Bob Crants Pulls Back the Private Equity Curtain

Thursday, August 16, 2007

Liquidity Crisis??

Several people have asked lately what the implications of the current credit crunch and associated fall in the equities markets will have on the private equity market and on Pharos. The answer, as you might expect, is a bit complicated and a bit counter-intuitive. Overall, I would argue that it is a good thing for private equity in general, a good thing for Pharos, and a bad thing for hedge funds.

Lets start with how a credit crunch impacts private equity in general. First, the cost of completing leveraged transactions just went up, in many cases by at least 200 basis points. Some transactions won't get done, but those that fail will be deals there were either too leveraged anyway or where the fundamentals were questionable. Ironically by pulling the worst deals out of the pipeline, the credit markets are doing the private equity markets a favor. The `black eye' associated with failing to get a deal done is much less painful than the `black eye' associated with a large failed deal in the portfolio. By weeding out the worst deals, returns on private equity returns should improve in the out years. For the deals that do get done, it is certainly possible that returns decline, as more equity may be required or actual costs of debt exceed projections, but except for the most highly leveraged deals, these costs should be manageable.

The associated collapse in the equity markets is similarly a mixed bag. Obviously it pushes out some exits, and reduces the likelihood of some of the dividend recap transactions that pervaded the market for large deals the last couple of years; but prices for new transactions will be lower, and the market will ultimately stabilize and normalcy will be returned. The impact, therefore, will be short-term for some transactions in firms' portfolios, non-existent for others, and positive for new deals. All-in-all not much to worry about.

The impact on Pharos is probably more favorable overall than the market. Pharos focuses on adding value to its portfolio companies and generating returns for our investors through growth at the underlying companies, rather than simply leverage. Our portfolio companies are less leveraged than the markets, have higher growth rates than the markets, and have less need, on balance, for near term capital infusions. In other words, no big deal for now, and positive for the future because valuations should be lower for new deals.

Private equity ultimately is supposed to be an illiquid asset for investors. Investors are patient and rational, and by managing a portfolio of companies for the medium and longer term rather than for the next quarterly report to analysts, improvements can be made and value increased. Some firms have clearly forgotten this, and many firms including lots of hedge funds have come into the market and driven up prices with their high amounts of liquidity and large amounts of leverage. To the extent that these firms are ultimately shaken out of the market, that should be a good thing for the remaining private equity firms, like Pharos.

While no one likes watching the market decline every day and hearing the financial press talk about problems, the impact on the private equity world should be much less than for hedge funds, real estate funds, and other types of alternative investments. Here the core businesses are being hit, and confidence on the part of investors is being shalken. We will keep on going, building value, and hopefully delivering strong returns to our investors.

If you have any questions, feel free to post, and don't hesitate to take a look at our website

Bob Crants

Thursday, January 04, 2007

Is the Private Equity Market Frothy?- Not Necessarily

Many articles have been written about the record levels of large deals being proposed or completed in the private equity markets, from Harrahs to HCA. Pundits have offered up that this is due entirely to the massive amounts of cash that have been raised by private equity firms and those firms chasing bigger deals in order to invest the money. While there is some truth to that, I would offer that there are other factors at work.

First, the balance sheets of Corporate America are at record levels of conservatism. Corporate America currently has record amounts of cash and low levels of debt at a time when interest rates are still quite low on a historical basis. This is in part due to the markets skepticism about large scale M&A transactions, and part because of the volatility of the past associated with more aggressive balance sheets. In short, in todays regulatory environment and with frivolous lawsuits being filed daily, it is easier and safer for CEOs to do nothing, and let cash pile up, rather than to do the best things for shareholders. While those CEO's would acknowledge that Corporate Finance 101 would tell you this is inefficient, they would argue they just want to be careful and will return money to shareholders over time with dividends and buybacks. This will usually satisfy an unsophisticated market. To a private equity firm with deep pockets, however, this is a unique opportunity. By taking a company private and therefore pulling it out of the regulatory constraints and litigation world, private equity firms can do what company managers should have been doing all along- optimizing their capital structures and trying to grow shareholder value. While sometimes this will be reflected in significantly increased leverage, or more aggressive growth and acquisition plans, private equity firms are rarely rewarded for crippling a company's prospects. As such, private equity firms serve as a check to management inefficiency and conservatism.

