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Where's the smart money going?

Private equity fund managers invested in some real turkeys at the end of the 1990s – that much has now become apparent. And, now that IPOs have disappeared as a quick exit route, it's easy to dismiss the asset class as a has-been. However, there are still plenty of great opportunities out there, you just need to be smart enough to take advantage of them, says INVESCO's Ray Maxwell.

Private equity had a ball in the 1990s. It was probably the longest party in history and while the music played and the champagne flowed, no one had a care in the world. However, it couldn't have gone on forever and the beginning of this century may well see the industry's longest ever hangover.

Many general partners are now wearing a glazed expression, holding their head in their hands, trying to remember how they got into the party spirit. Some may have seen the ‘fat lady' (a few may have danced with her) but they certainly didn't hear her sing. The heady brew of ‘the easy buck' led to making that one deal too many. I'm surprised that no one has set up a therapy group called NDDA (No Due Diligence Anonymous).
 
Many teams may be experiencing hubris, but life goes on. The world economy is functioning at a lower level of activity, yet there are still investment opportunities. For groups that were fortunate enough to raise new funds during 2000 and that have exercised a degree of prudence, the current environment is very attractive.

What's hot?
The ‘smart money' has a number of viable options. The most obvious of these is to do nothing at all as there are no real discernable trends. Quoted technology and telecommunication-based companies continue to issue profit warnings and are laying off staff in droves. Chip manufacturers are closing factories in response to declining PC and cell phone sales. Yet, simply looking at current conditions and deciding not to act could prove to be short-sighted. Many argue that technology is now all-pervasive and it certainly isn't going to disappear. As before, there is still a need to improve the existing infrastructure and there is still demand for systems to become faster, better and cheaper.

Other sectors could prove fruitful, too. The demise of the dot.com phenomenon and the increase in the holding period for technology investments has breathed life back into the life sciences sector. The development of genomics, proteomics, bio-informatics and stem cell activity have all heightened interest in the area. The attraction of life sciences, particularly in the area of drug discovery, is that large pharmaceutical companies are keen to acquire products that have cleared the clinical hurdle. Clearly, there are drivers that make life science attractive. However, investors should be cautious here because the promise of all these new areas has yet to be fulfilled. The life sciences sector is far from risk-free and the cost of failing clinical trials can be prohibitive.

In the venture space, the speed of innovation hasn't slowed much. However, there is a scarcity of capital. This means that venture capitalists with money to invest can be highly selective, take as much time as they need to do thorough due diligence and acquire equity at very low pre-money valuations. However, buying cheap is not the whole story. The metric has changed. Venture teams not only have to make certain that they can fully fund their investments, but they also have to demonstrate that they can bring more to their investments than simply money. Smart groups are applying business skills to their investee companies by working alongside management teams to ensure that they hit milestones and create valuable intellectual property. In this environment, access to a good patent lawyer is critical.

IPO and M&A markets may currently be dormant, but there is no reason to believe that exits will not be achievable a few years down the line. What is clear is that companies seeking listings will have to show more than just the promise of future revenues. Some pundits believe that the public markets such as NASDAQ and EASDAQ could offer value for venture groups to take private some of the technology companies listed there. However, I have yet to be convinced that too many venture groups will trawl in that pond.

‘Quick flip' flop
In many ways, the buy-out market is also having to change the way it assesses opportunities. This is because the debt market has become extremely tight and M&A activity has slowed almost to a halt. The day of the ‘quick flip' is over. Savvy groups are trying to be more innovative in their focus and in the way that they are structuring their deals. Groups are becoming a shade less opportunistic and are tending to concentrate on businesses where they have acquired specific knowledge. Many groups in all areas of the buy-out market had already adopted buy and build strategies to add value and we're likely to see this coming through more and more.

There's no doubt we're in a period of uncertainty. But it's not all bad news. As ever, it is important not to have paid too much in a deal. Yet even if private equity houses have paid over the odds, it could be to their advantage in the current market. Buy-out houses are having to hold on to their investments for longer and the cash that they have injected may well last longer than they had originally anticipated. This could remove the need for rounds of follow-on financing.

Opportunity knocks?
The great thing about venture capital and private equity is that there are always opportunities. But it is only the smart guys who can make money when the wind is blowing in the competition's face.

Private equity fund managers invested in some real turkeys at the end of the 1990s - that much has now become apparent. And, now that IPOs have disappeared as a quick exit route, it's easy to dismiss the asset class as a has-been. However, there are still plenty of great opportunities out there, you just need to be smart enough to take advantage of them.

Ray Maxwell is managing director, private equity, at INVESCO Asset Management