The Terms They Are A-Changin’…

In the coverage of the on-going economic unpleasantness, there’s been much attention paid to the market for debt and derivatives, and to the potential impact of the difficulties there.  But the whole of the financial firmament is troubled, even the less-sexy domain of private equity investment in operating companies: the money that VCs, investment banks, and other wranglers of private capital put into companies with an eye to riding them to sale or an IPO.  It’s not a huge market in comparison to the trillions of dollars in CDOs and default insurance traded in 2007, but it’s not peanuts: in 2006, there was roughly $400 Billion in this sort of VC and private equity investment activity in the U.S.; and perhaps more to the point, those investments drive the growth– and the much larger values– of the companies they fund.

In the last week, I’ve been awash in reports, some in the press, some from friends, of private equity investors leaning on the companies in which they have stakes to reprice those stakes– to give the investors more.  The arguments from one case to the next are idiosyncratically different in their details, but they all have the same general thrust:  “we made our investments expecting more growth than it now seems likely the company will achieve, so you (the company) should give us a bigger stake.”

Some of the take-back requests are coated in offers of interim financing, aggressively (read “punitively”) priced to accomplish the take-back.  Others are more naked:  “Just give me…”

As strikingly, these “requests” are made in a totally unapologetic way, with the confident brio that entitlement engenders– and often with the veiled (sometimes unveiled) threat that an unhappy investor will at best be unhelpful to the company in the future; at worst, an antagonist in court.

Importantly, in the cases of which I’m aware, the issue is in no way misrepresentation.  The companies had plans on which the investors, after due diligence, invested; the plans were followed…  and like essentially all plans, worked in some ways and not in others.  The issue that called the question wasn’t any of that; it was the sudden dramatic downturn in the economy:  credit is tight; anxiety is high; spending has dropped like a rock…  a situation triggered– and to some extent at least, abetted, if not indeed caused– by the excesses of the very financial firms now doing the demanding.

I’ve been around long enough to have gone through several busts; I’ve learned that many (if not most) investors understand opportunism to be not just their right, but their obligation.  (And indeed, I’ve seen some forms of opportunism contribute powerfully to turn-arounds.)  But I’ve never seen opportunism practiced in such a rapacious way as these recent days– nor, I’d suggest, so desperately nor short-sightedly selfishly.

To a person, every one of the entrepreneurs I know who’s been approached in this way is some combination of offended and angry.  They get it that the economy is troubled; they understand that current financings might be at valuations down from prior rounds.  But they don’t– can’t– understand the rationale for revaluing those earlier investments.  There was certainly no prospect that, if the economy hadn’t tanked and the companies had over-achieved their plans, the investors would have offered stock back…  It’s a situation all too resonant with the first version of the Paulson Bail-out Plan: privatize the upside; socialize the risk.

Some of these entrepreneurs have no choice; they need cash, so they are holding their noses and swallowing the deals.  Others are finding alternative ways to get by and to grow.  But none of them will, I suspect, ever see their investors the same way again.  None of them will ever again hear the representations of these members of the incumbent financing class with the same degree of trust (which is, I believe, a real shame for the private equity folks I know who are *not* behaving greedily, but who may be tarred by this brush).

It’s been suggested that the end of the liquidity glut that fueled private equity (at the same time that it fed derivative creation/kiting) may spell the doom of investment banking and private equity as we’ve known it.  Certainly this kind of grab-back behavior by private equity investors suggests that it might.  Like crabs clawing each other back into a pot of boiling water, these investors are behaving in a frenzied, self-interested–and in the end, self-defeating– way that feels very like a final act.

But surely there will be institutions doing business as “investment banks,” “private equity firms,” and “venture capital funds” into the future. And with any luck, they will play some semblance of the “old” private equity role, which has been– and should continue to be– central to fueling innovation and growth.

I console myself that, to the extent that this happens, it will be folks like my funder friends who are equitably and constructively supportive of their investments who will prosper.  A. P. Giannini kept lending/funding on fair terms after the S.F. Earthquake of 06, and again through the Depression… and, even as banks failed around him in legion, built Bank of America into the trusted success that for decades it was.

Here’s to the Giannini’s of this century…  The Kings are Dead.  Long Live the Kings!