The State of Money, Part I: Private Equity Markets and Startups Before and During 2009

March 22, 2011

1:16 pm

This is part one of a three part series that looks at the private equity market and what it means for your startup.

The equity capital market is a space that exists between companies and financial institutions that works to provide capital for those companies. The financial crisis has had significant effects on the market and affected a changing landscape for the private equity realm and the entrepreneurs that look to it for financing startups and emerging companies.

Equity Capital: Where are you going and where have you been?

Most notably, the near disappearance of debt financing in the market, primarily between 2008 and 2010, led to a lack of exit opportunities for venture capital firms. Heading into 2011, there has been a slow but steady return of leverage and exit opportunities, which indicates that there is hope for an increasing number of deals and capital invested in startup and emerging companies in the coming years.

While there have been steady improvements in the market since 2009, the previous lack of exits has led an overhang of companies owned by venture capital firms. Until firms can liquidate the current backlog of companies, we are unlikely to see deal flow and capital invested into early-stage financing truly rally in the foreseeable future.

Adding to the difficulties facing the market, there is a new regulatory framework that market players will have to successfully navigate. The financial crisis has spawned the Dodd-Frank Act, which will add new registration and record keeping hurdles for private funds.

The dearth of debt financing and available exit opportunities has affected changes to entrepreneurial trends and strategies. Primarily, when equity capital markets become weak, there are fewer investments in startups and emerging companies, and those investments tend to gravitate toward the more extraordinary businesses. To attract financing, successful entrepreneurs have been required to be more patient, resourceful, and creative, while investors are obtaining more favorable terms than have been seen in previous years. In sum, it has become a buyers market.

What was the market like leading up to 2009?

Widespread Leverage. Thanks to the accessibility of leverage prior to the more deleterious effects of financial crises taking hold, 2007 saw record deal flow and investment in the private equity arena. According to PitchBook Data, there were more than 3,000 deals done and $595 billion invested.

Contracting Deal Flow. In 2008, the tumult in U.S. financial markets resulted in a marked decrease in deal flow and investment compared to the historically high 2007 levels. Despite the increasing lack of leverage, the capital invested and deals done in 2008 remained quite strong in comparison to years 2002 through 2006. Specifically, there were 2,219 deals done and $215 billion invested in 2008 compared to 2,055 deals done with $173 billion and 2533 deals with $301 billion in 2005 and 2006, respectively.

What was the state of the market in 2009?

Fear and Loathing. In February 2009, the market was characterized by uncertainty and unavailability of leverage. It was the worst year for private equity fund raising since 2003—funds raised were down 68% from just one year prior. The venture capital funds had only a slightly less difficult time; down 55% from prior year. It was their slowest year since 2003.

Frozen Credit Markets. A decrease in lending led to a fundamental shift in the private equity world: debt became less viable as a means of investment. The fact that private equity firms hold and support their companies for longer periods of time ties up venture funds too.

A Glut in the Market. Venture capital firms holding on to their companies longer had one major consequence for smaller start-ups and emerging companies: venture capital firms started making fewer early stage investments. Not only were there significantly fewer investments, but there was substantially less total capital invested than just 24 months earlier. Specifically, in all of 2009 there was only $61 billion invested in 1,349 deals. In 2007, $595 billion was infused into 3,002 deals.

In tomorrow’s post, we’ll look at what private equity is looking like in 2011.

Blaire Jones and Aaron Horn are the founders of the Georgetown Venture Law Society, an association of professionals and students at the Georgetown University Law Center dedicated to cultivating a greater understanding of the legal and financial issues facing emerging companies.

Image by flickr member Patrick Denker.

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Blaire Jones is a law fellow at National Public Radio, where she focuses on technology and intellectual property matters, and a new graduate of Georgetown Law. At Georgetown, Blaire discovered a special passion for helping startups leverage intellectual property and manage risk. You can follow Blaire on Twitter @VenEnthusiast.

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