The second factor going on is that the primary suppliers of capital to the private equity space are struggling to find alternatives that will generate 10%-15% consistent returns. Equities seem unlikely to be able to consistently deliver that level of return, bond rates are around half that in terms of coupon, real estate has had a great run, but seems unlikely to continue at high levels; so where to turn? In the last decade, private equity was seen by pensions as a diversification tool and an opportunity to generate maybe 20-25% returns on relatively small dollars. In todays market, the large buyout firms are essentially investing in the public equity markets, but doing so more efficiently. As such, 10%-15% seems more achievable and the private equity firms can do so with larger amounts of capital. From a pension fund's standpoint, this is a perfect fit. Lower returns than before, but the ability to put much more money out while exceeding the target returns necessary to fund their pensioners retirement payments.

With these facts as a backdrop, I think that the current perceived `bubble' in private equity is unlikely to burst anytime soon.

Let me know what you think.

Bob Crants

Wednesday, June 14, 2006

The Importance of a Good Team:
One thing that is regularly underestimated by individuals looking to join the world of private equity is the breadth of perspectives of the team. As I have stated in past posts, Pharos believes strongly in analyzing and managing the risks in the private equity business, as opposed to looking only at the upside potential of specific deals. Part of our ability to succeed in managing risks goes all the way back to the creation of our firm and our strategy for hiring. While all private equity firms strive for the best and brightest employees, we have always looked to hire from a mix of educational backgrounds, job experiences, professional experiences and other interests. The reason for this is simple, if we all came from the same great school with the same great professors and the same great jobs, we would have similar perspectives and opinions and most importantly we would be likely to make the same mistakes. By hiring professionals that have a diverse set of experiences, we are likely to look at transactions from slightly different perspectives, and as such, become less likely to make the same mistakes. In addition by empowering our professionals at all levels to say `no' to particular deals, we put that diversity of experience to the test. If five or ten analytical and skeptical professionals with different backgrounds and different experiences can't find a reason to say `no', then in all likelihood it is a pretty interesting deal that is worth exploring. On our team, Kneeland Youngblood, one of our founders and managing partners has a very diverse background including time as an emergency room physician, as well as serving on the boards of Starwood Hotels, Burger King, and the money mangement business of American Airlines. This breadth of experience is invaluable in reviewing and analyzing a large variety of deals. Similarly Mike Devlin has worked both domestically and internationally, has been a securities lawyer in new york, an investment banker with Goldman Sachs, and has been actively engaged in a large number of non-profit endeavors to expand his range of experiences. We carry this depth of experience through to our hiring at all levels and it helps us ultimately to be better investors. As my partner Kneeland Youngblood has stated many times, there is nothing more important than building the right team.

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Tuesday, March 28, 2006

Don't Hate me because I'm a Venture Capitalist

It's no secret that entrepreneurs don't enjoy the fund-raising process. Managers always feel like they understand their business as well as it can be understood and get frustrated with the amount of time it takes the `smart money' to get it. Managers are afraid that the venture firm was never really interested in the first place and instead were planning on backing a competitor. Managers believe that the terms are bad, the valuation is low, and that the VC shouldn't make so much money if it is really the manager that did all the work. Sometimes, managers even believe that the VC is out to steal the company, replace the management, and take the best ideas public without the manager's involvement and make millions or billions of dollars. Is it true? Maybe- but probably not.

There are lots of fair criticisms leveled at the VC industry from `too little money chasing too few deals' to `Venture firms' individual portfolio needs or preferences can keep a manager from growing his business the way that he wants to'. But is it an evil plot? no it is not.

Venture Capitalists have raised $10's or $100's of millions of dollars from large institutions that are interested in delivering pension benefits to their retired employees. They do not want to be in a situation where they fail to deliver those benefits, so they are not interested in taking on large amounts of risk. However, they do expect a premium return based on their willingness to tie up their money for a long period of time (10 years) and for investing in smaller or less liquid securities. How does risk management then play in?

