Vertical Pulse

VC Five-year Returns Tread in Positive Territory

The National Venture Capital Association (NVCA) was happy to report recently that most investment horizons for the period ending Dec. 31, 2006 showed positive returns. According to a press release the NVCA posted on its website "overall venture capital performance for the five year time horizon took more than a two point leap from Q3 2006, bringing the return from -1.2% to 1% in Q4 2006," which was positive territory since Dec. 31, 2003.

The NVCA noted that the early/seed fund five-year number was negative. The Thomson Financials’ US Private Equity Performance Index showed how VC investment horizon performance faired through Dec. 31, 2006:

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Early/seed VC five-year returns resulted in -3%

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Balanced VC five-year returns scored 4.10%

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Later stage VC five-year returns produced 3.70%

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All five-year horizon venture investing had a 1% return

This compared to five-year returns with the NASDAQ, 4.30%, and the S&P 500, 4.25%. "This latest report shows almost every category and horizon of US venture capital funds in positive territory, which reflects an improving but tenuous exit market," said Mark Heesen, president of the NVCA, in the press release. "The one exception is funds designated as early stage in the five-year horizon. The five-year returns continue to reflect the down rounds, early investor dilution, and higher-than-normal failure rate in the post-boom years. Overall the industry remains at historically consistent performance levels in the long term."

About two months ago I had the pleasure of interviewing a range of players in the venture capital industry, from banking to investing. From those conversations the sources identified which sectors are receiving significant amounts of VC funding.

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IT industries continue to receive the most VC financing

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Life science companies, such as biotech and medical devices, are a close second

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Clean tech, or alternative energy, is growing (though this industry receives considerable government subsidies)

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Web 2.0 companies

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Wireless infrastructure

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Digital media sector

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Software companies that have a software service model are still of interest to VCs

These will be some of the issues discussed at IncreMental Adavantage’s venture capital conference, which will take place in New York City in November. For more information, please visit www.incrementaladvantage.com or e-mail neomi@incrementaladvantage.com.

Tale of Two Markets

So, U.S. economic growth only achieved 1.3 percent in Q1 and has brought with it the much anticipated "slowdown." Well that’s funny, don’t tell that to U.S. consumers, companies who are raking in record profits, and the number of people finding jobs in today’s alleged plummeting market. So what gives? GDP has produced paltry numbers since the beginning of January, but yet it’s been all good news for the stocks, bonds, investors, wage earners, and many others. Who can explain this tale of two markets?

Recently, the economists at Wells Fargo Management put a study together that explains, "One small part (of the economy) is collapsing (auto and housing market) while a much larger piece is still growing robustly. This extreme bifurcation in the performance of economic growth explains why an ‘official mid-cycle slowdown’ is exhibiting very little of its traditional character." To expound further the housing and auto industry make up about 9% of real GDP and this small part of the economy has collapsed 12% in the last year. The remainder of real GDP rose to 3.5% last year compared to the overall real GDP growth of 2.1% in the same time period, the study found.

Wells Fargo economists said there is nothing new about uneven GDP figures throughout the entire market. However, "We do not recall another slowdown which was essentially contained to less than 10% of real GDP. More to the point, we do not recall another slowdown where 91% of real GDP continued to grow above 3%," the report’s authors wrote.

The recent Wells Fargo report went on for another several pages exploring the correlation (or lack thereof) between the housing crash and robust consumer spending. Economists also looked at the future of possible Fed policy, inflation risk, and stock market conditions.

The Art of Purchasing and Selling Collectibles

I have learned quite a bit about buying and selling art over the past few weeks. The following are among the most important facets of buying and selling art that we have uncovered thus far in our research:

• Dealers tend to attract more museum clients than auction houses, since the short lead time makes it difficult for museums to bid at auction.
• Condition reports on artworks are notoriously unreliable. (In fact, condition is omitted entirely from catalogue descriptions of oil paintings.)
• The big auction houses do not disclose terms of sales – reserve prices, or commission agreements – and withhold the identities of some sellers and nearly all buyers.
• Pieces of art whose previous owners were museums or well-known public figures are worth more than art that lacks such provenance.
• It is important to assess the relationship between a gallery and its artists. Many times the artists are under contract to the gallery.

