Exploring Private Exchanges

It’s no secret that the venture industry is reeling from a liquidity crisis – we’re constantly reminded that venture-backed IPO and M&A activity is at historic lows. And while there have been recent glimmers of hope via the IPOs of OpenTable and SolarWinds, we’re far from the proverbial IPO window being open again. To address the issue, the National Venture Capital Association (NVCA) laid out a “Four Pillar Plan to Restore Liquidity” back in late April. As part of the plan (the second “pillar”), the NVCA encouraged the use of enhanced liquidity mechanisms such as private market exchanges. While yet to gain much traction, a number of these newer private exchanges have garnered attention of late. They might turn out to be great for the venture industry, but I see a few issues, including the fact that they all seem to be doing very similar things meaning the space is very fragmented right now, and volume is much too low to put a dent in the liquidity issue. Here’s a rundown of some of the major new players:

Backed by venture firm Draper Fisher Jurvetson, XChange will use a bid/ask pricing system to allow the sale of private securities to qualified institutional brokers. I’m not clear on whether or not this includes LP interest in venture funds or just shares in a start-ups employees or venture firms may hold. XChange will also offer companies the ability to do a primarily issuance of shares (they’re calling it an “XPO”). Still new, the exchange is not yet fully operational.

With the support of the NVCA, a number of venture capital firms (Oak, NEA, Venrock, Versant, DCM to name a few) and apparently 200 institutional investors, InsideVenture might be the private exchange with the most industry support right now. InsideVenture offers “Hybrid public-private offerings” in which start-ups would have to file the same way as they would for a regular IPO, but the shares would first be offered to investors that are affiliated with InsideVenture. It does not seem like there is the options to do smaller secondary sales of direct ownership stakes in companies like with XChange. InsideVenture is open to only institutional, PE and accredited investors.

SecondMarket is one of the better established private exchanges. They claim to have 3,000 market participants, with $10 billion in traded assets. In addition to shares of private companies and limited partnership interests in private equity funds, the exchange is for all types of illiquid assets including auction-rate securities, bankruptcy claims, CDOs, and MBSs. To help attract bidders for these illiquid assets, SecondMarket has developed a proprietary "ManhattanAuction" which essentially pays bidders for bidding. The exchange is open to institutional and accredited investors only.

The newest private exchange on the block is SharesPost. In fact, it just went live with its public beta release yesterday. The interface is much more open than other private exchanges - after a basic registration process, you are able to view the shares of top venture-backed companies that are for sale, what the bid and ask prices are and, for some companies, the implied valuation (more on this later). It costs $34/month to post or interact with other posts (buyers and sellers), there are no commission fees, but there is an escrow fee of $2,500. Sellers remain anonymous except to the buyers of shares (who must be institutional or accredited), but all SharesPost members can view restrictions sales are subject to and prior agreements once even one trade is made on a company. The minimum proposed transaction size is $25,000.

Of the four private exchanges I've highlighted (there are plenty more that are not as sexy, including NASDAQ's PORTAL Alliance, the NYPPEX, and TSX Venture Exchange), SharesPost stands out the most due to its openness. Both SharesPost and SecondMarket only allow for the secondary sale of private company holdings. InsideVenture seems to do just primary (semi-public) issuances and XChange looks to do both. All complete the mission of providing liquidity, particularly for employees and smaller shareholders (save for InsideVenture), but I still think the larger liquidity issues will remain. It’s unrealistic to expect many substantial full-blown venture-backed exits through any of these exchanges, at least to the point that it alleviates the industry’s liquidity issues. They’re more of stop-gaps in my opinion, and I think they know that.

The fragmentation I mentioned earlier probably hinders all of them which is why I think there eventually will have to be some consolidation in the space to allow for more efficient marketplaces. For now, they will all face competition from not just each other, but traditional IPO and M&A exit avenues (if/when they come back) and a growing crop of direct secondary and traditional secondary funds which have the upper hand when it comes to negotiating terms since they can make purchases in larger chunks while keeping the transaction private. Speaking of which...

It probably hurts companies that list on a more open exchange like SharesPost if they are looking to obtain additional rounds of funding. It’s understandable why SharesPost went the more open route (because it should attract more buyers and sellers), but a lot of private equity and venture capital firms would not be comfortable with investing in a company that has so much of its information public (sorry, but obligatory: “it’s called private equity for a reason”).

