[Editor’s note: This is an Op-Ed piece written by Keith Benjamin, a venture capitalist at Levensohn Venture Partners]
Looking back at the public markets, a few strategies have worked very well over the last five years. Hedge funds have stood out with great returns and a perception of limited risk. Investing in cash generating companies that could be targets of buyouts has been another good strategy. As I started to discuss in the last post to my blog, the credit crunch is likely to dampen returns from those strategies.
Investing in technology stocks has not been relatively rewarding. The smaller capitalization stocks have suffered from lack of analyst attention, cost of regulatory compliance, and a public market that has appeared intolerant to volatility. Any disappointments cause investors to abandon tech stocks. There are thousands of stocks on NASDAQ without coverage.
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This trap has been reinforced by the investment banks. As commissions have evaporated, it no longer pays to sell institutions tech stock ideas. In contrast, commissions paid by hedge funds have become an increasing percentage of investment bank revenues. Similarly, the bankers haven’t seen significant banking fees associated with tech IPOs. In contrast, banking fees associated with buyout debt have increased dramatically.
There has been more banking fees associated with technology mergers and acquisitions. It’s been easy to sell private companies and smaller public companies to the larger public companies. It’s been hard to take a company public and have the patience and persistence to let it grow.
VMWare provides a compelling example. It was sold to EMC in 2004 for $625 million in cash, having raised $24 million in 2000. VMW went public last week and is now trading at a $25 billion market cap. This is a rare example where the private company’s value wasn’t lost in a merger. It also demonstrates how much money can be missed by not having the ability to go public in a supportive market.
The remaining supply of public tech companies has diminished. The more promising have been purchased, leaving few good growth stories.
With only 36 tech IPOs in 2006, there has been little new supply.
Part of the problem is that investment bankers are conflicted. When pricing IPOs, hedge funds can command a disproportionate share of allocations, quickly flipping, leaving some deals floundering.
Just because this sounds paranoid, doesn’t mean there hasn’t been a passive conspiracy with tech stocks turning toxic after the bubble.
This year’s tech IPO market has already shown that sentiment towards tech stocks is turning positive.
Technology investing is inherently risky with a few big winners emerging from a host of losers. Real growth comes from new technologies that displace old ones.
The credit crunch is a wake up call for those who perceived leverage is providing reward without risk. I see it as the catalyst to put tech stocks back into favor.
What could go wrong with this thesis? For an increase in the absolute return to venture, exit prices must increase. Historically, the highest exit prices have been achieved after IPO. If the credit crunch significantly hinders overall economic growth and stock market performance, we can still see more tech IPOs and tech stocks can still outperform. I am somewhat concerned that the recent increases in prices paid for venture deals may dampen the math. Tech stock prices will need to rise enough to these offset private price increases. Both need to remain tied to fundamentals, with the memory of the bubble helping maintain sanity. Scarcity has been a factor in tech stock prices, with the few large growth names running wildly, like Google, Salesforce and now VMWare. More supply should help satisfy demand.
If VCs see an alternative to M&A, they will take it. If bankers get paid, they will reinvest to support smaller cap growth investing. If investors make money in tech stocks, more will follow. I see everything lining up for tech stocks to swing back into favor.