Looking Back: Return Of Investment

A year into the credit crunch, the slow pace of LBO deal-making looks a lot like 2003’s post-tech bubble slowdown in venture capital deals. In both instances, limited partners have reason to be concerned over the inability of their general partners to do deals.

Today’s story is a familiar one: Mega-buyouts are extinct, sizable buyouts are rare, and small buyouts are under-levered. But counter-intuitively, the firms specializing in those extinct mega-buyouts are raising larger-than-ever funds. See The Blackstone Group’s $20 billion fund, Apollo Management’s $15 billion fund and TPG’s $18 billion fund.

Five years ago, venture capital firms found themselves in a relatively similar situation because they lacked opportunities for investment following the tech bubble burst. The subsequent freeze in VC deals caused worry among limited partners because, just like today’s mega-buyout firms, VCs that raised large pools of capital on the tail end of the tech bubble were sitting on the largest pools of venture capital ever raised. Firms like Menlo Ventures, Highland Capital Partners, Oak Investment Partners and VantagePoint Venture Partners were among those that were slow to deploy large pools of capital.

So what are today’s mega-firms going to do with all the new money they’re raising? It’s worth looking at what many VC firms did in 2003. They reduced the size of their funds to avoid letting the investment period lapse without drawing down all of the committed capital, and some even trimmed their management fees, according to a 2003 industry report.

Those moves make last week’s open letter from Guy Hands, the CEO of British LBO shop Terra Firma, seem less extreme. Hands wrote that buyout firms staring down an empty pipeline have three choices.

They can find safe havens for investing within the firm’s strategy and ride out the storm while preaching the virtues of long-term investing. They can change investment strategy altogether, a move not likely to earn a warm reception from LPs.

Lastly, they can wait out the storm and simply not invest. Taking that a step further, Hands advises fund managers that don’t see enough investment opportunities to return their fund money to their LPs. Historically, not many firms have been so bold, he pointed out.

The 2003 report pointed to one LP who encouraged VC firm Menlo Ventures to cut the size of its fund, essentially returning some of the undrawn commitments. The LP said Menlo Ventures was “in denial” about its ability to find deals. If that reaction, coupled with the Terra Firma letter, is any indication of LP sentiment in the coming year, buyout firms might soon be facing the same request.