One interesting piece of information that ends up out there is a company’s valuation – and even if it’s not out there or accurate, there are implications for venture capitalists invested in the companies beyond just maybe having that information public. A layer of complexity could be added to valuating companies under FAS-157, which has established the framework for measuring fair value. Under FAS-157, investors have to mark an asset to market, which I think would mean that venture and private equity investors in companies listing on a private exchange would have to take into account transactions occurring on those exchanges when it comes to quarterly reporting to LPs. Not a fun prospect.

It will be interesting to see what impact these exchanges have. I’d like to do a follow-up examining each one in more detail if possible. I’d also like to examine the SharesPost model a bit further in a future post because of the tie-ins to my previous look into crowdsourced venture capital; the purely on-line transactions, openness of information, and allowing regular individuals to participate.

Venture Capital Overhang: $118 Billion

This past week, the Alliance of Merger and Acquisition Advisors and research firm Pitchbook Data released a report which indicates private equity firms in the U.S. are sitting on $400 billion in overhang – the difference between fundraising commitments and invested capital. The figure is essentially the “dry powder” or uninvested capital private equity firms have at their disposal. The data was covered in a number of places over the past week, but VentureBeat writer Anthony Ha pointed out that the data does not include venture capital... so I decided to do some of my own research. Below is the chart I came up with for venture capital, using the same methodology the Pitchbook Data report uses (data from PwC, Thompson Reuters and the NVCA):

Source: PwC, NVCA, Thompson Reuters

Over the past decade, venture capital firms in the U.S. have amassed $118 billion in overhang. Of course the data is not perfect; you’d have to account for management fees, recycling of capital, etc. But it does tell us that venture capitalists are sitting on plenty of uninvested capital. Only in 2003 did the ammount of venture investment come close to equaling the amount of capital raised, and the average overhang per year is $10 billion.

The $118 billion figure isn’t too surprising. It’s pretty well known in the venture industry that lack of capital is not a major issue, in fact there might be too much capital chasing too few good deals. Also this year we’ve seen venture capitalists pull back sharply on investment amid economic uncertainly, deciding that focusing their attention on better managing and growing existing investments was a better use of time. We’re also seeing deal sizes come down as the cost of starting technology companies continues to drop. These factors explain the $118 billion and perhaps it’s being reflected in the recent slowdown in fundraising.

Growing With the Real-Time Web

More and more, the way information is shared on the web is shifting to real-time. The “real-time web” is emerging (Read Write Web covers this quite well). The easiest examples to point to are the ones getting the most attention (Twitter, Facebook, FriendFeed, etc.) but the trend runs much deeper. Using Twitter as an example though; what makes its service truly valuable is the ability to aggregate, search and monitor trends within the real-time updates. If you want the latest news (and by latest I mean not just up to the minute, but up the second) on most anything imaginable, there is now instant (or at least faster) access to it, making the information much more valuable. This ability to instantly access the latest information is changing the way we experience, consume and share information. Twitter is not only place where this is happening as Read Write Web points out. Indications of the move toward the real-time web can be seen everywhere: Facebook has implemented real-time updates; the New York Times recently launched Times Wire which provides a stream of news (pictures too) that is updated every minute; Google a couple of weeks ago declared that real-time search, while still an unsolved challenge for them, will be very important; Google is also launching an application that incorporates real-time information from the web, with its just announced online communication tool Wave; through enterprise collaboration tools, companies are starting to realize the value of instant information; new recommendation engines (competing with Amazon’s or potentially Microsoft’s new Bing) are using real-time user behavior to help make purchasing decisions, the list goes on.

So what does this all mean and where are the opportunities for venture capital? The real-time web is here to stay, but it may require people coming to terms with the fact that there is simply too much information to consume. Kind of like how with television there’s always something on, the same will be true (or is already true in some cases) with the new live web – you’ll be able to “tune-in” to a site and catch what’s “on” in terms of content and information. At the same time you will be able to subscribe to, search for, or record, information that’s important to you. There’s still plenty of room for growth around these concepts as the conflux and growth of valuable real-time data is still new. Venture capital can play a role here. Here are a few areas where I think new companies might crop up and have potential to be backed by venture capitalists.

