A speech given at the 2011 Thunderbird Private Equity Conference
I am very happy to be returning to the Thunderbird Private Equity Conference. However, I don’t like being up here this early given the full agenda and the list of scheduled speakers. Effectively, there are two full days ahead where people who actually know what they are talking about can punch holes in anything I say. In addition, given the pace of change these days, any views at 9 am on Thursday could be way off by the end of the Conference. Jim La Marche and John Cook did give me a fairly broad mandate, which included the state of Private Equity. I think the various panels and talks throughout the Conference will get into much more depth on that topic. I thought I would try to speak to some broader issues that have a bearing on the subjects we’ll be covering over the next two days. First, a little review of recent events:
The first quarter of 2011 was rather tumultuous to say the least, and we are entering the second quarter with very little of that turbulence fully calmed and the human toll and uncertainty continuing to rise. This has heightened concerns about specific Risks and, more generally, the global economy. I think it has also created a difficult psychology within which to make decisions. The combined level of risk and the diversity of the risks confronting us are unusual for the generations that have grown up since the middle of the last century. Our experience has been that the risks and challenges we faced were overcome and we went on to bigger, better and financially more rewarding outcomes. This has, in general, conditioned us to believe that whatever risks we see will be mitigated by someone and the United States, in particular, is somewhat immune to the full impact of events elsewhere. Today, it is less easy to separate the US from what is happening in the rest of the world, particularly as we have gotten ourselves into a financial situation that is more dependent on the rest of the world for a good outcome. It is also difficult to consider today’s risks as ones that will go away quickly and easily. And, it is hard to find that someone who will make it happen. On the other hand, there are elements within the US economy which benefit Private Equity, and that do offer real opportunity even in the uncertain times surrounding us today.
I will try to categorize some of the positive and negative elements within 4 topics: Mother Nature, the Economy, Intellectual Property and Innovation, and Strategic Risk. Then, I will make a few comments about Private Equity. Let me start with Mother Nature, where at least I may not hear any pushback until the cleantech panel late on Friday.
2010 and 2011 experienced unusual weather patterns, which caused significant chaos and devastation; epitomized by the floods in Australia and Pakistan floods. This past winter season saw record snow accumulation and very cold weather over much of the northern hemisphere with a day in February showing snow in 49 of the 50 US states. December and January saw very cold, wet weather in California, particularly in the southern half of the state, as Iben Browning predicted 30 years ago. Yet, 2010 for the planet ended up tied as the warmest since 1880, when comparable temperature records were first collected. Temperatures for January and February of 2011 are about 0.4 of a degree centigrade above the average for the 20th Century. There are those, including me, who view this warming pattern and the intensity of changes in weather patterns in general as a Risk, which must be taken into account when making business decisions. Of course, it also represents an opportunity.
Earthquakes and volcanoes are another element of natural risk. Certainly most would say less predictable – yet. And, as the recent Japanese experience has shown, we may be substantially underestimating the degree of financial and human risk we are subject to when such an event occurs. Clearly, the likelihood of the sequence that occurred after the earthquake was not anticipated. I am paraphrasing Niels Jensen in this recap of what happened almost a month ago. His write-up, featured in John Mauldin’s Outside the Box April 4th edition, is worth reading. The 9.0 quake was only the start of a chain of supposedly low probability events. After the quake all 16 nuclear reactors in the zone, including the 6 at the Fukushima plant, shut down, as designed, within two minutes. But Fukushima is a second-generation facility, similar to many around the world, which require continuous power to provide cooling. When the force of the quake cut off the primary power supply, the diesel generators kicked in, as planned, and cooling continued. A following tsunami was anticipated as well. The protection wall was designed to withstand a 17-footer. Unfortunately, the 45-foot wall of water and debris destroyed the generators, among other things. However, there were batteries designed to keep the cooling running for 9 hours, expected to be more than sufficient to bring the power lines back into play. The area was so devastated though, that nine hours was not nearly enough. Almost a month later, the situation continues.
I must say that referring to this as a series of Black Swans is an inadequate description. This is not a case of discovering a series of things that were not believed to exist. This was a misestimating of the probabilities of a sequence of events occurring. The Fukushima incident, in a negative sense, represents a perfect “Angry Bird” hit with the low probability vectors of pigs and material cascading from that first hit continuing to add points, or in this case a human and financial toll. Now that “Angry Birds” has entered our lives it is a much more adequate description of an event where probabilities have not been properly estimated or the low-probability events, in combination, have produced a final outcome outside of any expected parameters. Early metal fatigue on the skin of an airplane could very well be another Angry Bird event.
