Fear and Greed

Ross P. Barrett

What do the craze and Japanese market have in common? Thankfully, not much... anymore.

The late 1990's and the first part of 2000 saw the private and public equity markets primarily move by one of the two major motivating factors on Wall Street: Greed. The analog of greed is fear, which is also a factor in both the public and private equity markets.

During this age of unrealistic expectations, there were numerous instances where the typical due diligence process was compressed from months into days. There is even a story rumored to be true of a very reputable New York City VC firm that made an investment decision in a mere 72 hours of being contacted!! While this is an extreme example, no one will argue that average due diligence time was greatly curtailed. It was this lack of discernment that has been playing itself out as evidenced by so many company failures and bankruptcies. The notion of fast due diligence and easy money was emblematic of an unsustainable and broken market. Thankfully, like all things in a market-driven, capitalistic society, the market corrects itself.

But questions remain: Why the craze to get deals done so fast? Why were VC's, usually tight-fisted and careful with their monies, driven to invest the capital so fast? It can be summed up in the fact that venture capital investments ceased being a scarce resource and became a mere commodity. According to Venture Economics, in the period 1993-97, there were 136 venture funds in the US, with $75 Billion of committed capital. In 1998-2000, there were 1,837 venture funds in the US, controlling over $224 Billion of capital. And the commodity-like nature of VC money fueled the engine of unsustainable notions. The concepts of market share (following the mantra "get big, fast"), profit deferral (i.e. grow your customer base regardless of cost) and other non-revenue producing goals were pursued en masse.

A little common sense and a comparative look at other institutions that promote easy money policies would have foretold a recipe for disaster. Specifically, it is helpful to look at another dysfunctional market - one also gripped by a history of fear and greed - the Japanese economy. The Japanese economy has long pursued the notions of market share and profit deferral. This type of model is fueled by the Keynesian market approach of the Japanese legislature, in addition to the keiretsu support that Japanese corporations seek.

Unlike the Japanese model, which has been trying a band-aid approach at fixing its economy for almost 15 years, the American private and public equity markets altered its problematic bubble with a severe market downturn. This market downturn, in many instances, caused a cessation of new investments, a focus on triage and helped company valuations to fall in some cases by more than 80%. These facts, in turn, have caused the broken business models in the private equity space (e.g., and those in the public markets (e.g. eToys, to die on the vine.

I am not simply waving the American flag at the expense of the Japanese government. However, the lesson is clear. As has been noted, the pseudo-Japanese model, where capital is essentially free (either from government support or from corporate support) and the concept of keiretsu (where conglomerate corporate divisions or a VC's portfolio companies cross-sell products and services to each other) works no better in the US than it has for the past 15 years in Japan.

We now know that money is not a commodity. The due diligence process has returned, and only companies with sound management and a solid business model will attract financing. Companies can no longer build market share, defer profits and ignore expenses if they are not profitable in the process. Conversely, since capital is a scarce resource, companies must focus on lowering expenses, increasing productivity per worker and growing their top-line. Corporate managers who weather this downturn will never again spend in the cavalier manner that defined the late 1990's.

Additionally, while the cost of capital is much higher than 18-24 months ago, the fact remains that the cost of other corporate expenses (labor, real estate, computing power etc.) are at 10-year lows. This imbalance, in addition to the new parsimony of corporate managers, will equate to more profitable and efficient privately held companies seeking to go public.