• Of course there will be companies that further develop technology and infrastructure around the real-time web – this includes companies that build tools and software to aggregate real-time data.
• There will be plenty of companies that will be able to use the increasing amount of real-time flow of information and package and present it in useful ways – there are limitless possibilities here.
• Companies that can find a way to rapidly verify the integrity of real-time data, particularly news, will find themselves in demand.
• Advertising and generating revenue around real-time data will be vital – companies that build ads using real-time data will be important, and even more important might be companies that can figure out micropayments (allowing consumers of real-time content to efficiently and effortlessly pay for content they consume – there’s definitely a huge hole here that PayPal does not come close to filling, neither does Google Checkout).
• Finally I think video presents a huge opportunity – 99% of all video is still watched over a television, and while bandwidth is often a limiting factor, video is undoubtedly going to become part of the new real-time web as the line between television and internet video starts to blur.

Crowdsourcing Venture

 

I somehow stumbled upon this book today and it got me thinking about how crowdsourcing would work if applied to the venture capital model. Crowdsourcing allows you to tap into the collective knowledge of a community to carry out a task or find a solution to a problem and is most widely used in the development of new web technology (Wikipedia has a pretty sold entry on it if you want background). But a big drawback I see is that contributors rarely get compensated adequately for their participation - the company something is crowdsourced for stands to benefit the most, all from the hard work of others. What if people could actually have "skin in the game," wouldn't the results be much better? And even more, if applied to venture capital investing, wouldn't you be able to create not only a huge brain trust, but a huge investor base as well?

I wasn't aware of anyone else out there that had made an attempt at crowdsourced venture capital or was thinking about trying it, but after doing some quick research I found the idea did have some legs:

• Steve Newcomb, co-founder of Powerset, was featured over a year ago in a Wired article which shared his plan for a crowdsourced cleantech venture fund. His idea for the fund involved investor commitments as low as $100, with a maximum of $1,000 and investments decisions made by bringing in venture professionals to vet investments and then letting the investors choose from there. I'm assuming it would have been open to as many investors as they could get, perhaps in the millions. Not sure what's happened with this idea, but it seems Newcomb's attention is now probably on his new company, Virgance.
• The closest thing, by far, to a legit crowdsourced venture idea I found was VenCorps. VenCorps was originally an offshoot of crowdsourcing site Cambrian House. The original model involved ideas being vetted by the public for an initial vote, and then moving on to a due-diligence process and a more formal vote, where an “elite group” would do the decision making (not sure of the capital structure). But since, Cambrian House sold VenCorps' assets toNew York private equity firm Spencer Trask. Now, it looks like startups will share their businesses plans, then professionals and amateurs would help select the best in periodic “showdowns.” Winners of showdowns would receive a $50,000 investment (convertible debt, but I'm not sure how participation would work for those who have voted and have interest in investing).

I have a feeling these two groups hit legal issues at some point. If you want a true crowdsourced venture fund with full participation, you immediately run into SEC issues. I'm no expert when it comes to the detailed legal aspects of private equity, but I'm pretty sure to keep an entity private you would have to stay under a certain number of investors, wouldn't be able to solicit investors openly, and the investors you do get would have to be accredited (i.e. institutional or high net worth). I'll have to do some more research, (would love feedback here) but perhaps there are ways around all this - maybe via pass through entities for groups of investors, or offshore or other forms of organization.

For fun though, let’s says there were legal loopholes or no legal issues at all - here are some elements of my ideal crowdsourced venture capital fund:

• Standard fund structure, with the GP consisting of actual venture capitalists and the LPs consisting of the "crowd."
• The LP base, or "crowd" would preferably be selective, perhaps through a vetting/application process or by targeting a specific groups. Ideally, if making tech investments, I'd want a knowledgeable set of individuals, something like the TWiT Army, behind me. I'd like to set a commitment range, let’s say between $1,000 and $10,000.
• The fund would be completely web-based. All administrative aspects, reporting, voting on investments, communication, etc. I think it would be easier to take each investor's commitment up front via fund transfer and hold the cash in an interest-bearing account. Each investor would have their own capital account page, through which they could monitor their balance, vote on whatever the GPs wanted them to vote on, see their share of the investments, etc.
• As for the investment process, I'd allow LPs to suggest potential investments, but the GPs would also source deals. Everything would have to be very transparent (GPs staying in touch via forums, messaging, blogs and podcasts). GPs could continuously poll the LPs to gauge their thoughts while evaluating companies, even putting potential investments up to vote, but in the end the ultimate investment decisions are made solely by the GPs.
• Once investments are made, the fund has the benefit of instantly having thousands of individuals with a vested interest in the companies' success. This could be huge for internet companies. And while owned by the fund, LPs could make suggestions or offer up help to aid each company's development.

