Private To Public In 30 Seconds

John Neshiem has a revealing post up about venture capital:

Today I had tea in a quaint hotel in Carmel with an experienced investment banker from Hong Kong. Educated at a top American university, and quite professional, he was immediately impressive. He was interested in what the differences were between "private equity" and "venture capital".

I labored to explain it to him, but was not getting through.

Then he asked if he could tell me about an idea he had come up with for a startup. After he described it, I knew what to tell him.

He took about five minutes to describe his idea.

A venture capitalist can do it in 30 seconds.

That is the difference between a banker and a VC.

The fact that bankers are already -albeit unconsciously maybe - starting to wed the concepts of venture capital and private equity together says some very interesting things about what's to come in the private equity market.

This story also illustrates quite well the confusion - and the extent to which the confusion runs (up to the level of senior bankers) - over the concept of private equity. I encounter this confusion the whole time. So first, for those similarly baffled by the concepts of private equity and venture capital, venture capital is a means of financing a project while private equity is a type of business model. If I have an idea, and you're willing to give me $5 million for a stake in the company I'm starting up to carry out that idea, that's venture capital, and you become a venture capitalist. Now, there are two principal business models we can adopt in running the new company: either we can plan to list it on a market like the NASDAQ, in which case we're going to be running a public company, or we can plan to keep it private, in which case it's private equity.

Now consider that right now, the fad is in private equity. To be fair, it's easy to see why. You don't have to answer to lots of little shareholders, you don't have to file anything like the number of reports you do if you run a public company, and specifically you don't have to hold lots of meetings and announce what you're doing to the public every time you want to do something big like buy another company. With the tightening of regulations on listed companies over the last five years, the private equity model has become extremely attractive to lots of investors. One very senior PE dealmaker told me the other day that he sees the private equity boom continuing for at least another three to four years.

I don't doubt the mid-term buoyancy of the PE market, but there's a grand misconception right now that the private equity boom is self-sustaining. It's not, and it can't be. The reason is that capital has to find an outlet somewhere along the money-train.

It's worth looking back for a minute. Private equity today is very different from private equity in the days of the dot-com boom, when an investor made a private investment on the expectation of a rapid flotation. Here, the exit strategy was in cashing in your shares once other punters had bid them up several times over in price. Two or there years back the exit strategy was in a trade sale, like for the founders of YouTube, where you cashed in your chips in a share or cash payment (usually a combination of both) by a big company like Google. But today, as this story illustrates, there's no discussion of an exit strategy: private equity is just seen as a good thing to be in per se. That means that the only kind of financial reward you can expect from the business model is a substantial dividend payment. While this may all well and good - after all, it's the traditional method of running a business - the one-off monster sales of private equity companies create expectations of enormous returns by investors in private equity.

This is where the story is so poignant as a prophecy of things to come in the private equity field. The venture capital position immediately assumes a sale at some point. Without a sale of some kind, the type of quick turn-around big-return investments that investment bankers love to juice their balance sheets - and bonuses - are practically unachievable, and there are only so many companies the size of Google who can afford to buy a private start-up for $2 billion. So where's the next step? Obviously, the markets.

So, once the investment bankers who are getting in on all the action now discover that they can't sell all their private equity in the form of a trade sale, they'll be quick to push it onto the market. Some clever salesman will probably even bill it a private equity IPO', which makes no sense but will appeal to market punters nonetheless. The problem is, the true gems will obviously have been snapped up already by the Googles/Blackstones, so what comes to market will be more dubious-looking. If you think this is unlikely, look at Neisheim's comment again on what you have to do to make a successful pitch in the VC market: you have to do it in 30 seconds! How many of us can spot a truly great idea in 30 seconds? Does Warren Buffett look at a company for that amount of time before giving it the yay or nay? That's just about long enough the glance the cover of an annual report, and it's about as effective. Nesheim is right of course about the process, but it's the process itself that's so indicative of things to come.

It's the classic type of situation which creates a boom which quickly materializes into a bubble, with all the classic characteristics of a bubble too: distorting the original intent and business concept of the liquid that's keeping it together.