PureVC

Travels in Asia & Europe

I apologize for the lack of posts this past week. The past month has been a very busy one. We are considering opening an Asia and a Europe office and thus I spent three weeks in Shanghai and two weeks in Western Europe on a mix of business and pleasure. I´ve been laptopless for the Europe part so the blogs are coming from internet cafes.

At any rate, I wanted to say a few things about what is going on in both China and Europe. China has received a lot of media attention on their booming economy and I would agree that things have changed significantly over the past several years. While things are different, it is still obvious that they are not ready for the new economy and what it will require.

Some brief observations on China. They are still largely on a cash only system with little use of plastic or banks. The people I have spoken to don´t trust the government and still put money under their mattresses. It is hard to imagine an information era without the digitization of finance. Deception also remains a significant MO of the Chinese. Even the locals will tell you that part of the Chinese way is that you cannot trust anyone and that they will even rip-off the locals. It is hard to imagine doing business with people you do not trust completely. However, one good thing about the Chinese hasn´t changed - they remain in love with brand names. The Chinese perphaps even more than any other people have a strong love of top quality brands. Even if they can´t afford them, they want them and will pay for them. This is perhaps a major reason that Western companies are going to be able to penetrate the market.

I do think China has come very far very fast, although I suspect there will be a contraction phase and they will need to absorb all of these changes before moving even farther.

Western Europe on the other hand is looking more and more like the USA. The last time I traveled through Europe was pre-Euro. Now those inexpensive countries such as Czech Republic and Spain are terribly expensive. To make matters worse, the locals I spoke with said that their cost of living has risen extensively. Mostly because prices are now in Euros but salaries have remained as low as they were pre-Euro. While visiting some friends who live in Catalonia, I found that the culture is changing as well. Whereas the afternoon siesta was a time for napping and relaxing, younger generations and foreign companies are starting to work regular days without the siesta. English is spoken freely and happily in most countries (except France).

There are clearly lots of opportunities in both Europe and Asia, particularly for companies who want a truly global product.

Before I forget, one aspect of traveling has been a lot cheaper than before - Skype and Gizmo are being used in every internet cafe...

Why I Don't Buy IPOs II

I have received some grief for my previous post, Why I Don't Buy IPOs? Some readers were a bit shocked at how I could be a VC yet not buy IPOs. I wanted to follow up and clarify a few things. First, as I mentioned, IPOs can be a great investment if you have the chance to get in on a tranformational company. The problem is that access is still a huge problem. If you aren't a major financial player, you will have trouble getting in on an IPO of a very solid company. Notice that I am not referring to a "hot" IPO. A good IPO and a "hot" IPO are not always the same thing.

Secondly, there are several reasons why I don't buy IPOs. The two main ones are that I don't buy public stock that much because I don't have the time or the energy to research the dynamics of the public market. At the time of an IPO I do know a lot about the company, but a few quarters down the road, unless I am intimately involved in a company I will probably know its stock price but I don't scour quarterly earnings like I research S-1s.

The other main reason is that I have an abnormally large percentage of my personal assets in Private Equity. While that may seem counterintuitive or give me justification to buy public stock to balance things out, I prefer either holding Private Equity or cash. I have already mentioned that I do own some significant autopilot type of investments in public stocks, but the underlying holdings of those vehicles are not under my control.

One last reason is this - a VC or anybody who sells an interest or security to someone else has a fiduciary duty to be a responsible manager of their interest. When a company goes public that I invested in privately, I have to make a determination whether it is in the best interest of the LPs to realize their gain or not. As you have already read, more often than not, it is in their best interests to liquidate. One thing I did not mention is that liquidiation does not necessarily mean that the stock is sold. We are allowed to distribute stock and record the gain in our return books as of the day we distributed the stock to the LPs. So if our LPs decide in their own judgement to hold their stock rather than sell it, that is their call. We did the best we could and gave them the stock at a price that we determined was the best return possible on their private investment.

Suffice it to say that whether an IPO is bought or sold at the offering is more complicated for someone in the private equity industry than to the average person wondering whether it is a good stock or not. Every person has to deal with their own personal and financial circumstances. The VC additionally has to deal with the interests of his LPs.

