“Vulture” Capital? Far From It

1/24/12Follow @allegiscapital

They say the first casualty of war is the truth. Based upon recent events in the U.S. presidential elections, it looks like the truth is a casualty in politics as well. Whether out of desperation, ignorance, or political convenience, current and former contenders for the Republican presidential nomination have been questioning the long-term economic value of venture capital and private equity, which has been wrongly and unfairly labeled “vulture capitalism.”

First, let’s be clear. Venture capital and private equity—while related in that they both involve pools of private capital striving to generate returns for their investors (typically non-profit pension funds, foundations and university endowments)—follow very different approaches in achieving their goals. But neither seeks to undermine employees. In fact, venture capital typically creates jobs over the long term and private equity minimizes job losses.

Venture capital—a key component of the financial foundation for Silicon Valley—is focused on leveraging creative talent, capital, the hard work of employees and entrepreneurial experience to create and grow new businesses based on disruptive ideas. When successful, new businesses and industries are the result—creating new jobs for employees and wealth for investors and contributing to the competitive posture of America. When unsuccessful, the venture capital investors involved and their employee partners bear the costs of the failed effort. There are no government bailouts here—unless the politicians become involved a la Solyndra, the clean tech startup that fell into bankruptcy despite a $535 million federal loan guarantee. A situation like Solyndra is rare, however.

Venture capitalists and entrepreneurs don’t always win in the marketplace, but they don’t quit, either. In many instances, the same investors and talented engineers who failed will form new teams and pursue new dreams—always looking to create value and opportunity from ideas. The innovation flywheel is often successful and very lucrative: According to a 2011 Global Insight study, venture-backed companies accounted for 11.9 million jobs (11 percent of U.S. private sector employment) and $3.1 trillion in revenue in the U.S. in 2010—21 percent of the total US GDP–all based on an annual investment equal to less than 0.2 percent of GDP.

By and large, these are jobs at the higher end of the spectrum with solid, innovative companies—and often those that become global industry leaders, such as Intel, Apple, Google, Genentech, Facebook, Twitter, to name but a few. Ironically, while countries around the world are replicating the U.S. venture capital model and working overtime to encourage innovation and support venture capital ecosystems, U.S. politicos, themselves devoid of any new or creative ideas, have chosen to attack the engine of U.S. technology leadership.

Private equity also plays an important, though different, role in the U.S. economy. It builds and restores established but usually faltering companies. While colorful robber baron images of Gordon Gekko, acquiring functional businesses and breaking them apart for pure financial gain, may still be a popular reference point in today’s media, it is an inaccurate analogy in the vast majority of cases. Like venture capital investors, most private equity investors are paid for building real value, for themselves and their investors, not simply to make a quick buck. They do this by investing in under-performing companies, often in or on the verge of insolvency, in hopes of engineering a turn-around of a corporation’s fortunes. They apply a fresh perspective, capital, creativity, and hard work to re-imagining and re-making these struggling giants. It’s true that job losses sometimes accompany these transformations as managers work to fine-tune a level of business activity that they can profitably provide and support a foundation for future growth.

But a successful corporate restructuring preserves jobs, creates the opportunity to add more jobs in the future, and rewards investors (again, those same largely non-profit institutions). When the task proves too monumental, the investment is lost and so are many jobs, but that’s the same outcome that would have been experienced if the business had failed without an attempted turnaround.

Make no mistake about it—high risk/high return investing is hard work and not always successful. But often it is successful, raising the question of how the U.S. would benefit as a society if managers were not prepared to assume risks with their time, talent, and capital.

There are some bad actors in all areas of endeavor, and venture capital and private equity investors cannot claim to be exempt. Private equity investors, in particular, may sometimes try to tweak the system for a quick return at the expense of workers. But they are the exception. The politics of class division and “us” versus “them” are the politics of self-destruction.

With a globalized economy, energized competitors around the world, and serious fiscal challenges at home, it is as important as ever to support promising entrepreneurs with venture capital, celebrate their success, and encourage those who have failed to try again. This is no time, either, to dissuade private equity investors from trying to turn around established companies. Fostering the creation of new companies and fixing big companies is the American Way. Failure to do so runs the risk of repeating the lessons learned by England in the 1960s, when class warfare and an assault on capital led to a prolonged depression and loss of stature in the global economy. At this critical point in the history of our country, it would be refreshing to see the energy being put into distorted and patently false attacks on the most creative elements of our economy placed instead in constructive ideas to grow our economy.