First, the pension managers will diversify their own portfolios so that `illiquid assets' are not too big a percentage of their funds (so if the asset class fails they have other assets that might pick up the slack); next they put the venture firms that they invest in through a rigorous due diligence process that takes months (and sometimes years). Finally they put in place some degree of restrictions on what types of deals the firms they invest in can do.

Once the money arrives at the doors of the venture firm, one of two broad strategies will generally be applied. The first is to manage risk through diversification. This type of firm generally believes that it is virtually impossible to know which companies will be winners and losers on day one. As such, they have a simple set of rules that dictate that every investment that they make has the possibility of generating a 10-20x return. By taking this approach, only a certain type of idea (the big idea) gets through the gates, and only a certain valuation gets approved (low) because otherwise the upside isn't enough to get that type of multiple. Using this model a portfolio might have 20-30 companies, and the VC may be hoping for 5-10 winners, knowing that there will probably be at least 10 washouts. However, if those 5-10 actually generate 10x-20x return, then the portfolio as a whole will meet the return objectives of their investors and the VC firm stays in business. Why does a manager/entrepreneur even consider such an approach (they are going to pay me very little for a really big idea)- because the idea is only big if they have capital to attack it, and the big VC firms have all the capital that the entrepreneur can use. In addition, VC's often have industry relationships with past portfolio companies or otherwise that can help the growth process along.

The other way of managing risk at the VC level, is vigorous due diligence. This type of VC wants to truly understand every aspect of the business (whether management views those elements as relevant or not), the financial model, the customers and the strategy. What are the key assumptions, the market sizes, and track record of management. Why? because if they really understand it, they will pay higher valuations and expect a lower overall return. Does management like the due diligence process- absolutely not. Does management like the higher valuation and more favorable terms- absolutely. Our firm, Pharos Capital, tends toward the latter approach but certainly there are successful firms in both categories.

On the topic of VC's spending time on a company just for competitive purposes, or wasting management time when they are not really interested- I am personally not familiar with cases like that. VC's stay sufficiently busy that wasting their own time never really makes sense. There is always another deal out there to try to track down.

Make no mistake- you won't like every VC that you come across. The industry definitely attracts type A personalities. However, for every professional that is in the business because he thinks he can make a lot of money, there is a professional who truly enjoys the business building process and helping small companies succeed. The VC industry is a necessary part of the US economy, which is far and away the most dynamic and entrepreneurial in the world- as such, reserve judgment or at least, don't hate me because I'm a VC.

For the counter position to my piece, an interesting article is at:

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Monday, March 13, 2006

Origami- Why?

The buzz behind Microsoft's new `Origami' system or Ultra Mobile PC platform reached epic proportions over the last few weeks, bringing fans and critics out of the woodwork. To me, the system is less relevant than the macro trend toward user-friendly mobile content. Every time I have upgraded my phone or my blackberry, the embedded software has become more and more robust, thus reducing my need for a laptop or PC for a wide array of applications. Microsoft's new system for a smaller, more user-friendly tablet is simply an acknowledgment that the features that have driven the market share for laptops way up when compared to PCs, is now driving share of smaller devices up against laptops. Microsoft wants to make sure that it creates a stop-over point for people wanting to migrate down the size curve from laptops, but still think a blackberry screen is too small. By create a buzz-filled stopping point, while at the same time scrambling to gain share in the software market for smart phones and feature phones, Microsoft is trying to make sure it remains relevant outside the PC platform. Whether this new system does it or not remains to be seen- I will certainly toy with some of the newer versions and see whether they are a good fit for me. Right now, I am pretty happy with my Blackberry. Nonetheless, the product will sell a lot of units and will probably be successful in slowing down the migration to phones. This is after all what they were trying to accomplish in the first place.

An easier trend to predict is that with the advent of more and more feature rich mobile devices, there will be increasing demand for software and content optimized for mobile. We have looked at several companies that either create or consolidate content in this area and believe it will be a robust business for years to come. A personal favorite in that arena is

For more information on the origami system check out these links:;;

or simply take a look at the comprehensive coverage of the subject on

For more on my firm, check out

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Tuesday, February 21, 2006

The New Risk Rules for Private Equity.

