Some unexpected bright spots appeared in the outlook for mergers and acquisitions yesterday during a workshop for local executives, which was co-sponsored by Connect and the San Diego offices of the Allen Matkins law firm.

The overall M&A market is bleak. But John Stiska, who oversees venture lending for the San Diego office of Agility Capital, says the regional picture is not as bad as he would have expected. That’s because mid-market equity funds are still looking to buy “decent” companies. To Stiska, “decent” means stable, medium-size companies that generate between $15 million and $50 million in annual revenue, and which show positive earnings before accounting for interest, taxes, and other costs.

“In Southern California,” Stiska says, “that’s largely the defense contractors that have been developing new technologies for both military and commercial customers. We have a lot of them in Los Angeles, Orange and San Diego Counties. They have stable backlogs. They’ve done pretty well in the past couple of years.” Stiska says he’s encouraged because many mid-market equity funds, which raise their investment capital from big insurance and pension funds, still have lots of capital—typically $300 million to $800 million.

Stiska says he also was surprised because roughly half of the San Diego executives who attended the workshop indicated they’re not looking to sell their companies—they’re looking to buy another company.

Clark Libenson, a San Diego lawyer who specializes in mergers and acquisitions, told me the M&A program usually consists of presentations on how to prepare a company for sale. It’s one way that law firms discreetly market their services. But organizers wanted this workshop more closely tied to current market conditions, so presentations by Stiska and others showed how M&A activity has changed since the credit crunch essentially shut down financing in the second half of 2007—a full year before the credit crunch hit the rest of the market. Highlights from their presentations on the 2009 outlook include:

—Capital constraints will continue to limit M&A activity, but cash-constrained companies will likely sell divisions that are not central to their core business so they can raise cash and weather the storm.

—”Mergers of necessity” will likely emerge as a prevailing theme.

—Conditions point to a buyer’s market, with capital-rich companies acting as key consolidators—and beneficiaries. By some estimates, S&P 500 companies have an aggregate $630 billion in cash.

—Creative financing structures, private investments in public equities, and stock deals are likely to be more prevalent in M&A transactions.

—Companies unable to refinance their debt will be forced to consider such alternatives as restructuring, selling assets, or selling the company—with pre-arranged sales under bankruptcy becoming more popular.

—Mega deals have come to a dead stop since July 2007, but middle market transactions have continued, albeit at a slower pace—partly because they typically require a smaller percentage of debt financing. Since 1998, more than 90 percent of all M&A transactions have been under $500 million.

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Hercules Technology Growth Capital (NASDAQ: HTGC), a specialty finance company based in Palo Alto, CA, has closed its San Diego office—roughly a year and a half after announcing its expansion into the San Diego venture market.

The public company, which issues loans to startup technology companies and also makes venture investments, had three employees in San Diego, including managing directors Kim Davis King and Killu Sanborn. Hercules disclosed the layoffs as part of a staff reduction of five individuals, or approximately 11 percent of its total workforce, in financial results reported last week for its fourth-quarter and year ended Dec. 31.

The company did not specify where the layoffs occurred and Hercules’ offices were closed for the holiday yesterday. So it was not possible to determine where the other two layoffs occurred. Most of Hercules’ venture lending and investment activity is focused in Silicon Valley, although the company also maintains offices in Boston, Boulder, CO, and Chicago.

While Hercules reported a 39 percent gain in fourth-quarter revenue, compared to the same period in 2007, Hercules co-founder, chairman, and CEO Manuel Henriquez described the economic environment as “unprecedented” in a conference call transcribed by the web site, Seeking Alpha. “In my 20 years as an investor, I have never seen such a dramatic and quickly deteriorating market as we are currently witnessing today,” Henriquez said.

“Hercules expects a significant and continued downturn of venture capital activities in 2009, where we are predicting for a modeling point of view to see anywhere between $20 to $22 billion of (nationwide) venture capital activities,” Henriquez told analysts. That’s a 24- to 31-percent decline from the $29 billion the venture industry invested last year.

Henriquez said during the conference call that Hercules faces a $70 million payment in April on a major line of credit, which has prompted the company to both conserve its cash and seek additional financing. “Liquidity is suddenly the Holy Grail of the financial services community, followed by a heightened and continued awareness of credit concerns,” Henriquez said. “Despite the government’s attempt to unlock the credit and capital markets, we have seen little to no activity in terms of gaining access to these credit facilities.”

