Seismic Change in the Venture Capital Industry

"GLOBIS, Venture Capital, Japan!"
"GLOBIS, Venture Capital, Japan!"
"GLOBIS, Venture Capital, Japan!"

With this phrase shouted three times, I concluded my remarks to a raucous audience. I have given a speech every November.

I was in Hong Kong, attending the Asian Venture Capital Journal Private Equity & Venture Forum. With up to 800 participants, this is a major annual event at which members of private equity firms, venture capitalists, investors, lawyers, accountants, consultants, and others gather together from across Asia and around the world.

GLOBIS has sponsored the welcome reception of this conference for the last several years. Every year I am given the opportunity to say a few words at the reception, but participants are more absorbed with the beer, wine and food than the speeches, and basically ignore the speakers.

As a last resort to capture the audience's attention, I came up with these phrases to say. My remarks are usually simple. "I am happy to see all of you, please enjoy the conference. Today, all the drinks are on GLOBIS, and have a good time. Finally, I have three words I'd like you all to remember." After these introductory remarks, I shout out the phrases.

This has worked well every time, and energizes the venue. Recently, when I mentioned GLOBIS to some people I was meeting for the first time, they even responded with, "Venture Capital, Japan!" The fact that the GLOBIS name has gained this much recognition has made it worth sponsoring the event for several years.

Enough introduction; I'd like to get onto my main point. The mood was quite different than usual at this year's event. I have participated in this conference every year for more than ten, since around the time of the Asian currency crisis, but I've never felt such seismic changes as I did this year.

The morning after the reception, David Bonderman, a founding partner of Texas Pacific Group (TPG), delivered the keynote address. TPG is a player in private equity and manages large-scale funds on the same scale as Kohlberg Kravis Roberts & Co. (KKR), The Blackstone Group, and The Carlyle Group.

Mr. Bonderman was very pessimistic. "If I were you, I wouldn't expect any returns for seven years. Since we now cannot get financing, it's just not the right time for making deals, and this downturn is completely different from those in the past. There won't be any V-shaped or U-shaped recoveries; only an L-shaped recession."

Mr. Bonderman is notorious for being shabbily dressed, and wearing a wrinkled suit and a crooked tie with disheveled hair. When he showed up looking this way for his speech last year, it almost seemed as though he were saying he didn't give a damn what he wore, and in fact he looked strong and proud. But this year, his casual appearance merely came across as shabby, and I felt it was almost sad.

Even the audience appeared to sympathize with him; no one asked any hard questions since it seemed he was already facing a tough enough time. Everyone was thinking about the \700 billion investment by a TPG-led Group this April to Washington Mutual, one of America's leading financial services companies. As remarked by a participant in a panel discussion at Harvard Business School (HBS) last April, this was "the most foolish deal in the world of private equity." Amid the swelling wave of the subprime meltdown, Washington Mutual soon went belly up, the investments were all lost, and the share value plunged to zero.

The environment surrounding private equity is clearly undergoing a dramatic change. Since bank loans are hard to come by, it is difficult to attract investments and highly likely that companies that have received investments will suffer slowdowns, causing losses to investors. In addition, because shares in these companies were purchased when prices were high, several private equity firms have already suffered losses based on current stock prices.

The only good thing is that there is no redemption. Bonderman's TPG manages a hedge fund too, and he said that hedge funds have been even harder hit.

"The money invested in hedge funds has to be redeemed at the investor's request. That's why we have to sell the shares. On the other hand, private equity doesn't require redemption at all. Since investor funds are locked in for ten years contractually, you can remain a partner for the contract period."

Hedge funds, private equity and venture capital fall into a category known as alternative investments. From the perspective of institutional investors, investment options roughly fall into four categories: stocks, bonds, real estate, and alternative investments (these categories are referred to as asset classes; sometimes real estate is included under alternative investments). Venture capital accounts for a small part of alternative investments.