Private equity firms like ours, Pharos Capital ( are tasked by our investors with the goal of generating as much return as possible with the least amount of risk. As such, every question that we ask and every decision that we make in the due diligence process tends to revolve around managing the risks that we have identified, or making sure that we will get an attractive return on our investment if our new portfolio company performs well. While this seems obvious on many levels, part of the cause of the `internet bubble' was that one particular exit strategy, the initial public offering, tended to bias return estimates upward for venture and private equity firms because of the extraordinary valuations that public shareholders were willing to pay for companies that were in their development stages. Venture firms saw the opportunity to identify companies early on that might be attractive to the public markets, help shape them and `get them ready,' then take them public, realizing large gains on companies that were still works in progress, while sharing the risks of those developing businesses with public shareholders. In this way, many individual investors and mutual funds became de facto venture capitalists by taking companies into their portfolios that had not yet matured into stable operating businessess. While this could potentially work out for the public shareholders if the investors making those portfolio decisions had been able to buy in to those companies at `start-up' valuations and create enough diversification to allow the few winners to take care of a larger number of losers, the process breaks down if valuations are so high that upside is constrained on your winners and losers have further to fall. Lots of venture firms made a great deal of money in this fashion until the public market shareholders got burned enough times to understand the unusual risks they were bearing. At that point, the ability to exit through an IPO became difficult or impossible for venture backed companies. Of course, the rest is history, as venture returns soured since their portfolio companies needed additional capital and were unable to tap public sources and alternate methods of exit were not able to justify the higher and higher prices paid by VC firms for business plans.

One of the techniques that Pharos uses to manage this type of risk on behalf of our investors is focusing heavily on exit strategy prior to making any commitments. By making sure that we are not reliant entirely on the IPO market to exit our portfolio companies, we are able to create a balanced analysis of returns under various scenarios. For example, we are likely to look at acquisition multiples that have been paid for comparable companies to the ones we are considering. We will look at public company comparables for an IPO valutaion estimate. We will look at future cash flows to see whether the company would be likely to be able to recapitalize itself with debt or to repurchase our shares at predetermined pricing. Once we know the answers to these and many other related questions, we can set about determining how much we can afford to pay for a particular business and still feel like the risk-return is a good one. Only if we have multiple exit strategies, each of which show favorable returns, can we proceed with our investment.

What does this mean in real life? It means that it is quite unusual for us to invest in low-margin or commodity-type businesses. Even if those types of companies are quite stable and profitable, it is difficult to attract high mutliples on exit. Without high margins, returns will have to come from very high growth in sales (which is often quite difficult) or through acquisitions (which will often acquire much more capital). It means that we will be looking for companies that have a proprietary business model and have a competitive edge versus its peers (if it has any). It means we like market leaders, even if the market that they are leading is still developing. It means that we like business that provide enormous value to their customers, as opposed to simply being low cost providers of goods or services.

One example of a company that we have enjoyed working with is Atherotech ( . Atherotech's value proposition is fairly simple- it saves lives. Atherotech provides a more complete and more accurate cholesterol test than the standard lipid panel that we have all had done on many occasions. By providing physicians with more information about the types of cholesterol in patients' bloodstreams, people at risk of heart attacks or other coronary diseases are identified earlier and more accurately so they can seek the treatments that they need. In this case we invested relatively early in the development of the advanced cholesterol testing market, but we knew that the potential size of the market for accurate cholesterol testing was quite large. We also knew that the company's patent protection on its technology would allow the company to sustain its margins while still providing a great value to patients and doctors. Lastly we knew that the company could grow to be an IPO candidate, but also that any number of labs or medical equipment manufacturers would be interested in acquiring Atherotech as an entry point into the very large cholesterol testing market. All-in-all, it met our tests, and has proven to be a solid investment.

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Thursday, February 09, 2006

For the last 16 years I have been involved in virtually every aspect of the private equity markets, from helping companies raise money, to investing from my own account, to managing pools of institutional capital, to guiding private companies from their boards of directors, to helping companies find suitable exits. My hope for this blog is that people who have interest in the field of private equity will feel comfortable asking me questions or raising topics that will help both of us learn. The private equity markets are constantly evolving and if I can learn a few things from this audience, source a few deals, help an entrepreneur succeed, or provide a cautionary tale, then this effort will be a success. Let me know how I can help.

For additional information, I was recently interviewed at http:/

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