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What's ahead for venture capital?

Knowledge@Wharton talks to Alta Communications' William P. Egan, a veteran of the VC world, about the future of private equity after an economic lull.

On Jan. 9, The Barksdale Group, a high-profile $180 million venture fund launched by former Netscape CEO Jim Barksdale and his partners, quietly announced that it was closing shop. It is a sign of the times.

If one industry has been severely mauled following the dot-com and telecom debacles, that industry is venture capital--or private equity, as it is sometimes called. During the late 1990s venture capitalists--lured by sky-high valuations for high-tech start-ups of every ilk--poured millions of dollars into enterprises that have now gone down in flames. And with the fate of a broader economic turnaround still uncertain, it might be a while before the prospects of venture capitalists improve.

So what lies ahead for venture capital? Continuing its series of conversations with senior executives, Knowledge@Wharton spoke to William P. Egan II, a founder and managing general partner of Boston-based Alta Communications, which has some $1 billion under management. In 1979 he also founded its predecessor firm, Burr, Egan, Deleage & Co. Egan's introduction to the world of private equity came soon after he graduated from Wharton and became a manager of venture capital for New England Enterprise Capital Associates. He is a former president and chairman of the National Venture Capital Association.

We have gone from one unreality to another. It's like a bell-shaped curve.Q: When did the slowdown hit the private equity business? Did the terrorist attacks of Sept. 11 have a major impact?
A: The private equity business was starting to slow down pretty dramatically from the middle of 2000; Sept. 11 just put an exclamation point on that slowdown. For example, we have a Monday morning meeting in our firm every other week. In 1999 we would have had five pages of transactions that we would be interested in doing. That was the amount of deal activity. But during 2001, that went down to a page and a half. I speak now not about the quality but the quantity of deals.

Also, I was speaking recently to one of our limited partners and learned that the investors were experiencing a mild percentage of capital drawn against commitments. That was running, up until this year, at about 40 percent at this large retirement fund, which would suggest about a two-and-a-half year investment cycle. At the quarter ended June 2001, he reported to me that they were running at about 12 percent. This would suggest about an eight-year investment cycle. Obviously the pace will pick up, but it gives you a sense of how dramatically the train has slowed.

What brought this about?
From my perspective, we went through two significant phenomena. First, there was the Internet phenomenon; and second, we saw the telecommunications sector go through boom and bust cycles. Both areas saw unprecedented investment activity. Particularly in telecom there was an if-you-build-it-they-will-come sort of mentality. We have gone from that to a huge swing to the other end of the spectrum. Now the only things people want to look at are fully funded business plans. In other words, we've gone from a market where people were building new networks--no matter what the cost--in the hope that they would find the business to support it, to a different environment where you have to prove that whatever you build, you have enough capital to complete that. We have gone from one unreality to another. It's like a bell-shaped curve. We have figured out the lunatic fringe of each side. Now I hope good judgment will come into play and we will move back toward the middle.

Do you see any middle ground emerging?
Oh yes. I've been in this business since 1970. At our annual meeting a year ago, we were showing very good numbers in one of our funds. They were not good enough to put us into the top quartile at that time, but today they would certainly be considered astronomical. I remember saying to one of our limited partners at that meeting, "Whatever we do today, I want you to leave with one memory. And that is, 'This too will pass.'" In other words, things were way too good. They were unsustainably good.

What's happening now?
We are now in normal financial markets, in my mind, over a 30-year period. When a pendulum swings to excess, nature requires that it swing back. For instance, in the Internet area there will have to be some companies succeeding, and there are. We also continue to believe that in the long term there will be numerous significant opportunities in telecommunications. In fact, there are several companies, both public and private, that are going to be successful businesses but they will have to be financially restructured to get them on the right footing. That is one of the reasons why things are going to be slower coming back in the telecom area for venture capital or private equity. It will take some time for the problems to get sorted through.

