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By Douglas M. Schmidt, CEO and
Managing Director, Chessiecap, Inc. (Published December 6, 2004)
Perspective and patience have never been in over-supply on Wall
Street. No matter what the circumstances or market conditions, advice
from (solicited and unsolicited) always seems to be “do a
deal, go to market.” Deals pay the bills on Wall Street, but
often the advice to do deals flies in the face of current market
conditions and business logic. Case in point is the current fascination
with IPOs. As if the 90s had never ended, Wall Street firms have
loaded their deal pipelines with dozens of IPOs, the majority of
which will never get done. Every firm and every client is waiting
for “market conditions” to improve. Maybe it would be
better to examine closely these market conditions, understand the
fundamental economics behind them, and then make informed decisions
about future corporate finance strategy.
Market Trends
At Chessiecap, we have identified the market conditions which
we believe present opportunities for smart, prepared companies.
These trends fall into three categories:
Private Equity is back. For growth
companies with a strong management team, good revenue traction,
scalable products, and executable, documented strategies, private
equity funding is available. Venture capital firms, buyout funds
and mezzanine players have money and want to put it to work.
M&A Opportunities are re-emerging.
Companies are bought and sold all the time, but strategic M&A
comes in waves. We believe that technology companies will begin
to acquire again to enhance product lines and accelerate revenues.
For most companies, the IPO is still in
a galaxy far, far away. The economic stars are not in alignment
yet for IPOs. Strong performers in selected industries will join
the major exchanges, but all others risk being ignored by investors
in favor of more established performers.
Now, to figure out how to take advantage of these trends, let’s
figure out how we got here.
Situation Analysis: Yes, Virginia, Maryland,
and DC, There Really Is a Business Cycle. In the market where
most companies compete, the absolute tenet that ought to dictate
corporate behavior is “supply and demand.” No matter
how much Wall Street wants to believe otherwise, you can no more
go against the dictates of supply and demand than you can force
IPOs on a reluctant public. A recognition and perspective of the
Business Cycle is critical to making good financing and M&A
decisions.
The Business Cycle Affects Markets.
The economy builds up a head of steam. There is a time when the
economy performs at a peak level, with all inputs contributing and
benefiting. But excesses and imbalances eventually build up. The
economy hits a wall and then stumbles or crashes. A recession becomes
Nature’s way of resetting the variables and leveling the playing
field. Ultimately, when enough jobs are lost and paper fortunes
are beaten down, new opportunities arise. People and capital lift
their heads again, and the cycle repeats itself. Business cycles
can be as short as six years or as long as eleven. The last one
was a pretty darn good ride, which compounds today’s perspective
problem.
Where We Are. It’s not hard
to tell where Chairman Alan Greenspan and other economists think
we are right now. We are in the early years of a recovery –
the beginning of an upswing in the business cycle. Mr. Greenspan
and his team are working carefully to let the recovery take its
natural course. Much can and will go wrong to disrupt the cycle,
but the likelihood is that the economy will march on through these
troubles and continue to build towards its next peak some many months
or years from now.
Recognizing and adapting to the business cycle has never been a
strong suit of Wall Street. In fact, Wall Street is something like
a perpetual adolescent with no sense of history and a belief that
no harm will ever befall it. In the go-go days of the late 1990s,
it seemed the party would never end. When the reckoning of 2001
came around, you can imagine the shock to many young bankers whose
whole professional career up to then had consisted of an ever-rising
stock market. Now that the recession is over and we are in an upturn,
the natural conclusion for many on Wall Street is that the party
is about to return – turn up the music and pour the drinks.
This mentality underlies the current Wall Street desire to wish
upon the economy a healthy IPO market. IPOs are scarce today not
because the economy is bad. It is just that the economy is not ready
yet.
Private Equity Takes Center Stage
At this point in the business cycle, private equity transactions
represent the most liquid and robust market for both investors and
companies. Private equity is a broad category that includes everything
from venture capital and mezzanine investing to leveraged buyouts
and private investments in public companies. The source of the funds
dictates the definition – privately managed funds that receive
their capital from institutions and then invest directly into companies.
Available Capital. Private equity
funds raised record amounts of capital in the last boom, some of
which is still available for deployment. In addition, many funds
have successfully raised capital over the last two years. The lion’s
share of private equity is funded by the most stable of all US and
worldwide capital sources – insurance funds, state pension
and retirement funds, universities and endowments. The last economic
boom solidified private equity as a viable asset class. Despite
some recent, horrible returns, most major worldwide institutional
investors continue to look upon U.S. private equity as an appropriate
place to put a small but predictable portion of their vast funds.
Signs of Life and Increased Activity.
To that end, private equity funds have persisted and currently stand
primed and ready to invest at this early point in the economic recovery.
With market valuation multiples low, private equity funds believe
that there is no better time to deploy capital wisely and to wait
for the market to lift all boats. Consequently, we see in the private
equity market competition for deals, multiple term sheets, and a
general aggressiveness among funds looking for new opportunities.
It is not all rosy. The early stage venture market is still fairly
snake-bit with recent memories of indiscriminate technology investing.
It’s not the same as before.
During the VC boom of the late 1990s, cycle times for deals were
short, and, sometimes, if competition was intense, due diligence
was surface level at best. Well, not anymore. Private equity investors
of all shapes and sizes have gone back to business basics. They
ask huge numbers of questions, they read thousands of pages of documents,
they interview management teams extensively, they check references
that aren’t provided by management, and they really learn
the market, product, and customer dynamics for companies in which
they want to invest. This used to be called “black chopper”
due diligence and only a few investors did it; now it’s called
“standard operating procedure” by investors. Companies
seeking an investment want investors to “do work.” That’s
a good sign. Just remember that your company will have to do work,
too. Here’s what companies need to show in words and execution:
- The strategy is clear, executable, and defensible.
- The market is big and the competition is
more than manageable.
- The product strategy, architecture, roadmap,
and delivery timeline match the resources in place and customer
and market needs.
- Products can be successfully deployed and
used by customers for a reasonable price.
- Sales and marketing programs will acquire
customers and partners and move the company to a perceived market
leadership position.
- Management is demonstrably strong in every
position. The days of on-the-job training for CEOs are long gone.
- The financial plan is aggressive but makes
sense operationally and the current team can execute it.
- The company has defensible metrics that show
it is meeting its plan.
Now here’s the kicker: Except for early stage companies where
holes naturally exist, investors expect all of these things to be
in place and obvious in advance of an investment. If you want your
company to raise money, then develop a plan, write it down, and
execute against it very aggressively. If your company doesn’t
have any planners or doesn’t have time to go through the planning
effort or if your management team feels uncomfortable or is inexperienced
working with investors, get some help. Chessiecap’s business
model is built specifically to get companies operationally and financially
ready for market and then to execute premium value transactions.
While there is more private equity money out there than can be
invested in any reasonable period of time, your company still needs
to use the tools that get investors to say, “Yes.”
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