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| Private Equity |
A House of Cards
Eileen P. Gunn
04/01/2004
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William Baldwin, who advises affluent families as CEO of Pillar Financial
Advisors in Boston, recently had a client who was in a quandary. The venture
capital firm that backed this entrepreneur’s company had invited him to invest
in its funds, beginning in the late 1990s—a coveted privilege for investors at
the time. “He invested in one fund and made $2.5 million on $500,000 in no
time,” Baldwin recalls. “He invested in the next fund, which also did very well,
and then committed to a third and fourth fund,” all in quick succession, with
higher minimums and larger fees each time, Baldwin adds.
By 2001 the markets
for acquisitions and initial public offerings had dried up. The venture capital
firm, like most in the business, found itself unable to monetize its portfolio
companies, and it stopped delivering distributions to its investors. But it
continued to call in the money that investors had committed to its later funds.
With the stock market dropping, the entrepreneur found himself in a cash crunch
and, discouraged by such a quick change in fortune, he asked Baldwin to help him
get out. Baldwin found someone who would buy his paid-in interest in the venture
capital funds—at a steep discount—and take over the remaining payments.
“It
cost him,” Baldwin says. “If you do something like that, you’re going to take a
haircut. If you’re lucky, you’ll get back 50 cents on the dollar.” Other clients
have come to him with the same request—out of both necessity and frustration
with their venture capital firms. But his advice to them has always been to sit
tight and hold out for a better market if possible.
Similar scenes have been
playing out across the country. Venture capital has been in gridlock for three
years, leaving investors and start-up companies equally strapped for cash.
Between these two entities stand the venture capital firms themselves, flush
with money—some would say an excess of it—but with too few opportunities to cash
out of old investments to free up their attention and dollars for fresh
ones.
Once Bitten…
For long-suffering private equity investors, the worm may be
turning: The IPO and acquisition markets improved through 2003 and are
continuing to gain ground. But investors, observers and the venture capitalists themselves say there are still problems to be overcome before the sector is up
to speed again. Funds need to cull nearly dead companies—mostly in the
telecommunications sector—from their portfolios. And valuations at every stage,
from start-up to IPO, need to find a happy medium between the extreme boom and
bust levels experienced in the past decade.
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