A glimmer of hope?

We are living in uncertain times. Even before the atrocities in the US last week, economies around the world were showing signs of a slowdown. Now, after the attacks on New York and Washington, the tragic loss of human life is likely to be accompanied by a faltering of consumer and business confidence. No one can predict with any certainty quite what the outcome will be on the finance world, but most agree that it will not be a positive one.

This was the backdrop for last week's Venture Capital Symposium. It was a subdued gathering of people trying their level best to get back to normal life after the most abnormal of events.

So what was on their minds? The answer, in a nutshell, was: how to make up for the last few years of exuberance. After a period when, to quote more than one speaker, ‘anything and everything got funding', there are clearly funds with some real problem portfolio companies and there are many with investments that have gone to the wall. ‘The most active form of exit recently has been receiverships,' said Dominic Slade of Alchemy.

Not a great way of exiting an investment. However, many were concerned about exiting at all. ‘If we don't have an exit,' said Slade, ‘we won't get remunerated.' And neither, importantly, do investors see any return. The market for initial public offerings has all but dried up and trade buyers - the most common type of buyers for private equity investments - are becoming increasingly scarce as companies tighten their belts ahead of a predicted recession. ‘It is virtually impossible to float a company now and it's virtually impossible to secure a trade sale,' said Wol Kolade of Friends Ivory & Sime Private Equity.

This means that firms will have to hold on to their investments for longer than they had anticipated. ‘Holding periods used to be around three years,' said Javier Loizaga Jimemez of Spain's Mercapital. ‘But we're seeing older portfolios now and going to see longer holding periods in Europe of around five or more years. At the same time, though, investors won't change their investment return expectations.'

None of this is good for private equity firms or investors in these funds. It will reduce returns to investors and it will mean that many funds raised over the last three or four years will see poor internal rates of return - it's the early years of investment that really count towards IRRs.

The blame for much of this can be laid at private equity firms' doors. Over the last few years, many firms changed their strategy to invest in areas where they had little or no expertise. And, for members of the community to say that ‘anything and everything got funding' is a pretty shocking admission that their due diligence was less than careful during the dot.com and technology mania. After rushing to do deals at any price, firms could well be starting to count the cost now and wondering what to tell their investors. Many will be concerned about the value of their portfolios that they built up in the last two or three years. ‘Fund valuations have decreased on an unprecedented scale over the last few months, particularly among those with a heavy exposure to telecoms,' said Simon Wildig of Close Brothers Private Equity.

Apart from some navel-gazing, what does this mean for the future as funds prepare for a tougher fund-raising climate? Most venture capitalists agreed that we'd see fewer, but more considered, deals. We're already seeing caution creep back into the market and some speakers reflected this. Now that company valuations have fallen, many firms are claiming that now is a great time to buy. But they have to be sure that we've reached the bottom of the market, said Elderstreet DrKC's Michael Jackson. ‘Pricing will become much more efficient and competitive,' he said. ‘Yet one of the dangers is comparing today's prices last year's and saying, “isn't that cheap?” Remember that things were so crazy then.' They also have to be sure that the company they're buying can survive a downturn. ‘A recession is great - we can screw management,' said Janusz Heath of Dresdner Kleinwort Capital. ‘But if we're paying two times EBITDA and the business can't run in a poor economic climate, then that's two times too much.'

Going forward, private equity firms should place less emphasis on finding deals, said HSBC Private Equity's Jason Gatenby, and more on finding profitable ones. They should also focus on realisations, said Wildig. ‘Firms need to think about exits right from the start of an investment and never stop thinking about them.'

Firms are also likely to come under increasing pressure from their investors for liquidity as the value of their public equity investments has nosedived. This will mean that many funds will exit investments that they might normally have held onto in order to return cash to investors. This in turn means more secondary buy-outs. For investors in funds that are selling, this may not be such a bad thing. There are now many firms that specialise in secondary buy-outs and a seller will be able to get a much better deal for its company than before. ‘Ten years ago, the secondary buy-out market was much better for buyers,' said Thomas McComb of JP Morgan. ‘They were getting a discount then. Now, secondary buy-outs are much more competitive, so you're buying at net asset value or even a premium on net asset value.' Not such great news for investors in funds buying this type of investment.

However, there is some good news for all investors. There appears to be a far more sober attitude among private equity professionals than there was a couple of years ago. Firms are braced for difficult fund-raising times ahead. They are more likely to treat investors as clients. Requests for better quality reporting could well be met, speculated Wildig. There's a realisation that days of the quick flip are over and venture capitalists will have to work much harder for their money. It seems as though some lessons may have been learned from the exuberance we saw 18 months ago. And if all this proves to be the case, then we could well be on the road to a much more sophisticated European private equity industry.

The Venture Capital Symposium was organised by Euromoney. For more information on its events and conferences, please visit www.euromoneyseminars.com