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The Shape of Things to Come
By Peter Kelman, Esq.
This article appeared in substantially the same form in the Boston Business Journal, November 12, 2001.
What are we to make of the post-new economy? Or more importantly for businesses that grease the wheels of the economy - banks, law firms, and accounting firms - how are we to staff for the post-new economy? There is a disconcerting quiet in the Boston financial services community. After the nose-to-the-grindstone, no-time-to-breathe, go-go 90's, many professionals are unnerved by the current slowdown in business deals. The smell of the flowers simply can't substitute for the smell of money.
The economy is slumping; there is no news in that. Predicting the duration of the slump is a question for economists and psychics. As September 11 taught us, the road to recovery is filled with twists and turns no one can foresee. Even more important than timing the return to prosperity, however, is accurately forecasting the dynamics of the new prosperity.
Venture capitalists and investment bankers tell an interesting story about the last ten years. William Roman is the co-Head of Investment Banking at Tucker Anthony Sutro Capital Markets in Boston. At a recent presentation, Mr. Roman displayed a slide that showed the total dollars committed to merger and acquisition deals in the technology sector yearly since 1990. The graph displays a steady upward curve as the amount of money in these types of deals increased throughout the decade. However, two years significantly departed from the curve - 1999 and 2000. The amount of money committed to mergers and acquisitions in those years was more than twice what the curve would have predicted. His graph has one other interesting feature. The amount of money committed to such deals so far in 2001, the purported year of the slump, exceeds the amount committed in 1998, and in fact, continues the general upward trend established in the 1990's. Venture capital dollars tell a similar tale: a gradual increase in v.c. dollars in the 90's, a spike in 1999 and 2000, and a return to the curve in 2001. Rather than viewing 2001 as the beginning of a slump, perhaps it more accurately represents a return to the norm.
If 2001 is a return to the norm, then what fueled the investment spike of 1999 - 2000? Dwight Gertz is the president of Celerant Consulting, in Lexington, and the author of the best-selling business book Grow to be Great. He has been an astute observer of the dynamics that drive businesses to success and to failure. According to Mr. Gertz, four principal factors accounted for the unexpected investment spike. First, investors poured unusually large amounts of money into venture capital funds, seeking quick returns. The funds had to invest the money in something. Second, the Internet provided the technology du jour, the young, sexy outlet for older money. Mr. Gertz points out that this is no different than the circumstances under which money fueled a fledgling automotive industry in the 1900's. Third, boards of directors may have compromised their fiduciary responsibility to nurture the long-term growth of their companies by seeking rapid return on investment. Lastly, as the stock markets hit new highs, a company's equity became the cheapest currency to finance transactions. When stocks are high, large deals occur with little cash changing hands; as stocks fall, once again, cash is king.
Venture capital financings, initial public offerings, mergers and acquisitions -- the principal deals supported by the transactional side of the financial services industry -- all have one thing in common. Each undertaking represents a way for a company to achieve liquidity other than by generating revenues from sales. Lost in the ipo glitter of past years is the fact that unless a company needed the funds, it was typically counseled not to undertake an ipo. If a company's revenues from its products and services can generate the cash it needs, there is no reason for a company to seek outside capital. For example, Fidelity Investments is not a public company; it has never needed to go to the public markets to support its business model.
Such transactions share one other characteristic that can lead to financial meltdown. The collateral for these transactions is hope. Unlike traditional debt financing that is collateralized by pre-existing assets, these types of investment are collateralized by the promise of a future return. If the events leading to the hoped for return fail to materialize, the investors are left with nothing; what starts as a zero-sum game ends in deficit.
The transactional glut of 1999 - 2000 accomplished one principal thing. It gave life to companies that were unable to sustain themselves from internally generated revenues. Billions of dollars flowed to companies that the free-market system would not otherwise support. Investment is risky business. It involves the transfer of funds from a stable predictable setting to a speculative enterprise in which the investor hopes his / her money will be the catalyst for future growth. We give up a dollar today for the promise of two dollars tomorrow. The genius of investment is being able to tell today what will prosper tomorrow. It appears that the dominant investment strategy of 1999 - 2000 was too naïve. Too often money went to a business with an "e-" as a prefix or ".com" as a suffix.
In 2001 we are experiencing the consequences of misallocation of funds. Businesses fail and people are laid off from jobs. While painful to experience, this phase of economic slowdown is really the first step to a healthy recovery. It is the consequence of the free market correcting itself and purging itself of the products and services initiated by investments but not demanded by consumers. There were fundamental reasons why so many companies were unable to generate revenues to support themselves. Outside funding did not cure the inadequacy of their business models. As an unfortunate consequence of the correction, people sucked into the employment vortex created by investment dollars now face displacement as investment funding returns to normal. Gradually, resources will be re-allocated to those businesses sustained by revenue, not investment. But the transition will be difficult and take time.
Mr. Roman predicts that the investment industry will bounce back from its current lull. Although he does not think it will return to the heady days of 1999 - 2000, he is confident that the upward trend in investment dollars will continue. What of the financial services industry, how should it prepare for the future? Perhaps by creating an infrastructure that encourages businesses to be self-sustaining. The day of the investment triage is over. It is time for business to return to the credo articulated by John Houseman years ago in an ad campaign for Smith Barney, "We make money the old-fashioned way, we earn it."
Copyright Peter Kelman, 2001. All rights reserved.