...that’s it for now but I will definitely be revisiting this topic again.

Indian Private Equity: Conversation with a CEO

I recently had a conversation with the CEO of an Indian industrial forging company that specializes in automobile and oilfield related products. Here’s what I picked up on the venture and private equity opportunity in India from someone with direct experience operating a middle-market company there:

He conceded what many already know – that venture capital, particularly for high technology, really doesn’t work well in India. Aside from the lack (or enforcement) of intellectual property rights, there’s simply too much of a “copycat mentality.” Innovation happens more with processes or at the business level, because innovation in technology lacks the right risk/reward profile. For example, most young IT professionals would much rather work for an outsourcing firm and take the compensation the jobs provide rather than risk trying to innovate. For this reason, private investment in India will not be heavy in venture capital for some time.

There are many companies and industries that will be able to ride the country’s GDP growth to success. But beyond that, at the operational level, what competitive advantages does India have that make a compelling case for private equity investment? For most Indian businesses, low cost labor is the core advantage. In fact the CEO I spoke to said low cost labor might be his company’s only advantage in the global marketplace. Energy, raw materials, equipment and technology costs are pretty much level globally, but when it comes to the much more lucrative business of exporting product, labor cost savings are a huge advantage. And it’s not just the direct cost of labor, but all other related or dependent costs, such as insurance or transportation (drivers, handlers) that collectively provide a huge advantage.

In most industrial and manufacturing businesses, labor unions are still not a major issue, but they are beginning to crop up in larger Indian cities such as Mumbai, Delhi and Bangalore. Smaller, more rapidly growing cities should be able to stave off issues related to labor unions for another decade in his estimation. So, the long term potential for growth and profitability still remains even if purely based on the low cost of labor, you just have to go to the right places. In this respect, the biggest impact should be for manufacturers, particularly those who export. In fact, exporters receive incentives from the Indian Government in the form of credits which can then be sold to importers on the open market. Domestically, he identified industries such as financial services and consumer products and services that target India’s growing middle class as areas of growth. Infrastructure plays too can take advantage of the low cost of labor.

When I asked about potential detractors for private equity investment in India, the biggest drawback he saw was the trouble PE firms have in obtaining controlling ownership (or even any ownership stake at all) in companies that are family owned. It’s one thing to buy smaller stakes in large companies, but if the buyout model is to really take off in India, it’s going to take gaining the trust of families who own a large portion of the private businesses in India.

Another issue for investors is bureaucracy. Conducting business in India can be slowed extremely by bureaucratic policies and procedures. These can differ state to state and even city to city. To navigate it all efficiently takes experience and relationships, something impossible for outside investors to bring with them. This point can’t be stressed enough and is why the most successful private equity investments in India will have to involve Indians with opperating exerpience in the various regions of the country.

A Look At the Cleantech Investment Drop

Not only has cleantech investment by venture capitalists dropped off a cliff recently, but the average deal size has fallen significantly too – from $14.5 million in Q4 of 2008 to just $4.7 million at the end of the first quarter of 2009 (PwC/NVCA MoneyTree). Clearly VCs have figured out that deals that eventually need to scale to utility size are trouble. Still, I’ve heard many people point to the lack of project financing or debt (credit crunch) as to why things have stalled. In fact, venture-backed algae company GreenFuel Technoloogies shut down this week. The reason? They claim they were a victim of the credit crunch. But should VCs really have been reliant on project finance in cleantech investments in the first place?

Take a look at the chart below. I’ve graphed the average venture cleantech deal size over time, which I mentioned has fallen by almost $10 million, mainly because there were no major $100 million+ rounds. But what really shows how disproportionally cleantech was reliant on large scale financing is how much investment fell as a percentage of all venture investment.

