Mercer Capital had a great time sponsoring the Southern Capital Forum on Lake Oconee last week. The annual gathering of the venture community is a favorite to check in with many of our clients and get a read on capital markets from some intentional listening. Beautiful weather and the bucolic surroundings of Reynolds Plantation helped, and on the second day of the conference, Janet Yellen kept her foot on the cost of capital. So what’s not to like? Despite the generally upbeat attitude of the sponsor community, and plenty of planned fund raisings, we heard one theme repeated over and over again that threatens the broader asset management world: stretched valuations.
It was hard to miss that what used to be a Georgia-centric and then a southeastern conference has gained a national following. The Southern Capital Forum now attracts participants from New York, Chicago, and San Francisco. Why? Because the venture communities in New York, Boston, and Silicon Valley have pushed up valuations in those markets to the point that opportunities to invest profitably are few and far between. Funds are going to Phoenix, Ft. Lauderdale, and St. Louis to find opportunities that are not available in nearby incubators, which seem to be popping up everywhere. But the entrepreneur communities aren’t as established in secondary markets, so while the competition for deals is smaller, so is the number of deals. We heard several comments from the podium that gave us pause for the immediate future of alternative investing (and prospectively the investment community as a whole):
- “Angel investors are back, and no smarter than they were pre-2008.” Tourists to growth equity investing, and special purpose vehicles have re-emerged. Investing by these groups is no more intelligent than it used to be, but it pushes up the competition for deals – which pushes down the cap rate, which depresses returns, which could end up depressing LPs.
- Mega-funds have gone down-market into traditional VC opportunities to try to generate alpha. “90% of VC returns are generated by 10% of the funds” and that seems to be going to the biggest players these days.
- LPs are “desperate” to get into growth capital funds.
- “You make money when you buy – which is a lot harder these days.”
- “Valuations are stretched and terms are loose.” Participating preferreds are becoming less common in Silicon Valley and the other strongholds of VC investing.
- Capital raises have become a technology company’s “defensive moat” to ensure a high enough spending pace to develop expensive products (or to develop products expensively) and buy market share. “We’re pushing on the outer level of sustainable valuation and burn rates.” In other words, we’re past sustainable.
- The concept of “valuation agnostic” has emerged, with some sponsors suggesting they can use terms to protect against downside risk while creating a coupon.
- “It’s become difficult to impossible to build a firm on proprietary deals. Sellers are more sophisticated.”
There was lots of talk at the conference about “Unicorns” – a term for mega-cap venture companies which didn’t even exist two years ago. Some suggest that Unicorns exist because some very successful high growth private companies don’t want to deal with activist shareholders. Still, LPs need an exit, and the IPO market has been providing that (though at a more modest pace than 2014). However, venture investment rarely gets a full exit until a secondary or tertiary offering, if they don’t have to dribble stock out over time. The upshot of this is a growing concern that there is an emerging venture capital overhang in the public equity markets, as funds seek exits for larger investments.