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Lessons learned from past mistakes - the cost of failure and under-performance.

Failure and under-performance are often considered to be unavoidable hazards of the venture capital industry. This extract from an EVCA and Price Waterhouse report questions whether this should really be the case and looks at how venture capitalists can spot problems before any damage is done. (Published in 1998)

EVCAThe cost of failure and under-performance

Between 20 and 25 per cent of reported venture capital exits, by number, take the form of write-offs and around a quarter of most venture capitalists' portfolio investments are considered to be under-performing.

The Price Waterhouse survey results indicate that many European venture capitalists accept occasional investment failures and a certain degree of poor performance in their portfolio as two unavoidable hazards of operating in the venture capital world. Furthermore, it is a common view that time is more efficiently spent on maximising the gain from investments which perform well, and searching for new opportunities, rather than trying to save money already lost in companies that are performing badly or near to failure. Nevertheless it cannot be forgotten that two per cent of the European venture capital portfolio is written off every year, which means that the other investments have to work harder to deliver returns on target.

What causes a deal to fail?

Most venture capitalists believe that the major causes of failure and under-performance relate to misjudgement of the marketplace for the investee companies' products or problems with the management of the investee business. Sometimes the two issues are combined because management is unable to cope with change in their market place.

Venture capitalists are also wary of family or ‘lifestyle' businesses and recognise that the risk of failure is greater with turnarounds, start-ups and early-stage investments, and smaller companies generally.

Significantly, venture capitalists believe that paying a high price for a good business using a highly geared deal structure does not increase the risk of failure or serious under-performance. Some small reduction in investment returns may be accepted as the price of winning the deal. Price Waterhouse was surprised by the near unanimity of this view and believes that venture capitalists are ignoring the experience of the 1980s which saw a large number of failures of highly leveraged companies. The survey results might have been different had the question been asked at a different point in the economic cycle since prices paid in leveraged buy-outs have only recently reached a new peak with some deals being done at historically high multiples of ten to 11 times earnings before interest and tax, and the effect on performance has not yet been felt by most portfolios. While many incorrect pricing or structuring decisions may be a consequence of misjudgement of the market or management, there is a range of other possible causes, such as overoptimistic cost-saving projections or rash decisions in the heat of a competitive auction.

While most venture capitalists feel that syndicate partners are generally not the cause of failure, there is a widely held view that disagreement between co-investors often prevents problems being solved at the optimum time.

All the above findings highlight the importance of thorough and objective due diligence, not just financial, but also covering the market, product and management. Perhaps it also indicates that venture capitalists should specialise more in particular sectors, as happens in the United States and increasingly in Europe, in order to ensure they understand the industry they are investing in.

How to spot a problem

There is wide agreement that delays in receiving, or changes in the format of, management information constitute the most common early warning signs of difficulties in an investment.
However, these signs are often easier to spot with hindsight than at the time they occur and venture capitalists agree that even when they recognise such signs they are not always quick enough to respond.

Collective hindsight indicates that venture capitalists need to be more proactive in taking action to investigate and correct problems, using advisers if they have insufficient resources in-house. Currently, even when investors identify a need for urgent action, such as a change in the management, such action may be delayed or not taken at all due to disagreements among syndicate partners or the difficulty of dealing with the management.

Most venture capitalists' experience is that a second (and unplanned) round of funding aimed at rescuing a business is often inadequate or misguided and futile. There is therefore a general reluctance to take part in such exercises. Sadly, even when the case for more funds is a good one, the money often comes too late.

Price Waterhouse's conclusion from the survey is that while venture capitalists are right to focus on what they do best - the new deals - there is an opportunity to do more to ensure that prompt action is taken to correct poor performance or potential failures.

This is an extract from Lessons learned from past mistakes – a report written for EVCA by Graham Turton and Julian Smith of Price Waterhouse Business Regeneration. Full copies of the report cost E100 and can be ordered on the EVCA website - www.evca.com 

The European Venture Capital Association's mission is to promote globally and to facilitate the development of the European private equity and venture capital industry through active lobbying and development initiatives. It seeks to help create an entrepreneurial environment in Europe and promote European private equity and venture capital to institutional investors worldwide. For more information, please visit www.evca.com
         
Copyright © 1998 EVCA