It helps to put the data in this context because it shows that other sectors, while still experiencing declines in dollar amounts, were not affected nearly as much by the lack of large deals. And by other sectors, I’m talking mainly about technology deals, which have always been mainstays of venture investment. By and large, they are less capital intensive and, really, it’s where venture’s expertise lies. This level is where I think cleantech venture investment belongs.

The current average deals sizes (around $5 million) in cleantech are much more reasonable and the capital going in is still adequate enough support innovation. A recent New York Times article covers the shift in this direction. Liquidity-wise, hybrid tech/cleantech deals have much more promise too. Of potential acquisition targets, they seem like they are the most attractive since they can still produce great return multiples in reasonable amounts of time. Scaling is faster and cheaper - all VCs know this. So instead of trying to hit “grand slams” with large, utility scale projects it may be better to leave those to the utilities and GE’s of the world. VC’s should not be chasing stimulus money, or be in denial about the capital intensity of most renewable energy investments. To me, there’s nothing wrong or concerning about the decline in cleantech venture investment if it represents a shift back to venture’s roots.

A point on the data I used: I realize there are a number of sources I could have used (MoneyTree, The Cleantech Group, VentureSource, Greentech Media, etc.). And they all report different figures due to differing methodologies. The key is not to get caught up in the differences there – they all show the same trend which is the most important thing, particularly when looking at industry data on private equity, which always inconsistent among the different sources.

The 1999-2000 Problem

The fact that venture capital has not produced quality returns for 10 years has been getting a lot of attention lately, particularly as LPs start having to make tough decisions about whether or not to continue to commit to the asset class. When a typical LP looks at their portfolio, what do they see?

Let’s assume that it’s a fairly well established institutional investor who has been in the asset class since the early 1990s. My best guess is that it looks something like this: reasonable commitments and excellent distribution activity from (vintage year) funds up to 1997-1998. Then things hit a wall. The good times ballooned out of control into the “irrational exuberance” (I hate that term) of 1999 and 2000 when LPs went gangbusters committing to VC funds. Needless to say these did not perform well. So next, the tech bubble bursts and you have a massive pullback - there are probably relatively much fewer vintage year 2001-2003 funds in most venture portfolios. Too bad, because these funds, on average, have performed pretty decently. Then investing activity picks up again, you see more 2004 and 2005 funds, which have had acceptable performance and some distribution activity but are still young enough to hold further promise. Commitments probably increase significantly (though not as much as with buyouts) in 2006 and 2007 as the economy was firing on all cylinders. These funds are too young to have produced meaningful returns, as are 2008 funds which most LPs pulled back on investing in due to liquidity issues.

So with this picture of what LPs are looking at let’s go back to the 1999 and 2000 funds: The returns, everyone can find a way to live with. If you’re a 1999 or 2000 venture fund, an IRR of 0% would be above average, and most funds would be happy simply returning commitments at this point. VCs can live with this because most have already moved on: “hey we think we can return all of your capital in what were two really crappy years for everyone, and we’ve learned our lessons and promise not to mess up again.”LPs are probably willing to accept the returns as well. But there’s one problem- so many of these funds have so much capital still unreturned. It’s one thing to have these returns down on paper; it’s another thing to actually achieve them. We’re talking about funds that have to wind down operations in the next year (ok, throw in a couple years of fund extensions, but it’s still going to be a challenge). At year end, the net asset values of 1999 and 2000 funds was some $33 billion – a huge chunk of all venture capital, even after huge write-downs in Q4 of 2008.

What’s going to happen to all these investments and funds? Venture firms are going to have to either get really creative, really lucky, or liquidate at massive discounts. This is a major issue that isn’t talked about enough, but will be over the next couple years, I think. And it raises further questions which don’t have clear-cut answers, like: Will 2005-2007 funds be faced with similar issues if the exit markets don’t improve? And is this more of a fundamental issue with venture capital now? Take, for example cleantech deals and funds – there are already questions around being able to build, develop and exit solar or biofuel companies in five to seven years. I’m not saying venture is dead, there’s definitely a need and place for it, but it’s going to be different. For one, we may be looking at longer fund terms which means more illiquidity and higher return expectations. It may also mean a rise in liquidity options, such as special markets for illiquid assets, and secondary funds specializing in companies or LP interests in venture funds that need to conclude operations.