Friday, September 18, 2009

High investment return expectations may limit VC spending

Private capital lenders and investors may not engage in a meaningful volume of lending for another 2-3 years, according to new research from Pepperdine University’s Graziadio School of Business and Management.money2

The Pepperdine Private Capital Markets Study, which sought to learn how private capital providers view return on investment in the midst of the recession, found that venture capital firms expect a 42 percent ROI on an annualized basis, while private equity groups expect a 25 percent return.

They’re hardly alone. Asset-based lenders expect 11 percent; mezzanine funds expect 18 percent; and bank lenders expect a 6.5 percent return on investment.

For business loans being booked these days, the median reported rate is 11 percent. But 22 percent of the survey respondents said the all-in rate borrowers will pay for a loan tops 15 percent.

These high expectations and requirements could very well make it hard for private capital providers to strike deals in the short- and long-term. They also suggest there is more pain ahead for a wide range of enterprises seeking private funding.

Private capital lending may be limited for a period of six months to up to three years, the study found. The timing couldn’t be worse.

Recent reports from the U.S. Department of Commerce suggest the economy has finally stopped cratering. In fact, some specific key sectors are showing signs of life. Factory orders and shipments of goods in the manufacturing industry such as metals, construction machinery, turbines and electrical equipment have stabilized and showed a slight uptick in June, meaning that existing and new businesses may soon be able to make a plausible case for increased capital.

Historically, investment in early stage growth companies takes off at the start of a recovery and contributes significantly towards leading the country out of a recession.

However, more than half of the asset-backed and private equity investors surveyed said they believe the U.S. gross domestic product will decrease well into next year. Median estimates of GDP growth are consistently negative.

The economic risks of a constrained cash flow extend far beyond the success or failure of struggling start-ups.

Job creation is a significant concern. Economic recovery has always included a recovery in small business. Private equity and venture capital play a critical role in investing and encouraging fledgling enterprises that grow into steady and robust job providers. More than half of the companies in the 2009 Fortune 500 were launched during a recession or bear market, according to a report from the Ewing Marion Kauffman Foundation.

That same study suggests that job creation from startup companies is less volatile and sensitive to downturns when compared to the overall economy.

Finally, there’s innovation. An increasingly large share of the more than 12.1 million jobs currently connected to venture capital are in areas such as energy and clean/green technology. In fact, according to a June 2009 report from the PEW Charitable Trusts, green energy investments from 1998 to 2007 generated jobs 15 percent faster than the entire California economy (more than 125,000 jobs over the ten year span).

Clearly, there’s an upside to private capital providers who catch the wave when it is about to break. But judging by the anemic level of funding and exorbitant expectations for returns, we’re a long way from returning to the VC ‘heyday’. If the economy is going to recover at a reasonable pace, private capital lenders need to set aside their lofty expectations and take on greater exposure. The company they save, ultimately, may be their own.