And as we are seeing, the outcomes of Angry Bird events are not necessarily just event specific. The Fukushima event will have a bearing on the pace and cost of future nuclear energy installations, the costs associated with existing nuclear facilities and the technology of installations as well. It also has an impact on almost every other energy source. Again, that introduces additional risk, but also opportunity.
Let’s move to the Economy. This will be brief, since someone who truly knows what he is talking about, Joe Quinlan, will be speaking this evening. However, if I can comment on the weather, I can certainly talk about the economy with as much conviction. In December, along with everyone else, I published a brief comment on the outlook for 2011 where I concluded that we could see fairly decent growth, with employment picking up and the possibility of a 5% GDP quarter at some point during the year. Profits would look especially good. I said that the surprise could come later in the year with a pickup in the construction markets. The construction industry at its peak employed 10 million people. It is currently employing about 6 million. The peripheral industries that feed into construction are also down significantly. This industry has historically accounted for the amplitude in downturns and upturns in the economy. There was no evidence of an upturn in this segment in December and there still isn’t. But, with housing affordability at a high and cash in the banks available to finance a pickup, this remains a possibility. It will happen at some point. It is a question of when. It is amazing to me that the economy is doing as well as it is with this sector clearly not helping. With the emerging markets doing well, and some recovery possible in Europe, I also believed we would see an uptick in the global rate of growth. Well, much has happened since December. With the outcome of events in the Middle East remaining uncertain, Europe still having credit issues and tightening, the emerging markets tightening, the US having a noisy fiscal deficit problem, weather impacting the first quarter, and the impact of the earthquake and the nuclear problems on Japan and the rest of the world, there has to be some shaving of near term growth. However, the historical evidence of similar natural disasters, particularly in developed countries, is for a reasonably quick rebound reinforced by stimulus to replace and rebuild. The uncertainties particularly coming out of the Middle East and Japan can produce an immediate negative effect on decisions to buy bigger ticket items including making investments. This usually doesn’t last. While the quarter just ended could have grown as little as 2%, I continue to believe we are in a self sustaining period of economic growth with that 5% print still possible. The Risks are higher. We need to watch oil and the US Congress. But we could likely see this growth continue into 2012. And profits in the US, as measured by the S&P or the NIPA statistics, will have doubled from the lows in 2008, which, incidentally, coincides with what the market has done. This likely means an OK environment for IPOs as well, which could be good for private equity. The bigger concern is not this year and next in terms of the US, but in a relative sense how does this compare with growth in the rest of the world over the decade, and maybe longer, as we attempt to work our way out of our financial situation. I would posit that the US may be in for a long period of decline in its relative standard of living as currencies adjust to reduce the trade imbalances that exist today. This has significant implications for where and in what one should be investing and what should be the time horizons on those investments. Something I hope a couple of the panels will explore over the next two days.
Intellectual Property and Innovation
On that happy note let me turn to the topic of Intellectual Property and Innovation. The US has been the leader in the creation of Intellectual Property and the Innovation required to produce that lead. The financial markets, both private and public, have clearly paid for that leadership. Our technology companies, electronic, medical and other, have historically commanded a premium valuation as a result of an implied Net Present Value of what can come out of their R&D efforts as well as the efforts of other companies created by Venture Capitalists that often become a part of these larger companies. Of course, there are also those few that become their own standalone behemoths. Let me raise a Risk, though. Today, the number of patents in force with their origin in the US and Japan are each 20 times those of China. Last fall, China issued its National Patent Development Strategy for the next ten years. I would urge everyone here to get a copy and read it. China sets very high targets for patent filings over the next five years, dwarfing expected filings by the US and Japan. As importantly, it establishes a budget for Patent services that could reach $16 billion annually at current exchange rates. By the way, the requested FY 2012 budget for the US Patent Office is only $2.7 Billion. I am not sure this is a fair comparison as part of the Chinese funding is for lawyers and other professionals to support the filing process. But it does indicate they are very serious. China also proposes to have ten model cities focused on utilizing the patent system and to put in place the incentives to create a vigorous Intellectual Property Market. It states it will actively seek to acquire intellectual property from others. A couple of direct quotes from the Strategy are worth noting: “A large number of core patents will be acquired in some key fields of emerging industries and some key technological fields in traditional industries…[we will] encourage enterprises to acquire patent rights through innovation on the basis of digesting and absorbing imported patented technology…[we will] support and foster exports of patented technologies…and strengthen guidance on patent policies for enterprises