Private Capital Markets Project Survey Report
Interview with Dr. John Paglia, associate professor of finance at Pepperdine University on September 23, 2009
Introduction
Last month, Pepperdine University released its Private Capital Markets Project Survey Report. This survey by Pepperdine University's Graziadio School of Business and Management is the first comprehensive and simultaneous investigation of the behavior of the major private capital market segments. The survey specifically examined the behavior of senior lenders, asset-based lenders, mezzanine funds, venture capital firms and private equity groups.
This week we are pleased to talk with Dr. John Paglia, senior researcher of the Pepperdine Private Capital Markets Project and an associate professor of finance at Pepperdine University. His research has appeared in The Wall Street Journal and The New York Times and has been published in a number of journals.
Sound off on this week's buzz in the Comments Section.
John, one of the most interesting findings in your survey was the variation in required returns by type of lender/investor. You discovered that senior lenders expect 6.5%, asset-based lenders demand 11%, mezzanine funds require 18%, private equity groups expect 25% and venture capital funds requiring 42%. Were you surprised by these findings, and will you comment on the rationale behind these various required returns?
Private capital providers are subject to varying levels of risk and price their exposures accordingly. Banks, asset-based lenders and mezzanine funds are vulnerable primarily to credit risk. Senior lenders, having priority in the capital structure and the option to demand personal guarantees, collateral and restrictive covenants, while also adjusting the multiple of cash flow lent or advance rates against collateral, accept lower returns for the lower risk of their investment. Asset- based lenders' expected returns exhibited a fairly wide range depending on type of lender and asset used as collateral. We observed higher rates for working capital loans and lower rates for real estate. Since these lenders face significant collateral liquidation risks, their expected returns are higher to compensate for that potential outcome. Mezzanine funds, in most circumstances holding a subordinated position in the capital structure, require greater returns for the additional risk and expect to earn approximately 12-13% in interest income while obtaining another 5-6% in equity return via warrants.
Private equity firms' and venture capitalists' exposure is primarily with equity risk. Private equity firms will typically take a control equity position in established firms that have positive cash flows. This approach has led them to businesses primarily involved in service, manufacturing and retail where the prospects for revenue and EBITDA growth are greater than 10% annually. As a result, their expected returns are less than venture capital. Venture capitalists are subject to the largest equity risks as they're frequently investing in minority interests of highly speculative companies involved in areas such as nanotechnology, biotech, medical devices, pharmaceuticals, software and so forth. These industries also represent the highest growth prospects in the economy.
In your survey, venture capitalists indicate expected returns of between 40.5% and 43.5%. However, the implied actual returns on the most recently closed funds range from 24.4% to 29.8%, which is significantly less than the returns expected on the current fund. How do you explain the variation between the expected returns and actual historical returns?
I believe there are two main driving factors—one of which was unexpected and temporary; the other is more of a longer-term phenomenon to which we must adjust. First, the weakening economic environment had a fairly influential role here—not only on the valuations of portfolio companies, but also on the ease of obtaining lucrative liquidity events such as IPOs. Second, unforeseen industry competitive changes also played a role in earning lower returns. Venture capitalists must be cognizant of the rates of innovation and time to market for new products, which have declined significantly due to technological and scientific advances. This trend will continue to add uncertainty as new products and firms emerge "overnight" in a market niche which appeared unoccupied when conducting initial due diligence.
You reported that venture capital firms use a variety of investment analysis techniques to evaluate investments. While 96% report employing a market analysis and 78% utilize a multiple analysis, 67% indicate they also use a "gut feel" even more frequently than they apply a discounted cash flow analysis. Should we be surprised by this reliance on instincts, or is this to be expected and does this typically serve lenders/investors well?
VC firms use a variety of techniques to evaluate potential investments, some of which are considered standard, such as discounted cash flow analysis and multiple analysis, and others more uncommon, such as market analysis and "gut feel." In most circumstances, the VC investor is attempting to determine the viability of the company, which will be influenced by the size of the potential market for its products or services. Unfortunately, with these analyses, there exists a fairly large amount of forecast error with new products and markets so the venture capitalist must have confidence that those at the helm will approach any unexpected events flexibly and strategically. Additionally, since venture capitalists work intimately with management of their portfolio companies to increase their chances of success, they need to make sure the chemistry is a good match and that they feel good about future prospects. So, although it is somewhat surprising to see that "gut feel" dominates discounted cash flow analysis techniques, generally speaking, it has served the industry well.