• During two weeks of auctions in New York in May of 2007, the two primary auction houses—Sotheby’s Holdings and Christie’s International—brought in more than $1.43 billion combined.

• More foreigners are participating in US art auctions. For instance, at a Christie's auction on May 9, 2007, 29% of the buyers were American and 48% were European.

• Art insurance is very expensive. Many galleries carry no insurance. Art insurance excludes "inherent vice" which means that natural deterioration (such as rot and mold); mechanical wear and tear; vermin and insect damage are not covered. Art insurance only covers damage from unexpected events like fire, theft and accidents. Policies may require that art collectors take conservation efforts such as controlling light and temperature in the environment as well as obtaining frequent reappraisals. Fine-arts policies also often contain a provision for loss of value that occurs when a piece cannot be completely restored to pristine condition after a covered claim. Some fine-arts policies cover as much as 150% of the insured value to allow for appreciation.

• Under "third-party guarantees" auction-houses enlist dealers, collectors or other backers to provide funds guaranteeing a prearranged price to sellers.

• Auction houses are acquiring art galleries in order to obtain more access to merchandise, entree into dealers art fairs, and new venues for executing sales privately.

• Art advisors are often paid by both the art purchaser and the gallery. The result is that the price of the acquired art is almost always boosted up (to protect the galleries' margins).

These are some of the issues that will be discussed at IncreMental Advantage's The Art of Purchasing and Selling Collectibles Conference which will take place in New York City on October 17, 2007. For more information, please visit www.incrementaladvantage.com or email neomi@incrementaladvantage.com.

FDA's Outdated Approval Process

The biotech and pharmaceutical industries have been vociferous advocates of reforming the FDA in order to speed up the drug approval process. In an interview I had with National Venture Capital Association President Mark Heesen over one month ago he specifically identified that as a top priority. Such reforms would help improve venture capital firms’, venture-backed companies, and public market’s economic performance. To further highlight his point during the past eight years, the apogee for novel drug approvals was 35 in 1999 and the low was 17 in 2002, according to FDA data.

Looking beyond the economic argument for reforming the FDA there is moral case to be made as well. Deal Flow Media came out with a story in its PIPEs Report newsletter today discussing how the FDA requested more clinical data before allowing Dendreon’s Provenge prostate cancer treatment to be marketed (causing Dendreon shares to drop to $6.33 on May 9, down 64.3% that day). "Many who suffer from the cancer, which kills about 25,000 men annually, strongly believe that the FDA should allow the marketing of treatments like Provenge as long as there are no safety issues," the PIPEs report states.

Study results showed no evidence that the treatment retarded the progress of cancerous growth, but clinical trial subjects who received Provenge lived about four months longer on average than those who received a placebo. "When you're staring down the barrel of a death sentence and you’re looking at just months away as many of us are, something that offers the opportunity to get maybe two months looks mighty good," Harry Pinchot, program director for the patient advocacy group Prostate Cancer Research Institute, told Deal Flow Media. "And the Provenge stuff – we were looking at potentially four months, which for a lot of us is a lifetime."

Patient advocates in the past have gone to court to try to make drugs under FDA review available to patients with life-threatening conditions. "It is the first of a growing number of therapeutic cancer vaccines to go up for approval, and is emblematic of the gap between medicine and statistics that paralyzes the FDA approval process and keeps vital treatments from reaching critically ill patients," wrote Richard Miller, president and CEO of Pharmacyclics and adjunct professor of oncology at Stanford University Medical Center, for The Wall Street Journal.

He added that part of the FDA’s problem is that it bases its approvals – for everything from medications for minor ailments to new cancer treatments – on the rigid application of the same outdated statistical standards. "Any new drug or other form of treatment, whether it's a therapeutic treatment for infected hangnails or a cancer vaccine, must meet the FDA’s standard of 95% certainty that any positive results claimed for its use are not due to chance."

These are some of the issues that are discussed at IncreMental Advantage’s conferences. For more information visit www.incrementaladvantage.com.

