VentureBeat

The current credit crunch caused by the subprime loaning crisis may help venture capital returns, and therefore start-ups.

That’s the argument of venture capitalist Keith Benjamin, of San Francisco’s Levensohn Venture Partners, as posted on his blog a few days ago, and which has been picked up by several publications, including this morning’s New York Times (the Times runs a cute graphic of a detour road sign in its story.)

Coincidentally, we asked Benjamin to write a post about this for VentureBeat. He has done so, and pushes the argument forward in a second post that we’ve published, about how tech stocks are returning to favor.

His basic argument is as follows: Investors shied away from tech stocks for years, fearing the post-2000 bubble risks. Leveraged investing strategies were perceived as less risky. For the last five years, he watched the skyrocketing returns from hedge funds and buyout funds “with jealousy,” he says. However, now we’ve just witnessed a sharp shift in perception of the risk for those leveraged investing strategies. Investors will return to things like technology technology IPO market, which is what really drives venture returns, and a reinforcing lust to invest in start-ups. Investors have finally demonstrated a willingness to buy technology IPOs. There were some 36 technology IPOs in 2006. He expects to see that number double this year: “In the middle of the liquidity crisis, VMWare went public, traded up sharply and stayed there.”

Notably, venture capitalist Stu Phillips predicted something like this eight months ago, in a column at VentureBeat, focusing on the likely correction in the buyout/private equity world. In an extreme case of bad timing, perhaps, he gave up raising a venture capital fund two months ago, before the credit crunch hit. At the time, he blamed it on the fact that investors were too focused on private equity to care about investing in another venture firm. Wonder if that’s changed.

Forget the Web 2.0 bubble, which is in the process of bursting.

Start worrying about the private equity bubble instead.

Our capitalist system has a habit of swinging between fear and greed (see Stu Phillips’ column today), and right now we’re seeing it lean toward greed • at least in private equity. Wealth has accrued, and investors — many of them public pension plans — are searching for places to put their excess capital. So they’re parking it with the huge private equity firms and hedge funds promising to put large dollars to work profitably. PE firms firms raised a whopping $198 billion in 2006, a record, and almost five times the amount raised in 2004. And they pumped $725.3 billion into companies, to take public companies private, and buying divisions from public companies that are trying to restructure. That’s another record, more than twice the level in 2004. The trend is expected to continue this year. One firm, Apollo Management, alone participated in $37 billion of transactions in just three days

Things are getting out of control. With PE firms buying up all these companies, they will need to sell or take those companies public again, in order to cash out of them. But no one knows how they will do that. If you try to sell these companies on the public market at the same time, the resulting downward pressure will kill the stock market (Stu Phillips says firms will have to hold their stakes, thus lowering returns, and causing a shakeout). Meantime, the excess cash is pushing up stock values artificially, because if a company doesn’t like its stock price, it knows it can get a premium price by selling to a private equity investor. Alternatively, if a company’s stock price dips too low, it becomes an acquisition target. So, of course the market has gone up! The Dow is at record highs.

We recently corresponded with Roger McNamee (pictured below), who two years ago raised a technology-focused private equity firm, Elevation Partners. He tells VentureBeat, in an email:

Private equity has been a turbocharger for the market. Every time private equity takes a company private, they pay a big premium and investors mark up the rest of group in the hope that another PE firm will come along. This has forced private equity to pay ever higher prices for the deals they do. As long as rates remain low and the economy is strong, private equity can pay up.

That’s the problem. Most economists say 2007 is likely to herald an economic slowdown. If it slows too much, we could be in for a choppy ride. It takes a long time to unload stock, even in the best of markets. McNamee helped buy disk drive maker Seagate in 2000 while he was at Silver Lake Partners. Though Seagate’s value rose within a year or two, and is now near an all-time high — creating handsome profits for Silver Lake on paper — the firm has been unable to sell Seagate shares very quickly. It still owns a large portion of Seagate shares — six years later. And that’s a near-ideal case. Continues McNamee:

For the past couple of years, private equity has been a safety net under the public market. Stocks go down less than you would expect on bad news because private equity is there….So many companies went private in such a short period of time, that you have to wonder what happens in three years when they all want to go public again. What happens if the market says no?

Another example is the purchase of Warner Music Group for $1.25 billion in 2003, by a group of investors led by Thomas H. Lee Partners. Within two years, Warner Music made dividend and other payments to those investors of $1.43 billion, in other words paying off the Thomas Lee and other investors the entire cost of the acquisition. Like Seagate, the investment represents a fortuitous case. However, even in these best of conditions, Thomas Lee has been unable to knock it all home with a sale. It is stuck holding to the company, with a declining stock price. Warner can’t merge with EMI, as originally envisioned, because European anti-trust regulators have said no.

The bubble might continue to grow for a while, because there’s so much cash still looking for a place to go. But its time for investors — and here we mean state employees and others whose pension fund money is being pumped into these PE funds — to start asking questions. It’d be too bad if joe public investor is left holding the bag again, just like in 2000.