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Huntington Capital, San Diego’s boutique private equity and venture lending firm, says it has made four investments so far from Huntington Capital Fund II, after raising $78 million in capital for the second fund it formed last May.

Partner Tim Bubnack told me in October the privately-held firm was seeing a lot of prospects, as companies sought alternative sources of capital amid the U.S. credit crisis. As a newcomer that specializes in venture lending and equity financing, Bubnack said Huntington had no exposure to subprime home loans or troubled financial instruments.

Despite the recession, Bubnack says Huntington is still arranging financing for private companies with strong management teams, increasing sales growth and industry-leading products or services. Huntington did not disclose the size of its deals, but Bubnack told me in October his firm looks for small-to-mid-size companies that need less than $6 million. All four investments from Huntington II have been in Southern California companies, including two in San Diego:

— Anakam, an Internet security firm that was founded in San Diego to combat online fraud through innovative, software-based authentication and identity management technologies.

— DR Technologies, a San Diego-based employee-owned aerospace and defense engineering company that uses advanced composites to design and make structural components and subsystems for NASA, the Department of Defense, and major aerospace companies.

— LifeModeler, a San Clemente, CA-based software developer that enables orthopedic surgeons to use computer-based modeling to help guide joint replacement surgeries.

— Environment Furniture, an environmentally friendly Los Angeles-based business that uses reclaimed hardwoods and lumber from sustainable forests to make “eco-chic” furniture.

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Huntington Capital partner Tim Bubnack says the San Diego firm, which operates as both a venture lender and private equity investor, has raised $78 million in capital commitments for its second fund. The firm hopes to raise a total of $100 million for “Fund II” by early next year.

Bubnack told me in October that business activity at Huntington has been bustling despite the economic downturn and credit crunch. Huntington hasn’t been subjected to the same economic pressures as traditional lenders—partly because it raises capital for its loan and investment fund from limited partners instead of relying on financing from big banks and other mega-lenders.

Founded in 2000, the firm provides debt and equity financing to mostly private high-growth companies throughout California and the southwestern United States. Huntington’s criteria excludes most early-stage startups because it prefers to make lower-risk deals. That means it’s seeking well-established, small-to-mid-size companies that need between $1 million and $6 million in capital, and generate from $10 million to $50 million in annual revenue with positive cash flow.

“Our funds are typically used to support management-led buyouts, acquisitions, recapitalizations or other general working capital purposes,” Bubnack says in a statement released by Huntington. “Because of the flexible ways that we can structure a transaction, it is not necessary for our clients to sell or take their company public.”

Investors in Huntington’s Fund II include Hamilton Lane (on behalf of CalPERS, the state’s public employees retirement system), Impact Community Capital (on behalf of Allstate, Farmers, Pacific Life, Safeco and State Farm insurance companies), Union Bank of California, and other institutional investors.

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The turnout was heavier than expected as the San Diego Venture Group convened its monthly breakfast meeting yesterday for a program on “Company Financing Alternatives in a Challenging Environment.”

Coordinators had arranged tables for 300 in the outdoor pavilion at the Hyatt Regency La Jolla. But interest was so high in the topic that several more tables were set up to accommodate the overflow.

The ensuing discussion, though, was sufficiently gloomy to prompt CommNexus CEO Rory Moore to stand and remind the audience that “some of the greatest companies were started in the hardest times.”

While capital is available, the four panelists emphasized that financing has changed dramatically, and providers are now very cautious.

“It’s all about preserving capital and staying focused on the ships you’ve already launched, rather than looking for new ones to launch,” said panel moderator Carl Eibl, a managing director at San Diego’s Enterprise Partners Venture Capital.

As cash gets scarce, venture companies face a dilemma, Eibl said. The overall effects of plunging markets and frozen credit mean that venture firms will be facing a “Sophie’s Choice” in deciding which of their portfolio companies get to live.

At the same time, Eibl noted that the third quarter that ended Sept. 30 was a “record quarter” for many of Enterprise’s portfolio companies. So it’s hard to justify peremptory cutbacks for a company that is “growing well” and generating revenue, Eibl said.

As a result, Enterprise Partners has added a number of market indicators to the list of things they want their CEOs to watch, Eibl said. Changing these “dashboard metrics” helps focus everyone on the economic conditions the company faces several months out, and Eibl says “We check those metrics with our CEOs every month.”

Private equity investor Jim Caccavo of Steelpoint Capital said he participated in many discussions about “massive losses” among institutional investors during a recent trip to New York.