Notes on Water Technology

The following are some of my notes taken from recent research that we have conducted on the water industry:

• Desalinated water is roughly 30-50% more expensive than rainwater.
• Seawater desalination is more expensive than desalination from brackish water. This is because ocean water typically requires more power to bring the water up to the temperature where it will pass through the reverse osmosis membranes more easily. Also, brackish water is less salty than seawater. 
• While most desalinated water is piped from the desal facilities, some desal water may be placed in containers and delivered to distribution points that way in the future. The containerization of desal water would enable the desal facilities to be located further offshore. This could help eliminate the community opposition to desal facilities which are placed closer to the coasts. The environmentalists are concerned about the highly-saline concentrated discharge that comes out of the desal plant and has to go back into the bay or ocean.
• The salt that arises from the desal process has almost no commercial value. In fact, there is a cost to discharge it.
• Emerging countries that invest in their water infrastructure will not need to buy much equipment from American companies as most of these countries are quite capable of producing pipes and pumps.

These are some of the issues that are discussed at IncreMental Advantage's Water Conferences. For more information, please visit www.incrementaladvantage.com.

The Sarkozy Victory

Investors all around the world no doubt cheered over Sunday’s news that conservative Nikolas Sarkozy defeated Socialist Segolene Royal for the French presidency. A country wracked by burdensome regulation, heavy taxation, and an interventionist government has produced meager economic growth and high unemployment around 9%. President-elect Sarkozy will have his work cut out for him to revive the French economy that will require tough battles with the powerful labor unions and far-left youth movements.

Decades of statism have taken its toll on French society. According to the Index of Economic Freedom 2007 France ranks 45, between Hungary and Jamaica. A number of African, South American, Caribbean, and Middle Eastern nations have better rankings in terms of economic freedom than France – a Western European nation that has been free from worries of military aggression and political instability from its neighbors in over 60 years unlike some of the other countries that ranked higher in economic freedom. The only other major Western European nation that scored lower in the study is Italy, which ranks 60.

Sarkozy, standing at 5’5" which has earned him comparisons to Napoleon from the media and his detractors, will draw a lot of criticism from labor unions and socialists (as we saw violent crowds protesting his victory Sunday night on TV). Several major Sarkozy policy initiatives will likely enrage the far left of France:

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Aligning French interests with the U.S.

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Cutting taxes

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Reducing the renown French bureaucracy

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Loosening rigid labor laws

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Curbing immigration

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Cracking down on crime

In order to secure France’s future as a leader in Western Europe Sarkozy should start with the education system. Judging from socialists’ strong support among the high school and college population very few youngsters understand the obvious merit and benefit of a free market system. Last summer Newsweek reported that high school text books in France, Germany and elsewhere in Europe blamed entrepreneurs for unemployment, alcoholism, Internet fraud, and cell-phone "addiction." Globalization is called an unmitigated catastrophe and the texts encourage students to consult the radical anti-globalization protest group Attac for further information.

This blatant disinformation reveals why capitalism is viewed in such a negative light in some European countries. It is the result of gross political incompetence as well. Such anti-business attitudes have caused the EU to fall 22 years behind the U.S. on economic growth, BusinessWeek reported in March. The U.S. reached the current EU rate of GDP per capita in 1985 and its levels in employment and research investment almost 30 years ago. In 2004 French citizens enjoyed a per capita GDP of $27,500 while across the pond Americans enjoyed a per capita GDP of $37,800.

"These are all aspects of the broader truth: European governments tend to be more invasive than their American counterparts. Brussels bureaucrats with taxpayer-funded sinecures undoubtedly benefit. But this approach doesn’t foster the high-tech industry vital to a modern economy," wrote CNet correspondent Declan McCullagh.

Investors should take note however, that Sarkozy is no Ronald Reagan or Margaret Thatcher. Some of his campaign rhetoric took aim at hedge funds, along with Turkey and immigrants. The president-elect has also said he supports state intervention in order to promote France’s "industrial champions." All politics aside, with the rise of Sarkozy, Germany’s Angela Merkel, and Eastern Europe’s free marketeers, the battle between Adam Smith and Karl Marx just shifted again in favor of the former. One can conclude from the fire and smoke filling the air of the French ghettoes that it shifted just in a nick of time.

The Buyout Business

The last couple of issues of Forbes magazine contained some interesting stories and insight into the buyout business. In its April 23 edition Forbes’ Bernard Condon wrote a piece on Malon Wilkus and his private equity firm, American Capital Strategies, which mostly handles mid-sized deals. What struck my interest was that Wilkuses’ firm went public in 1997 – way before KKR, Blackstone, and Fortress all made their popular play in the public markets.

