Endowments cutting back on PE?

According to PrivateEquityOnLine, Harvard University is in the process of looking to sell $1.5B of PE investments in the secondary market. With nearly $40B under management and 11% invested in PE, this represents around 1/3 of their PE stakes.

I am not sure this action has the hallmark of a hasty panic as indicated in Silicon Alley Insider. Following are comments to Henry's post earlier today http://www.alleyinsider.com/2008/11/the-cash-panic-sweeping-the-vc-industry :


1. While the PE market always has some defaulting LP's, and no doubt the % of defaults will rise in '09, it should not reach the epidemic proportions witnessed in '02-03. Many vintage '00-'01 funds had abnormally high % of investors as individuals/small family offices that were unable to meet capital calls or were margined too high due to lack of diversity of their portfolios. Professional institutions are indeed suffering today from being suddenly overweighted in PE (due to the 'denominator problem' that occurs when PE is tracked as a % of total portfolio value). If the portfolio value decreases, while the PE value remains constant, targets are overshot. By charter, this often triggers events to re-balance within proscribed formulas; which include sale of PE stakes and lower commitments to new managers. Institutional thinking often leads to a belief that the current pain of selling a portfolio at a 'discount' is less than the pain associated with being out of charter.

2. As for Harvard, I don't have any insider knowledge, but they have a reputation for being a market leader due to their early support of VC, and bold actions in the VC market. The later includes a proactive approach to limit exposure to VC funds that, in their view, grew too large for a market opportunity where their target companies (entrepreneurs) preach capital efficiency. I would not be surprised if they forecast the rates of return in buy-outs and real estate, which have traditionally been the largest component of the Alternative investment basket declining substantially. The prospect of these asset categories experiencing fundamentally declining returns, due to the prohibitive state of the debt markets, and deleveraging causing prices to drop, signal a prudent change in portfolio approach, not a panic.

3. Fund of funds, long a source of capital to the VC market are also experiencing long closing cycles. This will hurt PE and VC fund raising.

4. Today's exit environment is truly hostile. Other than hindering fund raising (a big thing), I am not sure it augers poorly for VC firms where we can 'buy low' and hope to reap returns through participating in equity value building by entrepreneurs building companies that will save their customers time, proffer revenues, or offer good old plain fashioned fun. The exit events for these investments are years off; who knows , we may have a President Bush in the White House when this happens....

Let's be reasonable

One of the smartest guys I know, who would never admit it, is Larry Wagenberg. Usually a market sober person, he's just turned bullish about the prospects for making money through investing in the public sector (that complements his venture activities); it's not that he's optimistic about the economy, just that he sees good long term value to be gained by investing when he sees a sudden buy/sell imbalance. His points about the yield curves, hedges gaining their footing, and consumer indexes are all well grounded and got me thinking about some fundamental points in the venture market.

For some perspective, here's numbers from Goldman Sachs reflecting on public valuations:

Software median expected 3 year growth in earnings: 12.2%
P/E to growth ratio for software: 1.2x (which means that if a company has a 20% growth rate, you would expect a 24x P/E multiple

These numbers highlight the steady, yet unspectacular growth in an industry commonly thought of as a 'growth' market. I suppose there's no better tell tale sign of a mature market than analysts tracking valuation as a multiple of maintenance revenue (5-8x)! Having grown up in the 80's, isn't it striking that they now track a mere 3 desktop software companies; Adobe, Intuit and MSFT? Game over.

This highlights when the turbulence caused by hyper growth settles, customers always anoint 2-5 'winners' from the scores of participants (as Geoff Moore would say 'Gorillas, Chimps and Monkeys'). The enterprise market is well along on the same path and we are seeing accelerated market concentration, where the number of vendors is in steady decline, valuations are based on maintenance revenues, and the best acquisitions are around cost reductions. Charles Wang (CA), you were way ahead of your time.

Expectation of growth has always been a key driver for valuation and the positive liquidity events that are the hallmarks of our industry. Mary Meeker recently cited interesting data in Morgan Stanley's latest Technology/Internet Trends publication:

2002 2007

Broadband growth(%) 78 23

Mobile user growth (%) 20 20

Internet user growth (%) 26 16


With the Internet phenomenon, at least the public companies, entering their 13 year, with revenues and users measured in the billions, it's clear the expectations for gross market growth have slowed and are factored into public valuations. Even given the suddenness of the adjustment, it's hard to find a great deal of fault with today's valuations when compared with expected growth. Per the folk at B of A (Brian Pitz), the P/E to Growth ratio in the Internet segment, based on '09 earnings, looks to be about 1x. Google comes in at .7 and Yahoo at 7x(small e)! They are expecting online advertising to grow at a steady and unexciting 14.6% CAGR (search, display, lead gen, classifieds, etc).

So, why am I an optimist at the prospects for venture investing in the internet, software and technology enabled service arenas?

1. The multi-billion dollar internet industry consists of a myriad of niches; many are emerging each year with hyper growth characteristics. Most will plateau when generating revenues in the sub-billion dollar range and will lead to companies that, when successful, will generate revenues in the hundreds of millions of dollars.

2. These companies have the potential to be created in an incredible capital efficient way. Just in time bandwidth and storage, administrative applications paid per user/month, open source tools and instant metrics for PPC/CPM enable instant adjustments.

3. The capital required to create a self-sustaining market leading player (albeit beginning in a niche) is a fraction of what it once was. Therefore, if a Company reaches a self-sustaining run rate at, after consuming a modest amount of capital, and is executing within a growth segment, it has the potential to handsomely reward its shareholders. Additional capital raised in these circumstances, will be done so at favorable terms to the existing stakeholders.

4. Reaching customers (to sell and support) anywhere in the world, at low price points, can now be profitable at prices that are staggeringly low. Moreover, the drive by entrepreneurs to pass along these cost savings to customers via low prices creates huge opportunities for sustained growth.

5. Customers expect the industry to 'eat its babies'. Out with the old and in with the new only accelerates in turbulent times when folk are forced to save costs, or lose jobs. When the stock shock passes, look for accelerated opportunity for companies with compelling cost saving metrics. Robert Levitan of Pando (I am on the board) leads with the message of 'we will cut your bandwidth costs by 75%, and keep your existing SLA's'. Hard not to listen.