The effects of those losses, however, have not yet rippled through the venture capital firms and other capital providers that raise their funding from institutional investors, such as pension funds, insurance funds and university endowments.

“We heard a ton of discussions about limited partners failing to make capital calls, Caccavo said. “That’s something I think we’re going to see more of in the next six months as both high net worth individuals and institutional investors default on their capital calls.”

Market losses in conventional stocks means institutional investors also will be left with disproportionate investments in venture capital funds and other high-risk alternative investments, Eibl said. That means they’re more likely to pull back on additional venture investments until portfolio managers have rebalanced their investment allocations.

The consequences will be far-reaching in the venture community.

Steelpoint Capital, which has 28 companies in its portfolio, recently terminated four CEOs “because they just were not reacting to the market,” Caccavo said. “So if you’re a CEO out there, you really need to be proactive, you need to be going to your board with what you plan to do.”

Caccavo later added: “You’ve got to start with absolute realism about what’s going to happen in the next quarter, the next six months, the next year, the next three years.” He urged venture CEOs to be prepared to scale back drastically.

Eibl agreed, saying, “You cannot tolerate people who are not producing. You have got to rank your employees and do what’s necessary.” At the same time, Eibl observed that layoffs taking place throughout the economy provide an opportunity to recruit extraordinarily talented people.

While it is obvious that liquidity is paramount and “cash is king,” Kathy Conte, a managing director of life sciences at Hercules Technology Growth Capital, said she has never seen a comparable situation in the 28 years of her career in finance.

“Everybody is looking through their portfolio companies, and everybody is thinking ‘triage,’ ” Conte said. She later observed, “I don’t want to be all gloom and doom, but there is a big liquidity crisis in the world.”

As a specialist in venture lending for life sciences companies, Conte said, “We have money. We are looking for good opportunities. But let’s not gild the lily. Money is very expensive right now.”

As for angel funding, Caccavo said it has become more important for entrepreneur and CEOs to learn if the person you’re talking to is liquid now. “Otherwise, you’re just wasting your time.”

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Unlike a lot of bankers these days, Tim Bubnack of San Diego’s Huntington Capital is pretty upbeat about his business.

“It’s an exciting time for us,” Bubnack said between meetings yesterday. “While the credit markets are seizing up, we’re providing growth capital that allows companies to continue to expand, grow their businesses, and in some cases, to execute buyouts.”

Privately held Huntington Capital, which specializes in “venture lending,” seems to be thriving despite the credit crunch and broader financial woes that have sent markets tumbling and pushed the U.S. economy toward recession.

Conventional banks have clamped down on lending as bad home loans and other credit problems morphed into an international banking crisis in confidence and an acute worldwide shortage of liquidity.

But Bubnack says Huntington, which has no exposure to subprime loans or the troubled financial instruments at the core of the U.S. credit crisis, has not been subjected to the same economic pressures.

While it is small—the firm has raised about $80 million from institutional investors for its second venture-lending fund—Huntington Capital is hardly alone.

In the San Diego offices of Silicon Valley Bank, a venture lender focused solely on technology and biotechnology companies, senior relationship manager Andy Pelletier says, “We’re actively closing loans and seeing a significant uptick in activity.” Pelletier said he could not be more specific, noting that Silicon Valley Bank is publicly traded.

Hercules Technology Growth Capital also is seeing “unprecedented deal flow,” although Manuel Henriquez, a co-founder and the firm’s chairman and chief executive, says that doesn’t mean Hercules is making an unprecedented number of venture loans.

“We are busier than we have ever been—but we also are being cautious about the duration of this winter storm,” Henriquez says.

Hercules typically joins with venture capital firms in funding technology startups, which gives the new company a mix of equity investors and debt. At a time when some prominent venture capital firms are warning their companies to manage for hard times, Henriquez says he also is advising his “portfolio companies” to batten down the hatches.

“Even though we’re in the debt business, we’re telling people to use less debt,” Henriquez said. “It’s extremely expensive now. If you don’t need debt right away, you should wait 60, 90, 120 days.”

Companies that specialize in venture lending have thrived in part because they typically assume more risk in their deals than conventional lenders, which require borrowers to meet certain criteria or hold sufficient collateral before they will make a loan.

Venture lenders are willing to overlook conventional loan requirements, providing that borrowers have other positive characteristics, such as strong sales and positive cash flow. Such discretion … Next Page »

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