Wednesday, February 18, 2009

Alan Partricof's view of the changing Venture landscape

Alan Patricof began investing in the 1960's, a time of 'little venture' at Patricof & Company. He later rode the 80's wave into 'big investing' when he founded LBO shop APAX, and has now come full circle, back to 'little venture' with Greycroft Partners.

In a recent article in DealBook, he explains the reasons behind his move back to little venture. To summarize, he feels the changed prospects for IPO's is not a temporary phenomenon, due to its semi-permanence, venture firms (and entrepreneurs) ought to shift exit expectations exclusively to M&A. Seeing the bulk of M&A is in the $20-$100mm range, the amount of capital raised ought to be in alignment (far less than today) with the perceived exit.

As expected from Alan, it's a good general industry perspective that highlights dynamics that are changing the venture capital industry. It does, however, beg three open issues for discussion:

1. The number of public software/internet firms has declined over the past five years by nearly one third. The largest decline was in the ‘middle’ market, which is the most likely exit vehicle for venture backed companies seeking valuations in the $20-$100mm range. A growing imbalance is creating a gulf between the supply of sellers and the demand from buyers.

2. Buyers will continue to want to acquire successful firms, not the laggards. Two measures for success have always been market share and growth. Good teams will be able to build respectable companies, in a capital efficient manner, and be satisfied with a more than respectable 5x return. I have no doubt that other teams, experiencing hypergrowth will shoot for bigger wins (e.g. Google, Youtube or perhaps Twitter). Or will dig themselves into a capital starved hole. It's not the bankers that give firms wonderful exits, it's paying customers that build market share leaders. Bankers are facilitators; intermediaries which bring capital to shareholders/companies.

3. Early stage Venture firms tend to embrace a culture of controlled risk. As such, we experience a not insignificant company mortality rate. Such a 'death' rate is then masked by a couple of portfolio 'ten baggers' that provide the bulk of returns for investors. Take away the big hits and the investment culture must change to one closer to the buyout world where no bad investment goes unpunished.

I expect the exit ’stagflation’ to continue only so long as the center weight of innovation is around applications with little innovation at their core, and many competitors at the ready.

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