Bob Ackerman Jr. Ackerman is the founder and a managing director of Allegis Capital, an early-stage Silicon Valley venture capital firm that invests heavily in cybersecurity. Follow @allegiscapital

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  • http://www.brianpiercy.com brian piercy

    Robert,

    My previous employer, Freescale Semiconductor, is viewed among my peers as an example of what can happen to a company once PE is involved. (The episode is most assuredly not viewed well by the remaining employees.)

    I can appreciate the spirited defense of your industry, but paragraphs like “There are some bad actors… … politics of self-destruction” are not going to win you any points. Sorry.

  • Bob Ackerman

    Brian -

    Thanks for your thoughts. I knew Freescale well when it was part of Motorola. I had a great many friends there and was also very aware of the strategic reasons why Motorola decided to divest themselves of the division at the time. I think there is a legitimate question as to whether or not PE firms can be successful with technology businesses where investment in research and people is the seed corn upon which future success will depend. I would tend to suggest the answer is “no”. I have seen these same phenomena in other industries as well. That said, I worked strategically with Motorola when they dominated the workstation market with the 68000 family of microprocessors and watched them slowly surrender a dominant, global market position to INTEL due to combination of factors – including an inability to adequately invest in product development, a product vision that missed the mark and challenges in execution. These factors had nothing to do with PE. Nor did the circumstances that led to the bifurcation of Motorola a year ago.

    As for my comment on the politics of self destruction, investment capital is essential to fuel the growth and expansion of an economy. Capital is attracted by a combination of risk adjusted returns, market growth, and fiscal policy. If we create a hostile environment for capital – by denying these realities – the capital will go elsewhere and our economy and standard of living will be the worse for it. Since the end of the WWII, our country has been the beneficiary of being – generally speaking – one of the most attractive places in the world to invest capital – human and financial. Unfortunately, this is now changing… Investors are deploying capital to other parts of the world where they believe they can generate better returns – at the expense of the US. We are not seeing a wholesale withdrawal from the US, but a subtle shift in priorities and focus. By way of example, a major sovereign wealth fund – a long time US investor – is quietly moving the bulk of its investment staff out of the US to pursue investment opportunities in other countries. The commensurate reduction in investment capital will have a profound impact on entrepreneurs looking to start companies and established companies looking to grow and expand. This is not politics – it is economics. A not so subtle difference that is often lost on politicians.

    Bob

  • Konstantyn

    Bob,

    I think, the political angle is not stressing that the niche of VC has no importance. Of cause it is indispensable. The big question in the room is adequacy of VC practice. Many people consider BC as a part of startup ecosystem. And this is exactly the problem. VC is a part of the entire economic system. On a larger scale VC screws the deal.

    The way VC operates it needs, rewards, promotes, protects the hype. For example, the Gardner-curve reflects the established practice. The curve doesn’t really reflect a necessity or an unchangeable law. The hype pike is where VC makes the profit. Good judgment is substituted by overstretching the achievements. It worked for a while, until an inflow of excess capital covered the actual economic loss. I.e. in a balanced system the inadequate VC performance would be immediately visible. But in fiat money economy with huge demand for reprint it wasn’t. All numbers were growing. It wasn’t easy to compare run-away numbers, i.e. deviations of metrics, let alone understand that the deviations are actual values of interest, not the basis variables.

    The situation has changed. There is a saturation on the market. Any money reprint immediately incurs inflation. The run-away accounting is experiencing a grounding stop. It became apparent to many people that the investment practice has been flawed. Some VC insiders pretend not to seeing the issue. what do you think?