in the process of overseas mergers and acquisitions.” Implied in the budgets for patent services and in other comments in the document is a vigorous enforcement of patent rights. I have said this, and it may come true soon: once China has intellectual property rights to defend it will likely be one of the more aggressive enforcers of those rights. When the number of patents in force, by country, gets closer to parity it may very well be the US that finds itself on the defensive for not respecting IP. That hasn’t been a problem since the early days of the Industrial Revolution when the US was the upstart and more Intellectual Property resided in Europe. The net of this is that we may ultimately be a technology buyer of what China and others develop and produce unless we also look at what policies we can put in place to remain competitive. At the moment we have the intellectual leadership existing in a variety of our institutions, and the VC community is one of those institutions. Shame on us if we let that leadership slip away. That is a big Risk. If one becomes less sure about the sustainability – the lifetime of a technological innovation – because of IP ownership uncertainties or simply a large new source of innovation outside of our purview, values will change. On the other hand, there is also a positive consideration for the financial investors in US innovation and IP. China and others will be buyers of the intellectual capital created here. If return to ones LP’s is the ultimate goal it will be hard if not impossible to resist this new source of liquidity. I believe that when President Hu was here in January, it was to clear the way to set up shop for the purchase of intellectual property and other US assets. It may take time, but for VCs with investments in recent vintage years, this will ultimately be an important source of liquidity.
I want to spend a few minutes on another element of Risk and Liability that I think is less apparent. On the Working Knowledge Website of the Harvard Business School, there is a discussion developing on the Most Significant Ideas in Management for the 21st Century. One of the contributions I made to that discussion was a belief that corporations will come to recognize that there is a growing real financial liability from not incorporating certain elements that fall under the category of “environmental sustainability” into their strategic decision-making. There is already some anecdotal evidence in the market place that a valuation differential can occur between CSR adopters and their non-adopting counterparts. I use CSR – Corporate Social Responsibility – as an example of one as yet unquantified liability that the market, in its collective wisdom, seems to be trying to quantify. Whether it is geopolitical risk, local political risk, climate change, civil suits, labor issues, technological risk, intellectual property or other forms of discontinuous innovation and disruption, there may be a growing value differential put on those companies, managements and investors who exhibit a willingness to make explicit their recognition, mitigation or exploitation of those risks. This is a bit more esoteric and less definable than the earlier topics, but I don’t believe it can be ignored.
State of Private Equity
So where does all this Risk and Opportunity come into play relative to the state of private equity today? I think, at the moment, the apparent risk is overwhelming what may be the real opportunity. As we all would admit, venture returns are cyclical and they tend to follow the public equity market returns. The amount of capital historically allocated to the sector has also tended to follow, not lead those returns. For the last ten years and more the industry has been living with too much capital chasing too few opportunities driving up the entry price for most investments and supporting too many also-rans in certain sectors. This is while the public markets have experienced a shrinking of multiples as capital in the US moved toward energy companies and financial companies – historically lower multiple sectors – as well as to markets outside the US. Follow-on capital has shied away from venture-backed investments requiring VC’s to use letters of the alphabet in additional rounds that haven’t been seen for three decades. Published median returns by vintage year for the past decade are nil to negative. This is not dissimilar to vintage year returns on immature portfolios in the late 80’s before ultimate returns experienced in the 90’s proved to be quite good. Granted, the apparent risks feel higher. These risks are real, but that is what real private equity investors are supposed to be able to assess and reflect in their investment judgments. And the competition is less. Total funds raised this past year are down almost 85% from the peak in 2000 and to a level relative to public markets, last seen in the early 80’s – less than a tenth of a percent of public market capitalization. In addition, by some measures, the amount of uninvested early stage venture money residing in funds is down to less than 20%, also the lowest level in the last 30 years. Some are predicting that up to 50% of currently active private equity franchises may not produce a successor fund. Many institutional LP’s have reduced their allocations to alternatives because they need the cash or, looking in the rear view mirror, they have changed their strategic allocations. This is at a time when IPO’s are starting to rise and the supply/demand picture for capital has changed to the advantage of the investor. I suspect you will hear more about this in one or more of the panels. And I give credit to Susan Boedy of Knightsbridge where most of the numbers I just mentioned came from. She is on one of those panels. In closing, I think we have much to discuss regarding Risk, Opportunity, Structure of the Industry and where the opportunities lie. I look forward to two days of good dialogue as well as a future time when the real returns from the investments of the last several years become more apparent.