Carlyle's Grady: Don't run out of money

Investor says VCs, startups should plan ahead as case credit crisis persists

Bob Grady, who runs the venture capital arm of investing giant Carlyle Group, is of two minds regarding the current financial crisis.

In the short term, it could help VCs on the investing side by bringing down startup valuations.

"There's been a big disconnect between entry and exit valuations," says Grady, a former investment banker who helped take 150 companies public with the San Francisco firm Robertson Stephens during the 1990s.

With 90% of the exits for VC-backed companies coming through M&A deals in the last eight years, blowout IPOs that used to juice venture-fund returns are getting harder to come by, Grady says.

Yet because VC firms are flush with capital after several years of strong fund raising, competition for early-stage investments remains high, pushing up valuations.

That's why the VC business has been getting tougher. It's also why Carlyle changed its strategy after the tech stock bubble burst and began using its venture funds to invest in and acquire later-stage startups, as well as taking traditional venture stakes. Nearly all the exits from its 2001 fund have been through acquisitions.

"We saw that the IPO market was broken," Grady says.

He blames a series of regulations passed after the dotcom bubble burst, which he says combined to "take all the value out of equity research and help kill the investment banking business model."

Whether it was over-regulation alone that has killed the market for tech IPOs can be debated. The long memories of money managers burned by buying into unprofitable dotcom and telecom issues that later went belly up certainly didn't help.  But either way, the result has been the same: small growth companies have been virtually shut out of the U.S. public equity markets for most of this decade.

Now the spreading financial crisis is about to make it even tougher for young companies to access capital.

In the near future, he thinks the credit crisis will impact tech firms both private and public, and that VCs and startups with a limited amount of runway may want to play it safe when it comes to raising money.

"Financial services companies have been big buyers of technology over the last few decades," he says. As that industry shrinks and consolidates, it will impact vendors who sell to them.

On top of that, the hedge funds that have been big buyers of growth stocks have seen losses of 25% or more this year.

When they open up their redemption windows at year's end, many will have to sell shares to meet their capital commitments to investors.

Late stage startups that use up a lot of cash can't assume that capital is going to be there in the near future, says Grady, so they may want to start taking some pre-emptive actions.

Grady says he's been going over capital needs with his portfolio's companies during the past year and telling them to "make sure you have the capital to finance your growth even in a tough marketplace." 

In response, one startup got a larger line of credit. Another, Internet health care startup HealthCentral Network, took a large $50 million funding round that included strategic investor IAC.  A third raised another round of venture capital "just in case," says Grady, joking that he learned an important saying while a banker at Robbie Stephens:

"Don't run out of money."

Beyond the immediate need to do something to free up credit markets, "even if the details aren't perfect," Grady says there's another issue that will linger.

In the long run, the fallout from whatever is done to fix the crisis could be bad news it if results in capital markets that are more restrictive than those found in other countries. That could stifle innovation and weaken the country's competitiveness in the global market, according to Grady.

"The long-term issue is the health and competitiveness of the U.S. economy," he says. (We'll have more on the state of the venture capital industry in a segment with Grady next week.)