Tuesday, March 10, 2009

The other shoe

Yesterday, I received a year-end financial report from one of the venture firms that I am invested in. The firm cited adherence to FAS 157 (mark to market rule) and proceeded to list their investment values with markdowns ranging between 10-50%. Such markdowns are greatly predicated on year end values of comparable companies (clearly an art form).

In previous years, venture firms would markdown companies that significantly missed plan, or were involved in a tangible transaction (e.g. investment round) that reflected a lower price. Proactive markdowns, based on industry comparables were rare, and that was unfortunate.

I have no idea how long, or how deep this downturn will last, however, it's evident that it will take sometime to right the ship and only rarely does one know the exit value of an investment. Today's proactive portfolio valuation, however imperfect, provide LP's better visibility to true asset value, and enable them to run their businesses better. Rule 157 enables institutional investors to more consistently hold their portfolios, consisting of private equities, public securities, and real-estate to a common standard; which for the long term augers well for the private equity world.

Today, many institutions are suffering from a 'denominator' problem, where the percentage of assets invested in private equity greatly exceeds proscribed limits, due to the collapse of the public security valuations. This round of 'mark to market' will hopefully go a long way towards bringing private equity valuations and percentage allocations into alignment.

Many institutional investors won't be surprised by the write-downs, many will even welcome them as a way to clean house and set the stage for a new approach to their portfolio management. What worries me is that many firms won't be aggressive enough in taking a realistic approach to portfolio valuation. Instead, hoping their portfolio is unique, or that valuations will shortly return to pre 2008 levels, they will be more 'conservative' and leave themselves vulnerable to unrealistic exit expectations that will surely affect the timing and form of the exits which LP's require to fund their requirements.

Expect other shoes to drop:

1. It's easier for a VC to cease funding for a company already written down in their portfolio (less downside). Unless a venture firm has a mature portfolio of self-supporting companies, it is likely a triage process will be undertaken to allocate reserves to support the minority of investments with the best likely outcome. The others will be closed/sold/ignored.

2. Look for more 'carve-outs' for management teams whose paydays sit behind investor preferred securities. Recognizing that maintaining alignment with the teams that bring you through an exit is important, investors often put in place a 'phantom equity' mechanism that rewards teams for an exit; even one that does not return capital.

3. More down rounds, diluting management and non-participating investors, in portfolio companies where the lead investor has already taken a mark down.

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