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Forecast for US venture: clearing skies

Conditions have not been clement for US venture capitalists for a few years now: difficult economic conditions, falling company valuations and a practically non-existent exit market have all dented confidence in the sector. But, says VenCap International's Allen Latta, it looks as though things are starting to improve.

US venture capitalists have weathered what has been called a ‘perfect storm' over the past several years. However, a growing number of indicators suggest that the worst of the storm may be over, and that the forecast for US venture capital market in 2004 is for clearing skies. There are several elements that give rise to this forecast: the US economy's progress, recent stock market activity, and trends in the venture capital industry.

The US economy: one step forward…
A number of recent economic reports suggest that the US economy is slowly gaining strength. The gross domestic product for the second quarter grew at a better-than-expected annualised rate of 3.1 per cent, up from 1.4 per cent in the first quarter. Initial claims for unemployment benefits have slowed, and the unemployment rate for July fell 0.2 per cent to 6.2 per cent. Further, interest rates continue to be at their lowest levels in decades and inflation continues to be in check. The icing on the cake was that The Conference Board's index of US leading economic indicators increased for the fourth consecutive month in July.

All these factors have contributed to an increasing sense of cautious optimism. Federal Reserve Board chairman Alan Greenspan stated recently that he was ‘optimistic' of an imminent financial recovery. His view is supported by The Business Roundtable's quarterly economic outlook survey conducted in July. This survey of leading CEOs indicates a ‘modest but measurable' improvement in the CEOs' outlook for the economy over the next six months.

However, there are still signs that the economic recovery is fragile. Consumer confidence took an unexpected dip in July, but rebounded in August. July's positive employment numbers were contradicted by an unexpected decline in non-farm payrolls. Moreover, the Federal Reserve indicated in its recent Beige Book survey that the economy continued to improve in July and August, but that there were several pockets of weakness. Overall, however, the US economy appears to be heading, slowly, for a recovery - and the public markets have taken notice.

US stock markets: off to the races?
The major stock indices experienced strong gains in the second quarter. The Dow Jones Industrial Average rose 15 per cent, the S&P 500 climbed 17 per cent and the Nasdaq surged 20 per cent in the quarter. These indices are now trading at their highest levels in over a year. This rise is attributable to a number of factors, including the positive economic news and favorable earnings reports. The second quarter earnings season is largely over and most of the S&P 500 companies met or exceeded Wall Street estimates - another encouraging sign.

The recent performance of the public markets has provided an opportunity for the IPO and M&A markets to open up.

The IPO and M&A drought is easing
The key to performance for venture capitalists is their ability to exit their investments at a good price in a reasonable period of time. Exits are achieved through initial public offerings and mergers and acquisitions of portfolio companies. Unfortunately for venture capitalists, IPO and M&A activity ground to a halt over the past few years. But very recently, something has happened - activity is increasing.

There were only ten IPOs in the first six months of this year; in July there were eight. Recent technology IPOs include the highly successful offerings of Netgear, iPass and FormFactor. While this IPO activity pales in comparison to the bubble years, it sets the stage for a stronger IPO market in late 2003 and 2004. Speculation continues as to when Google will go public, with predictions of an early 2004 IPO.

Similarly, the market for mergers and acquisitions has become more visible. Recently announced technology transactions include Yahoo!'s agreement to acquire Overture Services, Oracle's hostile bid for PeopleSoft, and PeopleSoft's acquisition of JD Edwards & Company. The number of mergers and acquisitions for small-cap companies (those with market capitalisation under $2.0bn) increased to 111 in the second quarter, according to Merrill Lynch, up from 74 in the first quarter. More importantly to the venture community, there were 90 deals announced in the second quarter for companies with market capitalisation under $200m.

VCs applaud the resurgence of the IPO and M&A markets as it means that they will be able to achieve liquidity for their existing investments, and will have more time to focus on new investments.

Venture capital: the ice is beginning to thaw
Something not seen in quite a while occurred in the second quarter of 2003: an up-tick in venture investment activity. Investments totalled $4.3bn in the second quarter, up from $4bn in the first quarter, according to the MoneyTree Survey by PricewaterhouseCoopers, Thomson Venture Economics and the National Venture Capital Association. The number of companies financed rose to 669 in the second quarter, compared to 647 companies in the first quarter. This was the first quarter in over two years that there was an increase in investment activity. While one quarter doesn't signal a trend, the news is encouraging.

Other welcome news is that after three years of cuts, IT budgets are expected to increase by 3.5 per cent in 2004, according to Goldman Sachs' recent IT Spending Survey. One notable finding of the survey was that a massive 26 per cent of respondents plan to increase their IT spending by ten per cent or more in 2004. This is very welcome news to start-up technology companies as well as the venture capitalists that fund them.

Confidence is also slowly building among venture capitalists, according to Deloitte & Touche's second quarter Silicon Valley Confidence Survey. The survey recorded increasing optimism towards the economic climate over the next six months. It stated that ‘improvements in the public markets, economic stability and the easing of tensions overseas are key drivers' for the recent sense of optimism.

Forecast: clearing skies
The storm that has lingered over the venture capital industry appears to be weakening. Economic and market trends are fueling activity and cautious optimism. While the storm is not yet over, these indicators point to 2004 being a year of clearing skies for the venture capital industry.

Allen Latta is a director of VenCap International and heads VenCap's US office.

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