funds. LPs generally lapped up the pitch and as a result during 2006 and early 2007 there was a ton of money raised and invested very quickly at relatively high valuations. Sound familar?
Fast forward to today’s market and the “fundamental value” of many private equity funds appears highly suspect thanks to two main developments:
- The credit markets have completely imploded effectively making it impossible for private equity firms to refinance existing debt.
- The recession is impacting earnings and cash flow which in turn is increasing the likelihood of loan defaults.
Against this backdrop, the massive leverage that enabled private equity firms to put up such huge numbers in the 2002-2005 time frame now looks like it has the potential to absolutely decimate 2006-2007 returns.
But don’t take my word for it, just look at the market. Unlike VC investments for which no reliable daily market values exist, most private equity deals issue publicly traded debt and that debt provides an immediate window into the health of the deals themselves. Just how healthy are those deals? Not very healthy at all.
Even after today’s big rally, the kind of senior bank loans often issued against private equity deals are trading at or near all time lows with some of the highest profile private equity deals trading at discounts of 25-30% from par. What’s more, many closed end mutual funds that specialize in such loans are themselves trading at 20-30% discounts to their Net Asset Values which strongly suggests that senior loans have even further to fall. Clearly the market is anticipating some major defaults in private equity land in the near future.
Defaults are bad news for PE funds because they are generally catastrophic for the equity holders in a deal and the equity holders in these deals are, you guessed it, the 2006-7 private funds. Thus, if the market is to be believed, a lot of private equity funds are going to see catastrophic losses on their equity investments in the next couple years.
Private equity LPs, like many homeowners these days, are about to learn a lesson in the downside of leverage. They may end up wishing they put all their money into 1999 VC funds instead. Imagine that!
[Ed. note: Bill asked me to chime in, as a prerequisite for reposting this from his blog. My guess — and it’s nothing more than that is that the ’99 VC IRRs will be slightly worse, but the ’06 PE funds will lose more actual money. Your thoughts? – D. Primack]