"When ACS needs money, instead of spending months wooing institutional investors or loading up newly acquired businesses with bank debt it simply takes a week or two to stage another stock offering," wrote Condon. The story also points out that last year ACS closed 26 deals compared to KKR’s seven. Two years ago the firm had a buying limit of $250 million where today it is $800 million. After the market dip in 2001 many private equity firms could not raise money for their next deals because banks stopped lending. However, ACS was able to maneuver and make some deals. Its stock returned to 53% in 2003 when economic recovery set in.

In its May 7 edition Steve Forbes himself attributed the buyout bonanza to inflation. "[It has also] prompted a massive amount of borrowing for corporate takeovers and stock buybacks. This borrowing binge will enrich investors in the short term. But longer term it’s setting up a train wreck that could be even more destructive than the gaudy bursting of the high-tech bubble in 2000," he wrote in his column "Fact and Comment." Forbes also pointed out that today’s inflation is partly the result of the Federal Reserve creating too much money in 2004-05.

These are some of the issues that will be discussed at IncreMental Advantage’s June 19 Structuring Private Equity Transactions conference at The Harmonie Club in Manhattan. For more information visit www.incrementaladvantage.com

America Remains a Leader in Innovation

The Federal Reserve recently reported that American businesses now spend as much on developing and purchasing "intangibles" -- mainly the intellectual property of research and development, software and databases, as well as branding, marketing and training to use these ideas -- as they do on their equipment, plants, real estate and other physical assets. By another recent and rigorous calculation, America's total stock of intellectual property today is worth about $5.5 trillion, equivalent to about 45 percent of our gross domestic product and greater than the GDP of any other nation.

These are some of the issues that are discussed at IncreMental Advantage's Intellectual Property Conferences. For more information, please visit www.incrementaladvantage.com or email neomi@incrementaladvantage.com.

The Pyramids of Egypt

I recently saw an extremely interesting program about the Pyramids of Egypt on The History Channel. The pyramids were absolutely ingeniously engineered even by today's standards, let alone when taking into account that they were engineered some 45 centuries ago. At that time, the ancient Egyptians did not even have use of the wheel. No one expects any of the buildings today to last even a fraction of the amount of time that the pyramids have endured.

A few interesting facts about these pyramids are that:

• The lengths of each base of one of the pyramids is 755 feet. Each side is exactly the same length, save for one side being off by a mere two inches.
• The same pyramid has 2.3 million limestone blocks. The blocks were so finely engineered and carefully placed that it is impossible to slide a credit card between the blocks even today. The blocks were laid at a rate of one every two minutes every day for 23 years.

Blackstone Anticipates a Slowdown?

Anticipating a slowdown in the U.S. economy many private equity firms recently have been gobbling up retail businesses, which usually perform well in market downturns. The Blackstone Group was the latest yesterday announcing that it had completed an acquisition of a controlling stake in Retail Grocery Inventory Services (RGIS). It is the world’s largest inventory and retail services company. RGIS Holdings LLC current ownership group retained an unspecified, but "significant," stake in the company.

Goldman Sachs & Co. provided bank debt and mezzanine financing for the deal, which is an interesting note considering The Blackstone Group did not call on the Wall Street firm to assist in its proposed IPO listing over one month ago. The media portrayed it as a rebuff to Goldman since Blackstone hired the services of every other major Wall Street firm. Blackstone’s press release did not include how much an affiliate of the private equity firm bought its controlling interest in RGIS.

As far as anticipating a slowdown, hedge funds, private equity firms, accounting firms, and banks have been creating new funds or positioning themselves to benefit from the next wave in restructuring. For instance, Jeffrey W. Maillet launched Noble Asset Management LLC in February, which will invest in distressed securities. Grant Thornton LLP announced yesterday Mark Toney will be joining the accounting firm as a managing principal and co-leader of its Recovery & Reorganization Services practice. Recently Andrew Wilkinson, a restructuring guru, moved to Goldman Sachs from Cadwalader Wickersham & Taft.

These are some of the issues that are discussed at IncreMental Advantage’s conferences. For more information, please visit www.incrementaladvantage.com.