As venture capitalists close the books on one of their worst years ever, another group of investors is looking to take some of the misery off their hands.
These investors are creating a lively secondary market by buying stakes in venture funds whose limited partners no longer have the patience–or cash–to wait for a recovery.
Like Sam Zell, the billionaire financier dubbed the “grave dancer” for his skill at spotting value in distressed properties, these “venture vultures” look to profit by purchasing marked-down assets at the apparent bottom of a boom-and-bust cycle.
Venture investments, a form of private equity, have plummeted in value in the last 18 months. But unlike public stock, private equity is hard to value and not easily traded.
A small but growing percentage of the $400 billion committed to private equity since 1996 is finding its way to secondary buyers. The biggest buyers are investment banks that have raised multibillion-dollar funds to purchase private-equity portfolios from institutional sellers looking to reallocate their portfolios.
But the sellers increasingly include tech entrepreneurs and other individuals who were cash-rich during the 1990s and joined the stampede into venture capital.
Gary Brinson, the well known value investor and retired money manager, says he saw the secondary market start to simmer when investors got their June 30, 2001, reports.
“They were shocked in some cases by the deterioration,” Brinson says. “I think when people see their year-end reports, it probably will cause further consternation.”
U.S. venture funds averaged a negative 18 percent internal rate of return at the end of June, the latest period for which data is available, according to research firm Venture Economics.
At the end of the third quarter, venture capital investments had dropped in value by about 70 percent compared with a year earlier.
But those numbers don’t adequately describe the financial and psychological impact on individuals who committed money to venture capital funds in the mid- to late-1990s, according to Brinson and others.
Private equity partnerships typically run 10 years to 13 years, with payouts coming in the latter years. Limited partners agree to commit a fixed amount, but they do not pay the entire sum upfront. Rather, they pay in increments at the general partners’ discretion as the funds are invested.
Partners initially saw the paper value of their holdings triple during the boom. Now they are holding stakes that are valued, in some cases, at 30 percent below their invested capital.
To make matters worse, they are on the hook for more money. Some are simply throwing in the towel.
“I get a call once a week either from an individual or a fund manager saying, `So-and-so isn’t going to be able to make their next capital call,'” says Jeffrey Moelis, a principal in Paul Capital Partners in San Francisco, which specializes in the private equity secondary market.
“Up until 18 months ago, if I got one call in a year, that was a lot,” Moelis adds.
Jerrold Newman of Willowridge Inc. in New York says institutions typically are not sellers, but his firm is “seeing a lot more activity from the individual who has to dig into his pocket to meet the next capital call.”
Institutions such as banks and pension funds are by far the largest holders of private equity, contributing more than 85 percent of the money raised by venture capitalists.
However, record numbers of private investors, flush with cash from the long-running bull market, piled into venture capital during the high-tech stock boom.
Adding fuel to the trend was a change in securities laws in 1996 that threw open the doors to the newly rich. The Securities and Exchange Commission raised the maximum number of qualified investors allowed in a private partnership to 499, up from 99.
“Because of the amount of money that flowed in, a lot of it from uninformed investors getting in for the first time, I suspect we’re going to see quite a bit of [selling] as we roll into next year,” Brinson says.
“I believe we’re going to see some significant investment opportunities over the next 12 to 18 months.”
Such buying opportunities are not for the unsophisticated investor.
Most secondary buyers do not purchase partnerships that are less than 50 percent funded, and they painstakingly research a fund’s holdings.
Venture investments typically are carried on the books at a value determined during the most recent round of financing, which can be much higher than current market value.
“It’s harder than ever to value these partnerships,” Newman says.
Another concern is that prices get bid up as more secondary buyers enter the market–a boon for distressed sellers but a deterrent to savvy buyers such as Brinson.
“If there’s too many of these funds being formed and they’re willing to pay a higher price,” Brinson says, “then I’m just not going to play.”
