Is Subprime’s Loss the Tech Industry’s Gain?

The whipping that lenders have taken in the subprime mortgage market could prove beneficial to the nation’s technology sector, according to a venture capitalist-turned-professor.

Howard Anderson, a founder of the Yankee Group, as well as two venture capital companies, and now a professor at the Sloan School of Management at the Massachusetts Institute of Technology, argue that the subprime debacle will free up more money for investment in the country’s technology sector.

“If you look at the reverberations, it will make the private equity buyout business worse, which will make technology, vis a vis buyouts, look better,” he told the E-Commerce Times.

Diminishing Returns

What will make the buyout business worse is a crunch on lending that will lower the returns on investment that buyout firms can deliver to investment banks and institutional investors, he explained.

“As their returns go down, which means venture capital returns will look better — not because they’ll go up but because the other is going down,” he said.

For example, he continued, before the credit crunch, a buyout firm might be able to leverage 80 percent of a deal with somebody else’s money. Now they may be able to leverage only 50 percent of a deal that way.

“What that means to the private equity guys — T. H. Lee, KKR, all these multi-billion, private equity funds — is their returns are going to go down,” he observed.

More IPOs

The reason for that, he continued, is that they’re going to have to put more money into their deals and they’re going to have to pay more for the money they borrow to execute those deals.

“Where they were showing a 20 percent internal rate of return before,” he explained, “now they maybe they go down to 10 percent. The venture firms that were showing a 12 percent return now look better.”

Anderson also contended that with the private equity window closed for awhile, the IPO scene for tech companies may improve.

“Investment bankers have to do something with their money,” he declared. “How are they going to make their bonuses at the end of the year unless they do some deals?”

Good, Not Giddy

The tech industry, he noted, has done well during the recent economic downturn.

“Returns are getting better,” he said. “In 2002 when people would ask, ‘How’s the tech sector going to do for the next five years?’ my answer was, ‘It’s going to suck.’ And it did.”

“Now it’s better,” he continued. “It’s not giddy the way it was in ’99 and 2000, but it’s better.”

Because of that, more mergers and acquisitions may be looked on more favorably by investors, he added.

“What we’ve been seeing are acquisitions at about two-and-a-half-times sales,” he observed. “That number didn’t look good to investors, but it will look better since there won’t be as much private equity buyout stuff.”

Ugly Bubbles

That 2.5-times-sales number pales compared to days preceding the bursting of tech and telecom bubbles at the turn of the century, when companies were being sold for 10-times sales.

During those heady times, Anderson recalled, his venture capital company, Battery Ventures, delivered annual returns of 65 percent to its investors.

He remembers a company valued at US$36 million selling for $3 billion 18 months after Battery invested in it.

Those days, he acknowledged, are well behind the tech sector. “There’s no going back,” he said. “The American investor lost a couple of trillion dollars when that boom busted.”

A Better Nation

If the subprime fiasco diverts more money to venture funds, the whole nation will benefit, asserted Richard Horan, senior managing director at the Slater Technology Fund in Providence, R.I.

“For a decade or more we’ve been witnessing financial engineering as a way to squeeze greater yield out of investment strategies that make a limited contribution to the growth of an innovation economy,” he told the E-Commerce Times.

“If for reasons of a credit market collapse the flow of funds into those sectors declines and that bodes well for venture capital investment,” he said, “I think we’re all better off because the companies seeking venture capital financing are companies achieving true innovation and contributing real growth to the economy.”

Net Ad Market Hit

While the subprime problem may create some opportunity for tech companies, it will have its downside, too, warned Ted G. Wang, a partner with Fenwick & West, of Mountain View, Calif.

“The general economic slowdown caused by it is no good for anyone,” he observed.

“I have some clients in the Internet space,” he added, “and some of these subprime guys have been big Internet advertisers, so if their ad-spend decreases, that could hurt Internet companies.

“On the positive side,” he added, “it makes the technology sector look more attractive.”