It is common to disperse various asset classes into America, Europe, Asia, South America, China, Africa and other parts of the world and to develop investment portfolios. For GLOBIS' venture capital business, this means investors are asking two things:

(1) Is it worth investing in Japan?
(2) Should investors consider venture capital among the asset classes?

Recently many investors in Asia have stopped investing in Japan and have shifted to China and India. In addition, there has been a trend toward avoiding venture capital as an alternative investment. It is not easy to collect money around the world.

Let's take a quick look at the venture capital business, in which operations can be divided into investment and fundraising. Investment involves discovering start-up companies, making the investment, joining the management team, promoting business growth, listing the company, or selling the business. Raising funds means collecting cash from around the world to use for investment.

Most of those attracted to venture capital business want to participate in the investment operations of the venture business. Therefore, fundraising operations, such as marketing and IR, are not as popular.

My basic management approach is to do what others can't do or don't want to do, and so fundraising has become my primary job, and as a result, I travel around the world to raise money. As part of this, I have been promoting GLOBIS' venture capital investments, as I mentioned at the beginning of this entry.

And now a movement has emerged that will cause seismic changes in the venture capital business.

This movement first appeared in Silicon Valley in the U.S. The reality is that after 1999, most venture capitals there had not even recovered their principal. Just as they were about to recover from the bursting of the tech bubble, they were clobbered by the subprime bubble collapse. Faced with a worsening slow down in consumption and corporate performance, fundraising at investee companies has been rapidly deteriorating. In addition, stock prices have cratered, and there have been no new listings in the past three quarters. The situation seems severe.

It is said that China and India, which have been hot up to now, are facing serious problems as well. Because of the continued stock price bubble, the share prices for investee companies were overvalued. Then, the economic downturn hit, so of course there can be little expectation for listings and selling. Many of the venture capital firms from the U.S. who had made inroads into China and India are projected to fail.

On the other hand, of course, Japan is not exempt from these influences. Japan's situation, however, can be said to be better than those of other countries. The rest of the world must be surprised by the fact that new listings are still appearing in Japan. Japan's venture capital returns are likely to remain better than those in other countries for several years to come.

Fortunately, GLOBIS' venture capital investment returns are not bad, relatively speaking. Our first fund, the Globis Incubation Fund established 1996, has generated more than a sevenfold return for investors, and our second, the Apax Globis Japan Fund established 1999, has already recovered the amount invested. Listings of promising companies are waiting in the wings. In 1999, venture capital funds around the world collapsed, and the Nikkei average has lost half its value since then. Under these circumstances, I think GLOBIS is holding up well (of course, investors expect a higher return, so we should not be too satisfied).

I think the VC industry is entering an era of weeding out weaker firms. George Soros said at a public hearing, "I wouldn't be surprised if hedge funds decreased to half, one-third, or a quarter of what they are now." I won't be surprised either if the scale of operational funds in the venture capital industry (including the private equity business, of course) declines by half.

A fifty-percent drop in the size of the industry is a major, seismic change. What we can do to prepare for this change is to strengthen our own foundations. Fortunately, there are many promising firms among the companies we have invested in. I would like to ride out this storm of seismic realignment by keeping a firm hand in the management of these companies.

My stay in Hong Kong was brief but significant. We held a board of advisors meeting, consisting of investor representatives, and had an opportunity to exchange opinions with them. I also moderated a panel discussion on venture capital and was able to grasp the global situation first hand.

I left for Japan still mulling over the words, "from now on, there will be an L-shaped recession," and this very day, U.S stock prices fluctuated violently. In just one day, stock prices have shifted in the unbelievable range of nearly $900. What will happen to the world as a result of the changes arising from this volatility?

This weekend, the heads of major nations are scheduled to gather in Washington, D.C. for the G20 meeting. From now, a serious economic downturn will strike the world.

Individuals and companies who are steadily doing what they have to do will survive and prosper, just as in the fable, "The Ant and the Grasshopper."

Yoshito Hori
November 17, 2008
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