Why KKR Shouldn't Have Done It

I've refrained for some time from posting about KKR's IPO on the Amsterdam Euronext exchange. However, there have been a lot of provocative articles in The Deal, WSJ, and NY Times suggesting that the KKR IPO is a "transformational" event in the private equity industry. Perhaps it is indeed a transformational event, but if anything, the IPO shows that KKR is just like any other greedy private equity firm that is striking while the iron is hot.

There are a lot of good reasons that KKR floated their private equity fund - easy access to lots of cash while retaining incentive fee structure, less reporting requirements to investors, doing away with the need to go back to investors for each fund. Indeed, it is an ingenious financial strategy - an endless well of "dumb" money with no one to report to but themselves. Or is it?

This strategy has been tried before. As one article alludes, it is this type of event that may indeed signal a market top. Remember "meVC"? Draper Fisher Jurvetson launched this similar type of public venture fund at a market peak. Remember Internet Capital Group and CMGI? Both variations of the sort of private equity holding company that KKR has established. All of them fizzled off without much fanfare. Albeit, these were venture funds, not cash-flow driven buyout funds. Also, this is KKR we are talking about - the original Barbarians at The Gate!

There are three things I really don't like about KKR floating a public fund. The first is that they have cheapened their elite private equity brand by offering shares to the public, at the expense of their private funds. While I suspect the hybrid buyout-hedge strategy of the fund will enable them to do some creative deals like never before, my question is this - if KKR is so good, then why change their strategy?

Secondly, I do not believe that private equity investments are suitable to the general public. The general public wants high quality short term results, quarter after quarter, this is not the modus operandi of private equity investments. When the market turns sour and a few deals blow up, public investors will not be able to stomach the heat.

Lastly, I believe that the best part of private equity is the strength of relationships built among investment managers and their limited partners. The oldest and most respected funds have generations of investment relationships with prominent families, endowments, and pension plans. When I invest in a fund, I am initiating an investment relationship with the manager, not just for one fund. A firm's true strength is the strength of its investment relationships. If KKR has a bad fund, they undoubtedly will be able to raise another one based on these relationships. However, when the buyout downturn hits, who will KKR be calling for the next fund? Public investors? I think not.

Financing a Real Estate Deal

I have been posting an awful lot on IPOs and S-1 filings, so I thought I would take the time to post on the topic of Financing a Real Estate Deal.

We have been asked by a local developer to put together a small amount of Subordinate Secured Debt for a well known RE development in the area. The project has been in the works for several years and ground has been broken. All of the main equity partners have been in the deal from the beginning and a major financial institution is handling the primary financing. The developer would like an added cash cushion as energy and production costs have risen. The developer doesn't want to hassle with the onerous fees and terms of a bank and so he is trying to arrange some "cheaper" money.

So basically we are putting together an investment group that will loan an amount of money to a developer. The loan or debt is secured by the developer's personal assets including his partnership interests in several other projects. The debt is called "Subordinate" because it does not have seniority in preference compared to other debt holders. What this means that in the case of a default, the holders of "Subordinate" debt are not first in line to receive claims.

We initially tried to negotiate for Preferred Convertible Debt. Preferred Convertible Debt is probably one of the sweetest deals for an investor as it has the conservative component of a Secured Debt with the option to convert that into project equity if the investor desires. Thus if the project doesn't go as planned, the investor can recoup his investment as a preferred debt holder. If the project looks to succeed, the investor can convert into equity and reap the investment multiple of an equity investor.

At any rate, our negotiations for convertible debt failed as the project was very far along and early equity investors would not allow any further sharing of profits. Normally, I would say that Secured Debt, particularly the subordinate kind, is pretty far down the line in terms of desirability. It is safe, but you will not get the outsized gains that a typical private equity investment would give. If your alternative is putting money in a savings account or CD, then it is much better. However, in this situation secured debt financing works very well because the project is very far along and the note is secured. Although it is subordinate, it really doesn't matter as the developer has substantial personal assets so in the worst case scenario the debt can be reclaimed from personal assets. In addition to the high interest rate of the loan, there are transactional fees that will go to the group. The last piece of the puzzle was that we were able to negotiate the developer to give an option for the investor group to purchase first phase units. Given that the project is very desirable and oversubscribed with limited supply, this was of interest to many in the investor group.

