The Looming Exit Bubble of 2012

by: Dan Ramsden

There seems to be another front on the horizon. The weather may circle in, but you can never predict these patterns with precision, on or around 2012. While some of the troubling elements are being monitored, some others are not.

This following one has been noticed and reported, most recently in the New York Times: A substantial increase in corporate debt maturities could rough up high-yield markets around the 2012-2014 timeframe, which surge could test credit capital liquidity and is prone to exert significant upward pressure on borrowing spreads.

Here is something else, of a related nature and analogous consequence, that is less noticed: The surge in venture capital fund-raising of the 2005-2007 era will come to be 5-7 years old in 2012, and this is the typical age at which private investment funds enter their wind-down mode. Approximately $100 billion was raised during those three years. (A similar surge occurred in private equity in the 2007-2008 period, which will celebrate its 5-year anniversary around 2012-2013 as well. This article deals mainly with the venture category, recognizing that the two fields are not unrelated.)

The wind-down of this 2005-2007 venture class vintage (ignoring for now the potentially competing wind-down of the 2007-8 private equity vintage), could present a serious problem for the system, and by system I mean much more than the private investing community strictly speaking.

In my previous post I touched on the relationship between public equity markets and strategic M&A as the two principal “exit” alternatives for venture capitalists. When the IPO market is not there to keep M&A honest, as it were, exit valuations suffer.

Let’s now imagine an environment in which (a) corporate credit is squeezed for reasons previously referenced, (b) higher borrowing costs reduce equity values and at the same time push the relative risk and return balance further towards debt and away from equity (from an investor’s standpoint), (c) the IPO environment as a result slows down or stalls, (d) the corporate M&A environment (reflecting all factors listed) slows down, and (e) venture capital, unable to realize liquidity events commensurate with funds raised, cause their limited partners to suffer losses that exacerbate these challenges, beginning with item (a) onward.

The scenario is not dissimilar to that of late 2008 and into 2009, through which venture capitalists battled – some more and some less successfully – and are still here to tell the story. But there is one important difference: In 2008 and 2009, these funds were largely at the 1-4 year anniversaries of existence – basing this generalization on the heavy fundraising concentrations of the 2005-2007 period, as described – and the need to exit was not yet pressing.

We may wonder what the now-infamous Sequoia slide deck could look like in 2012 or thereabouts, if merely slamming the breaks on new capital outlays does not even address the issue: if the goal at that point is no longer just to preserve liquidity, but to return capital.

Perhaps the scenario is overstated. The venture capital (and private equity) segment will not be on the clock at precisely January 1, 2012, to immediately begin liquidating. Unlike corporate debt, venture capital contains maturities of different kinds, and private investment funds have some flexibility built into their structures for the timing of wind-downs.

Moreover, the total committed capital of these vehicles would not necessarily have been invested by the time of liquidation. But $100 billion raised by VCs in a 3-year period is no joke, and even on an adjusted basis constitutes serious exiting to do. As this could take a while to accomplish, and as 2012 may be marked by an assortment of other capital market strains, as noted, an orderly liquidation may not be a bad idea: beginning now.

Disclosure: No positions