Feb 19, 2009 
What a difference a month made.
In early September of 2008 the stock market was perched on that wobbly mesa where it had been trading in a more or less sideways corridor for the better part of the summer. Rumors about the fall of Lehman Brothers, which had been making the rounds since back in the spring, were surfacing anew and giving renewed emphasis to the downward bias that had never truly gone away since the middle of 2007 when the burgeoning toxic soup of the credit markets finally spilled messily out of the container and into full public view. Then came the day of that fateful decision – when the same government that had rushed to the aid of Bear Stearns in March to prevent a St. Patrick’s Day Massacre took a pass on Lehman and unwittingly unleashed the Panic of ’08.
Even as the stock market was starting that fall into the abyss in the second half of September – and bear in mind the vertigo-inducing freefall of 3,000-plus points on the Dow Jones Industrial Average didn’t happen in one day but over about a month into the third week of October – even as it was all falling apart your ever-optimistic author continued to assert that the case for venture capital appeared compelling. All that money piling into Treasury bonds didn’t really want to be in Treasury bonds – it was risk-seeking capital in search of a destination.
In normal times there are a handful of alternative venues to serve as that destination: the market for publicly traded stocks, real property assets, stores of value like commodities, hedge funds, and the market for privately held equity such as leveraged buyouts, specialized partnerships in areas like oil & gas exploration, venture capital, and the relatively recent phenomenon of stock market platforms for very early-stage companies that still largely depend on private investment (more about these in a forthcoming Rita blog installment).
It is unusual for all of these risk asset classes to be nearly uniformly unappealing, all at the same time, but such was the case for all the asset classes cited above save for one: venture capital. The venture capital market has almost no correlation to either stock or property markets, does not rely on the price of oil or any other commodity, and is not dependent on robust, liquid markets for speculative-grade debt capital as with the LBO market. The VC time horizon is long, meaning investors should be more comfortable about riding out the present downturn. Looking at the numbers, the National Venture Capital Association and Thomson Reuters reported that investors in VC lost 1.6% for the 12 month period ended September 30 2008 – not much to get excited about to be sure, but still preferable to the -22% return for the S&P 500 over the same period, or the -13% showing for the HFRI Hedge Fund of Funds Index.
Essentially, the attraction VC would seem to offer to risk asset-seeking investors was that it has little to do directly with the most egregiously negative forces at work in the markets and the economy, but does in fact have a relationship to the most promising ones – including that in a potential recovery scenario the most likely viable engine for growth may come from technology-intensive sectors such as alternative energy, biotechnology and broadband 3.0 solutions like intelligent energy grids. In other words a recovery in the market could favor sectors that are heavily represented in VC portfolios – and these portfolios would thus find a bevy of willing buyers to provide a market for their future IPOs and other exit vehicles.
Not that there is any guarantee this scenario will actually play out, but then risk assets are called that for a reason – because there is uncertainty and variability among potential outcomes. Also, there is a history of spectacular growth stories emerging from moribund economic times – both Apple and Microsoft, after all, came into existence during the decade of malaise and stagflation otherwise known as the 1970s. If there actually is an optimistic case to make for our economic trajectory going forward it probably involves lots of groundbreaking technology leading the way (goodness only knows it doesn’t likely involve another debt-fueled consumer binge as the path to the Promised Land). Venture capitalists are some of the most terminally optimistic people in the world, and those who invest in their funds are prone to catch this infectious spirit.
So as I ruminated over these matters back in the fall of last year the luster of this asset class seemed to get brighter and brighter, or so I thought. And that brings us to the difference a month makes.
The difference in investor sentiment between the last week of September and the end of October was a difference in magnitude - the difference between wallets being open to the possibilities of risk-seeking assets and being padlocked shut to anything that did not bear the insignia “direct obligation of the United States Treasury”. In other words, risk-seeking capital generally speaking went on sabbatical. The results show. The Barclays US Treasury 7-10 year Bond Index returned 18% to investors for 2008 – and most of that stunning gain came from the deluge of risk capital dollars flowing in during the last three months of the year. That capital is still in hibernation – but at some point it is going to want to come out of the ho-hum world of Treasury bonds and back into something interesting.
In fact that is already happening to a certain extent. Technology indexes in the public stock markets are significantly higher than broader market averages, as I wrote about in a previous entry on the biotechnology sector. The Dow Jones Industrial Average is down more than 10% for the year to date, while the technology-weighted Nasdaq Composite is about flat. Growth-oriented technology stocks across the range of market capitalizations are outperforming so-called value stocks, mostly because the latter category is chock full of those banking and consumer-related names that are in the swamp along with other poorly-performing sectors like energy and industrial materials.
So the climate seems like it could be right again for VC. But over the past couple months I have started to wonder if that is really going to be the case. Not because the VC case isn’t compelling – I truly believe that it is – but rather because I believe the psychological scars from the last four months may last for some time to come and may alter the nature of the whole risk paradigm. Venture capital requires a greater degree of commitment than other investments – the time horizon is longer, the fund managers have to instill confidence (and many track records are looking rather sparse these days) and there are various and sundry legal, tax and other issues for prospective investors to countenance.
Are there alternative avenues for investors who want exposure to a particular breed of risk asset with low correlation to other investment markets that offer enticing prospects for growth at commensurate levels of risk? In our previous installment on this blog we looked at technology sector plays in the publicly traded marketplace – a good destination for more traditional investors who require the daily liquidity of traded equities. There is another vehicle, though, that provides a space somewhere between the very liquid public markets and the illiquid world of institutional world of venture capital. This is the market for listed early stage companies – and although it has been around for some time in one form or another the market has recently evolved. In forthcoming entries to this blog we will be looking at this market in more detail.