  • http://www.linkedin.com/in/crnoble Chris Noble

    What is being criticized is not venture capital or private equity per se, but the way it was conducted by Bain Capital under Romney’s leadership. Bain would make an equity investment using mostly-borrowed money, leverage the acquired company’s balance sheet to the hilt, pay itself huge management fees out of the acquired company’s cash and then try to sell the company off piecemeal. It was a strategy that led to either bankrupcy for the company or a big return, but usually no mid-point scenario of risk-managed growth. This strategy can make sense to a portfolio investor who can count on a few big wins to pay for the crashes, and with a very favorable tax treatment of the gains, but is terribly destructive to the overall economy and to the company’s workers, who take on all the risk without a portfolio to fall back on. Let’s try to stay out of the mentality of arguing between “regulate everything” and “regulate nothing”. Capitalism and government regulation are not enemies. They need each other in a mature and civil society.

  • Bob Ackerman

    Chris –
    Thank you for your comments and for making some good points. As a venture capitalist and equity investor, I am personally not a big fan of debt/leverage. When things are going well, leverage amplifies the upside and conversely, excessive debt can kill a company. When you are building a company from an idea – typically the domain of venture capital – debt plays a very limited role in the growth of a successful company. Frankly, there are usually insufficient assets to attract the attention of most bankers through which to secure a loan. From my perspective – there is a much closer correlation between risk and reward in venture due to the fact we don’t use debt in any significant way.

    In commenting on Bain, in its early days, the firm was much more reminiscent of venture capital – primarily an equity investor. The investment theme was focused on building business as opposed to financial engineering. Hardly the activity of “vulture” capital.

    Unfortunately, as some investment funds grew, the opportunity to acquire existing businesses that were underperforming came within reach of fund managers and Private Equity diverged from Venture Capital. Banks, flush with liquidity, joined the process by making loans available to these new investors – allowing them to leverage their investments based upon the value of underlying corporate assets. When it worked, returns for all were truly impressive – further fueling the flow of capital into these large PE funds. Unfortunately, it did not always work. Sometimes it was management, sometimes the market, sometimes it was just too late for a turnaround. That said, I’m not aware of any investor who made an investments with the invention of failing. Regardless, when a PE-backed company failed, it tended to be substantially more dramatic then the young start-up in Silicon Valley that failed to bring its product successfully to market.

    One of the critical but unspoken issues in this discussion should be the use and role of debt. As we saw with the housing marketing through the lense of derivatives, excessive debt amplifies risk – not just returns. While I believe it is within a bank’s preview to make these loans for homes, private equity transactions or whatever – exposing the equity of their shareholders – I do not believe they should be able to make loans that will expose the assets of 3rd parties such as their depositors or taxpayer dollars. Government regulation would serve us all well by requiring that risk is only undertaken to the extent that the risk taker is prepared to absorb the full measure of the potential loss. This is where “too big to fail” in fact, fails miserably.

    Bob

  • Jimmy Sate

    Oh boy! The last comment reveals that the article is written by an ignorant or financially illiterate man.

    “I do not believe they [banks] should be able to make loans that will expose the assets of 3rd parties such as their depositors or taxpayer dollars. Government regulation would serve us..” – It reads like a sign there has been no understanding that the banking system was build on somebody else’s money. The notion of fractional reserve lending (loans backed by a small fraction of 3rd parties assets) seems to evade the author. But it is somehow typical.

    Shuffle the dirt under the rug, better yet somebody else’s rug. In this case VC are good guys – banks are bad boys. In fact, they both types of entities work with 3rd party assets. None is better. Who is worse remains a question.

  • Bob Ackerman

    Jimmy -

    Hpefully neither. Once upon a time in the west (USA) we viewed as investment banking and retail/commercial banking as two different businesses with different business models and risk profiles. With the repeal of the Glass Steagell Act, the distinction was removed – banks combined both functions into mega banks with global reach and highly diversified business models. Somewhere along the way, the differences in types of risk became blurred and the banking system put at hightened risk. Mortgages were made – bundled and sold – leveraged repeatedly – with little understanding or correlation of underlying credit worthiness and risk. As the bundles moved through the system – the risk went up and the perception/understanding of risk went down.

    I understand fractional lending reserves – its when you take on risk – that you do not fully understand – that exceeds your reserves and ability to absord the loss – that I have a problem. Leverage can be a very good thing when the risks are understood. When the risks are not understood or ignored (typicallty when banks are flush with cash and driven by a need to put it too work) a homeowner, a company, a bank, a privte equity firm or an economy can get in a great deal of trouble – very quickly.