I have mentioned before how Real Estate is so much like any other types of Private Equity. When it comes to Financing, this is especially true. Different tiers of debt is seen when structuring a leveraged buyout. Equity is used when investing early into the project. Convertible debt is used in times of great company/developer need. Getting your head around the different types of financing in private equity will definitely make a difference as you put together your RE deal.

Another VOIP Provider Files For IPO

As I suspected IPO filing activity continues to increase. Now I don't want my blog to focus too much on IPO filings so I am selective about the ones I write about, but this week another VOIP provider, InterMetro, has filed its S-1. When I previously said in my last post about the DivX IPO, that things were heating up and the quality of offerings seemed to be declining, I wasn't kidding. InterMetro's filing shows that they are a young post-bubble company that started offering VOIP services in March 2004. How can a money losing one year old company expect to tap the public markets and thrive? This is scary!

The VOIP space is indeed turning out to be "Web 2.0's" fertile ground for liquidity. I have posted about the evolution of this space previously. It started with the acquisition of Skype by Ebay. Then Gizmo's commercialization and VOIP wars between Skype and Gizmo and the introduction of Jajah's service. Then the Vonage filing. And now InterMetro.

I'm not going to waste much space on InterMetro because you all know that this is another company that is trying to strike while the iron is hot. VOIP is hot so you are going to see the floodgates open. I am however a little surprised because EVERYTHING IS GOING SO WELL with the second generation of web companies. There is NO NEED TO SPOIL IT BY CRAPPY IPOS! When you have momentum such as we clearly have since the meltdown, you can't get greedy and take your company public prematurely.

People often forget that even in a free for all marketplace such as the equity capital markets, you are interconnected with everyone else. While the markets are an efficient place that eventually punish and reward according to fundamental merit, they are influenced by emotion and psychology. If you take your company public prematurely you are doing the markets a disservice. People will lose money and not want to come back. You will get punished when you don't perform and then you will make it more difficult for others to go public. This prevents all of those innovative technologies from reaching the hands of the public.

Now maybe I'm being melodramatic. But the underwriters of this IPO, Ladenburg Thalmann & Co and Wunderlich Securities are two no name underwriters who I have never heard of before. Shame on you two no name banks that are trying to make a buck.

So I'm going to skip my rundown on this IPO - it is a one year old company in a highly competitve industry whose losses are increasing as rapidly as its revenues. The only thing I give these guys is that they have some real cajones for filing.

Why I Don't Buy IPOs

I've posted a string of posts reviewing S-1s. Interestingly, since my post about the Vonage IPO, traffic at my site has gone up almost 500%. I suspect that people are considering buying the IPO and are doing some research. Not that I care about readership numbers as I have removed all advertising from my site. At any rate, even though I have said I am not buying the Vonage IPO I want to add a disclaimer - this blog does not give recommendations on specific investments. While I clearly show my bias toward private equity investments, I do not recommend any specific manager or fund or investment.

I generally don't buy into IPOs or public equities that much. I used to buy IPOs and public stocks all the time, but I do not much anymore. When I do put on an occassional trade in my trading account, it is more out of boredom and in the interest of making a quick buck than for long term investing. I do have some significant autopilot type investments in mutual funds, but I really couldn't tell you their performance or whether they are 4 or 5 stars.

Why don't I buy IPOs? I am a VC. I make my money by creating value for companies. When a company goes public, the stock I have bought has already made a large multiple. I have taken the risk of illiquidity and turned it into liquidity and am duly rewarded. If I can unload at the IPO price I will make my investors a ton of money. If it goes higher I will make them even more. VCs are usually subject to 6 to 18 months of lock up of their stock, so it is my best interest to wait until a company really has momentum before letting it go public. There is no point for a VC to take a company public that will get hammered when it doesn't produce strong earning for 4 to 8 quarters after the IPO. Granted, usually a VC firm can sell some stock at the IPO offering, but usually the money comes  after the IPO.

So when I see a company going public, I know that some brilliant VC and the founders are getting liquid and cashing out. Any appreciation beyond the IPO price is GRAVY!!! But the meat is already being eaten at the IPO price.

Now this doesn't mean that money can't be made by buying IPOs or trading public equities. I in fact made my first chunk of dough by trading public equities for my own account. There are great companies out there that have made people a lot of money on the public markets. Fortunes will continue to be made on these markets. Just be aware that when you buy an IPO, you are buying something that someone has been holding onto for several years and is only now able to sell.