Can you explain how you see the telecom market turning around?
Numerous companies, both public and private, have significant revenues and earning capacity but they are too highly leveraged. In a nutshell, the people who own that high-yield debt are going to have to become shareholders. The existing shareholders are going to have to be squeezed down--but once you do that, you have a very interesting business proposition. You have companies that have tens of millions of dollars in EBITDA (earnings before interest, taxes, depreciation and amortization), but far too much debt to support that level of earnings. But if you restructure that debt so that it becomes equity, those businesses are not just OK, they are very attractive. There are several of these companies and they are not hard to come by. They have substantial high-yield debt and are trading at substantial discounts. A very good case can be made that until these companies restructure it is going to be very difficult to do any further financing.

What went wrong at these companies?
These companies got into debt for one of two reasons. They either built too much capacity or they funded too many losses. If all this had been done with equity, the companies may not have had good equity returns, but they would still have had cash flow. They got all this capital because money was fungible. At the end of the boom cycle, money had no value. The idea was worth so much more than capital. Frankly, ideas tended to be worth more even than management. That is why you ended up with so many companies that could not succeed being funded. These companies had neither good management nor the function that good management performs--a thoughtful use of capital. So all you ended up with was a bunch of ideas. And most of us in the private equity business were part of this folly.

This is not unusual. The same kind of phenomenon went on in the early 1980s when there was a biotech bubble. The difference this time was the unprecedented size of the private equity business and the scale at which things were done. But you can go back and see the same kind of mentality in biotech, or when Lotus 123 was developed and everyone was saying there would be 10,000 successful shrink-wrapped software companies. There have always been these periodic waves of euphoria. It's what Greenspan called "irrational exuberance," but in a curious way, that is probably what makes capitalism work. There's a new wunderkind--or ten of them--on the cover of some magazine, and that gets everyone excited about the prospects. In my opinion, there's no question that the Internet/telecom bubble was a mania. I am an optimist, but I think the downturns make the private equity business stronger. You learn more with your failures than you ever do with your successes. Your losses can be the best base from which to create new successes.

In this environment, do you see any reasons why investors should remain in the private equity business?
Private equity investing has been a very attractive area for institutions because it is a business where the investor group has an unfair advantage--in the sense that it is not an auction market. I often tell my associates that the day an entrepreneur can go to a machine and ask for bids for his offering, that's when I don't want to be in this business. In private equity the real value is that you help entrepreneurs. But from an investment standpoint, you also have the ability to be the market maker in a security and the buyer of that security. It's a wonderful business.

Results in the 1999-2000 time frame have been very tough, but it is not the first time this business has seen tough results. If you look at it over a long period, it has been a very beneficial period. If you are in the right time or place, you still have the chance to make a lot of money.

We are now in normal financial markets...over a 30-year period. When a
pendulum swings to excess, nature requires that it swing back. I have been in this business for a long time. The right time to make an investment in an early-stage investment is during a downturn. One reason for that is that capital tends to be valued higher so you can get a better deal as an investor. Second, people resources are far more available. A lot of good people are looking for work. And third, in a start-up you are not going to get many sales, so in a downturn you don't care that there aren't many orders coming around. So you focus on developing opportunities that will surface two or three years from now. That is why a down cycle is a good time to be doing this.

Where do you see opportunities today?
We run a fairly specialized fund. We do traditional media and telecommunications and then some Internet infrastructure kind of activity. We continue to think that the traditional media businesses will be enormously steady. Telecom wireless activity is going to be significant in the U.S. and overseas. There's a range of opportunities in that world. With what we have gone through, there will be fewer players competing for those activities. But everyone in the private equity business will have to reevaluate their approach toward businesses that require enormous amounts of capital. In telecommunications, particularly, the opportunities going forward will have to be more capital efficient.

What is the most important lesson you have learned from the dot-com and telecom bombs?
I have often heard it said in the private equity business that people are very important. I have come to the conclusion after 30 years in this business that management talent is a necessary but not sufficient reason to succeed. Management can never be overvalued, but it can be overestimated. Warren Buffett once said, show me a bad business and a good management and the bad business will prevail every time. So the lesson I have learned from the recent mania is that you may have capital and a talented management team, but if you are fundamentally in a lousy business, you won't get the kind of results you would in a good business. All businesses aren't created equal.

 
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