Thursday, October 16, 2008

The Investment Outlook Sours

But some financial experts believe that the current economic crisis could create as many opportunities for investment as it destroys.

By Mark Buchanan

No one knows what's coming next in the great financial crisis of 2008. Deep and lasting recession? Or temporary economic chaos followed by miraculous recovery? The financial upheaval has already soured the atmosphere for venture capital and innovation, as total investment this year looks set to fall for the first time since 2003. But some economists and financial experts believe that there is no need for gloom in the longer term. They even suggest that if the fallout leads to better-regulated capital markets, it could establish a healthier environment for innovation in the future.

Even so, in the near term, things could get worse for venture firms. "The current crisis doesn't directly involve venture-capital funds, but it affects them indirectly," says economist Andrew Lo, a professor at MIT's Laboratory for Financial Engineering. "As credit is withdrawn from the global economy, we're going to see less capital available for all purposes, including venture capital."

Indeed, the latest quarterly survey of Silicon Valley venture capitalists, published by Mark Cannice, a professor at the University of San Francisco (USF) and founder of the USF Entrepreneurship Program, highlights the bleak mood among VCs. Asked to rate their confidence regarding the next 18 months on a scale of one to five (five being the most confident), the average score was 2.89, the lowest since Cannice began his surveys in 2004.

This dour outlook will put strains on fund activities, experts say, probably wiping out some firms, while forcing others to be more cautious and focused on investments likely to bring short-term paybacks. So the most immediate consequences of the crisis, experts think, will be on venture-capital firms' abilities to raise money, and on their decisions on how to invest it. New venture groups thinking about raising money for entirely new funds may indeed find it very difficult until the financial environment settles down, says Joe Hadzima, a senior lecturer at the MIT Sloan School of Management. Furthermore, the general economic uncertainty and the shortage of free capital may discourage some investors from putting money into existing VC funds, as they will likely tie up investments for several years.

But this will impact different funds in different ways, as each fund tries to meet the capital calls of their portfolio companies. The "big name" funds, Hadzima points out, tend to have large and stable limited partners such as educational endowments, foundations, or pension funds, which have already allocated money to meet capital calls. Smaller firms may not be so well situated. "Some smaller venture firms may have problems if some of their limited partners are individuals who have seen the value of their investments go down and don't have much liquidity," he says.

But while most VC firms will take a more conservative approach to investing, that does not mean funding will dry up completely. "Companies with good plans will still be able to raise money," says Howard Anderson, also of the Sloan School and himself an experienced venture capitalist. "But funds will take longer to raise money. And you'll see fewer 'big bang' introductions of new companies that cost a fortune."

Others say that venture-capital funds will feel pressure to ask entrepreneurs to cut costs and work with less capital, and that investors will have less patience with underperforming companies. This pressure was evident in a recent presentation by Sequoia Capital, a prominent venture-capital company with a successful investment record. Last week, in an "emergency meeting" with the CEOs of its portfolio companies (details of which were leaked online), Sequoia representatives warned companies to cut costs, reduce staff, and focus on profitability in preparation for a dramatic downturn.

Certainly, Anderson says, there's likely to be a noticeable shift from investment in long-term and more speculative projects to shorter-term research and technology that promises a rapid financial payoff.

Nevertheless, most experts think that both investment and innovation will persist as they have through previous economic downturns. Some observers even suggest that the current economic crisis could create as many opportunities as it destroys. For one thing, Lo points out, a tremendous number of opportunities have been created in the banking and financial-services sectors. "I would expect an unusually large number of startups to be focused on new technologies for addressing the issues that led to our current crisis," he says. In particular, Lo mentions the development of new electronic-trading and risk-management tools.

The austerity and pain of an economic recession could also have positive consequences in the long term, Lo believes. He suggests that the financial crisis will lead to not only a clearing out of the financial-services sector, but also to much stronger regulation, which will have beneficial results. "No doubt the recession, which I suspect will last at least two years, will be painful," Lo says, "but during that time, markets and regulators will develop a series of innovations that will lay the groundwork for the future growth of the global economy, which will be spectacular."

Antoinette Schoar, a professor of entrepreneurial finance at MIT, agrees that looming changes on Wall Street will create new opportunities. "I think the best VC funds won't have trouble raising funds," she says. "Greater regulation of the banks, and the disappearance of investment banks, will [also] provide a lot of interesting investment opportunities for private investors."