I'm not saying that there are not good IPOs to buy. Sometimes there is a unique company that is the major player in its space that will transform its industry. Problem is that if you are the average investor you won't get shares. But those kind of companies can always be bought on the open market after the IPO. If their chances of success are so great, then it won't matter whether you got shares at the offering price or on the open market. Trust me, there is always an opportunity to jump on the bandwagon of a great company.

DivX's IPO filing

Another yummy S-1 appeared late last week from DivX, a provider of software that allows compression-decompression of DVDs and movies. This S-1 interests me because DivX is a bubble-era company that initially gained prominence by its software that allowed the compression and decompression of illegal copies of movies floating around the internet. Previous to companies like DivX, movie files were too large to be transmitted over the internet. After DivX, all you needed was a fat broadband connection and your buddy could connect to you via firewire or transmission could even be possible over instant messaging networks. For those of you who have always wondered how companies who give away their product for free eventually make money, here in DivX is a good example. After gaining popularity, DivX has started supplying OEMs allowing consumers to buy machines with the software pre-loaded.

The DivX filing is significant to me because it is yet again another IPO filing from a tech-bubble era company funded in 2000 that survived the meltdown and has achieved profitability. Since the meltdown, there have been countless articles written about venture capital overhang. While the popular press has worried about unused capital commitments, I’ve never really felt this was a real problem. The problem since the meltdown has been a tight IPO market with few liquidity channels available. Consequently, when VCs can’t achieve liquidity, their portfolios become larger and they are hesitant to put new money to work. When this happens, uncalled capital commitments build up and management fees accumulate and thus overall returns are dragged down a bit.

When liquidity channels are tight, venture investors must hold onto their companies longer. VCs won’t invest as readily in this environment. People think this is primarily because VCs don’t want too big of portfolios at one time and that they want to be able to manage risk in their portfolio by seeing if early bets will pay off. While the latter is partially true, the real detriment to having tight liquidity markets is that industries do not mature and evolve well without exposure to the public markets. VCs need their companies to go public so they can get a return on their investment as well as to see those markets mature and evolve. Industries do not change as rapidly until several companies are public. Several things are allowed to happen when tapping the public markets – increased merger activity, new ventures, consolidations, and products related to economics of scale.

The DivX filing is a clear sign that things are heating up. There is a feeling in the venture community that now is a great time to take those companies public that they have been holding onto. If you take a look at next week’s anticipated offerings, you will see Interwest Partners actually has two companies slated to go public, QuatRx and Novacea. In their defense, those companies are both out of Interwest VIII, which is a huge fund, so it is probably a coincidence. While I am happy for all of my venture brethren to get liquidity and turn those ROIs around, I am also a bit worried. I know of several companies that are contemplating their S-1 filings. Some are ready for the public markets, some are not. If you notice the SEC filing activity, you will find that the quality of companies has declined a bit and 3 to 5 quarters of profitability is not required. In addition to the poorer quality of companies, I am also noticing that management and shareholder teams have lots of 30-year olds on board. Not that I have anything against young people, but this trend reminds me of years past.

So before I forget, let's be students of the S-1 on the DivX filing:

Principal Shareholders: R. Jordan Greenhall (CEO), Zone Venture Fund, WI Harper Group, Insight Holdings.

Company Story: Started in tech-bubble 2000 initially providing video compression software, now including a media player, selling to OEMs now.

Leadership: Management team of several 30 something year olds, including CEO R. Jordan Greenhall, a 34 year old who had a brief stint at MP3.com before starting DivX. He’s a Harvard law grad. Interestingly, two of their managers hold the “CXO” title, which I have never seen on an offering memorandum. However, I am obviously getting a kick out of it as I have adopted that term for my own VC firm. Another interesting thing about their filing is their note to investors which eerily reads a bit like the introduction to the Google filing.

Financials: Expanding revenues of 8 mm in 2003, 16 mm in 2004, 30 mm in 2005 with 2 mm of profitability last year.

Final Assessment: This is a company that has survived the tech meltdown and appears to have momentum. No valuation is listed in their offering, but they have about 33 mm shares outstanding so I would estimate a 250 mm to 350 mm valuation which is around 10x 2005 revenue. This is an intensely competitive sector but this is a young management team that has survived some difficult times. It will be interesting to see how well received the offering will be.