Next Things First

Potenital 30-40% Venture Returns? by Rob Coppedge
December 11, 2008, 10:13 pm
Filed under: economy, venture capital | Tags: ,

This week El Paso Corporation reopened the high yield debt market which had not seen a new issue in five weeks.  The natural gas production and pipeline company placed $500 million of 5 year notes at a staggering 15.25% yield.

But 15.25% is a good deal!  That’s 25 basis points lower than an index of the 100 largest issues.  A broader index yields over 22%.  Is your Visa card starting to look cheap?

Because bonds have a par value, and often a coupon, it is arguably easier to see the true price of bonds as compared to equities.  So the high yield market provides a useful data point on the price of risky assets.  Adding a risk premium to the high yield market, it’s easy to see that the cost of venture capital today is 30-40%.  In other words, company valuations are down and venture investors can buy equity for relatively cheap.

Risk taking has the potential for handsome returns in this market.  At 30%, a $5 million investment would be worth $18.6 million after five years.

Why does venture capital have such a large risk premium over high yield bonds?  Bonds are senior to equity in a bankruptcy; often bondholders can recover a portion of their investment from asset sales.  Venture capital investments are almost always some form of equity and are not easily sold until the company is successful.  Of course, venture investments are a bet on an unproven technology or concept.

But venture capital has advantages.  The whole point of a venture capital investment is to develop a product or service that reduces costs or provides a cost-effective improvement in quality.  Both are needed – especially in health care – regardless of the broader economic environment. Plus, venture companies are often a clean slate.  New ventures do not have a bloated cost structure that was built for another time.

Investors with the skills to recognize valuable innovations will be rewarded with the most attractive risk-return trade-off in over a decade.  But keep some dry powder to help portfolio companies weather what will likely be a very difficult fundraising environment for the next two to three years.

Posted by EWright  (Eric Wright cut his teeth in early stage venture and now sinks them into the energy issues at Xcel Energy.)


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