Regarding exit plans, nearly 50% of venture capitalists report selling to a public company as the most likely course of action for a liquidity event, followed by nearly 25% indicating their plans to sell to a private company and almost 17% plan for an IPO. This differs from private equity firms with 35% of participants expecting to sell to a public company, and 34% of respondents indicating they will most likely sell to another PE group. Only 9.2% of private equity participants plan on an IPO as a liquidity event. Talk to us about the reasons behind the different exit strategies of these two groups.
This result is driven mainly by the growth prospects of the investee company. Many of the technologies or scientific advances pursued at the venture capital stages are well positioned for assimilation within existing frameworks of publicly-traded companies searching for growth opportunities through strategic acquisitions. Additionally, many of the companies pursued by venture capitalists ultimately require more growth capital (and at cheaper rates), such as that obtained in an IPO, than that supplied by the venture capital community.
In contrast, private equity groups are investing in lower-risk companies, such as those in service, manufacturing and retail that are frequently generating sufficient cash flows to fund their growth plans. These companies typically do not have the growth prospects to justify an IPO, nor do they wish to incur the compliance costs associated with being publicly traded. As a result, private equity groups have segmented by size, which allows them to sell to another private equity firm as the investee company grows.
Your survey tells us that 76% of venture capitalists believe the demand for venture capital will increase over the next 12 months while 64% of private equity respondents believe that the demand by companies for private equity will increase. What do you believe their optimism is based on?
I think there are a couple of factors worthy of mention. First, with any economic deterioration, a scramble for capital ensues as access to traditional funding sources becomes more restricted. In particular, bank lending has tightened and traditional self-funding sources such as home equity or other financial nest eggs have deteriorated in value. Second, higher unemployment rates ultimately drive the entrepreneurial spirit and thus innovation, which leads to additional capital demand. In fact, companies like Microsoft, Hewlett-Packard and FEDEX were founded in an economic recession.
As you acknowledge, deal flow is extremely important to private equity groups. They report that 26.7% of their companies for consideration come from direct marketing to owners. Another 23.6% comes from lawyers, CPAs, financial advisors and other professionals while business networking meetings account for 19.6%. Do you think the current economic times have changed the profile of deal sourcing?
This economic environment is likely to have influence on the profile of deal sourcing. Business owners are more concerned about risk of failure when times are tough and will expend more effort selecting a financing source that is a good match for them. Part of this diligence effort includes obtaining the opinions of trusted advisors such as lawyers, CPAs and financial advisors. I expect to see this trend continue for the foreseeable future.
You reported that private equity firms change the CFO in nearly 39% of the companies in which they invest, the CEO in 25% of their portfolio companies and the COO in 20% of their investments. Venture capitalists assign board members in approximately 51% of the cases while CEOs are assigned in approximately 27% of their deals. Do you believe that investors are not only interested in bringing in the most qualified individuals to run the company but also in having their own "insider" to oversee their investment?
Venture capitalists serve many functions for their portfolio companies. Among them, they provide investment, monitoring, and mentoring functions, and frequently add expertise on some technical and business management levels. That said, there is a certain level of comfort knowing that a chosen insider is at the table representing an investor's financial interests.
Did any of the survey results surprise you?
The result that surprised me most was that expected venture capital returns across all stages of investment were relatively constant. As expected, the multiple of expected sale price to total venture investment declined significantly with increased size and profitability of the investee firm, as did the expected time to exit, but the implied annual returns were fairly constant ranging from 40.5% to 43.5% across all six stages of investment. Naturally, I anticipated seeing higher expected returns for investing in companies that were smaller and had scant operating histories. This is one result we will investigate at a deeper level during our next survey in October.
What feedback have you gotten on your Private Capital Markets Project Survey, and what plans do you have for the survey going forward?
The feedback thus far has been excellent, and we've had the fortune of obtaining coverage in well-known national publications such as the Wall Street Journal and New York Times as well as many outlets that specialize in particular capital types, such as VCExperts.com. Since our last release, we've made a number of significant revisions based upon some excellent feedback from prominent members of various private capital market segments and will launch the updated version next month. If any members of your readership would like to participate, I'd encourage them to register at http://bschool.pepperdine.edu/privatecapital. The next survey will take place in October, and we plan to have an updated report published by the end of the year. Our surveys will continue on a semi-annual basis thereafter—one in the spring and another in the fall of each year. We're also exploring launching a Center for Private Capital Markets at Pepperdine, which would provide a formal umbrella under which this survey and other similar initiatives would be undertaken.
John, thank you for your time and insight.
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