Mezzanine Momentum

A number of articles have started to appear that shine a harsh light on the mezzanine merchant bank groups like Advanced Equities. These groups specialize in raising capital for later stage venture companies. These firms have formed strong relationships with various brand name venture groups and help them raise "pre-IPO" capital for their businesses. These include companies like Vonage and Alien Technologies. The groups include the likes of Kleiner Perkins and NEA.

Ron May recently wrote in his May Report:

"Let me get specific...The case against Dwight and Keith (Advanced Equities) is that they are kissing up to the VC firms and at the same time screwing over their retail clients. By the way, they also sell some stock to institutions but the institutions are more resistant to their highly inflated valuations. The VCs make out like bandits and the retail investors that AEI sells to scrape for the crumbs."

The standard procedure is that they find a company with a lot of buzz that has the momentum to potentially go public. These rounds carry extremely expensive valuations but are justified by being priced at a discount to a likely, near-term IPO. These were all the rage in 1998-9 when the IPO markets were hot and investors were able to quickly "flip" their positions post IPO. These investors are classic "momentum investors". In contrast to "Graham & Dodd/Buffett Value" investors that base decisions upon the underlying fundamentals of a company, momentum investors make their money by identifying trends and momentum in price movement and try to turn a profit based on the fact that the stock is worth x% more in the near future.

While the mezzanine houses have retail clients, their true customer is the provider of product for them: the venture firms. If they can get access to the hottest "stories", they can raise capital at extremely high values (and hence, really high fees) with the hope that their investors will do well post IPO. The VC's like this since it is cheap equity, Advanced & brethren like it since they get big fees and the retail clients like it since they can make a quick profit.

However, all good things come to an end. Should a "story" lose its zeal, and fundamentals become the driving force (or a market correction), then the retail clients get crushed. While this is unfortunate, I have a more moderate position on all of this. These investors should know that they are playing with fire. We all went through the Tech Ice Age just 6 years ago and we all know momentum investing when we see it. These retail investors are either a) greedy for a quick flip or b) ignorant about fundamental investment analysis. They are momentum investors and pretty much should know what they are signing up for.

Institutional VC's won't go near these deals, normally, with a 10 foot pole. These companies are priced at $200-$300m+ when they would struggle, often, to get above $100m in an institutional event. However, the allure of the IPO is strong and clouds judgment.

Vonage is a classic example of such a firm. We all know that telco service companies commoditize in the long run. We also know that when you have large, active incumbents on one side (AT&T, etc) and free offerings (Skype) on the other, things will likely not end well. Furthermore, as I have posted on numerous occasions, the Vonage service is horrendous. This is a situation where investors could actually sign up for the service and test it for themselves. I am guessing that few, if any, actually did.

Now, I am certain that a number of "ethical" issues will emerge over time regarding how these securities are sold. People also hate losing money and will launch a sea of lawsuits. That said, how short are people's memories and how easily can greed overcome rational analysis (or fear)? As they say, let the buyer beware...

Another sign that the bubble is in full force and likely unpleasant things are ahead for us.

Comments

[Ron May]

October 18, 2006

Matt,

I was trying to be fair, and trust me, I did try to give "both" sides of the story, but I may have made it seem that the VCs are responsible for AEI's sales pitches which they are clearly not.

I can tell you that my writing was far more moderate than one source on this. Another source was more balanced. I wrote this: "But if it really is late stage capital, if it really is right before the IPO, then a 12x return is silly. That is the kind of return that VCs look for when they get in right at the get-go."

So, we agree. All the pie-in- the-sky talk should be a red flag to any investor. How can a late stage entrant expect a 12x return?

I also think that the people I am talking to don't like the "hard sell" approach of AEI.

But I do want your opinion on this from my article: May here again. This is saying that they raised $38MM in Series F from their retail clients and that caused them to "give" $25MM to the VCs at the same time. The key sentence is this: "The issuance of additional preferred stock in this manner was not part of the original rights of Series C, D, and E preferred stockholders, which were entitled to protection from dilutive issuances through an adjustment to the common stock conversion ratio."

Matt, what is your interpretation of that statement that the additional stock issuance to the VCs was not part of the original rights of Series C, D, and E? I did not dig this up by myself as you can imagine. One source pointed me to it as proof of his argument that the VCs are being favored.

Does it mean that AEI gave away something that they should not have given to the VCs? What information should the retail investors have been given about this?

That would appear to be at the nub of the issue.

Ron

[mbmccall]

While there may very well end up being a smoking gun in all of this, I am assuming that much of the specifics was in the Offering Memorandum. The issue is that they probably did not fully inform the retail customers about how these terms varied from institutionally structured deals. You were correct in commenting that their customer is really the VC versus the retail customer. I would imagine that most retail investors did not even dive into the docs.

[Rick]

Matt,

As a former private equity associate and now a current public equity analyst, I think you may be ignoring a broader issue. Many private placement shops can certainly be run as a boiler room. I do believe you give too much credit to the retail "investor," who assumes the banker is following his/her fiduciary duty. While you and I would ask the question "if the deal isn't good enough for Kleiner Perkins to invest a follow-on round, why should I," many of the doctors and lawyers naturally assume that the valuation work and the "sales" pitch is honest.

I wouldn't want to offer an opinion on Advanced Equities; however, VC firms have certainly latched onto AE when they wanted to keep a company afloat but weren't willing to do it with more of their own (and LP) capital.

Yes . . . caveat emptor. But the private markets and "qualified investors" do not excuse investment bankers from pumping and dumping.

[mbmccall]

Very true, Rick. Pure private placement shops don't have nearly the conflict of interest and responsibility to look out for investors as do retail brokers like the Advanced Equities of the world do. The retail customer is trusting that they will be treated honestly and openly. I would have only hoped that after the "system" stung them in 1999-2000, that they would have looked at offerings with a more discerning eye. But, if not trained in this world, they will have trouble knowing what to look for and what are the norms. Of course, as Buffett say, invest within your realm of competency. Good points.

[tomo]

Matt, Thanks for the insight. The thought that keeps flashing in my head is the video of AJ and his night out on NYC and how the financial markets are so incestuous. The avg investor seems to take allot of what analysts say as gospel when recent history has shown how deceptive some really are. I'm beginning to like Real Estate more and more :) The nice thing about RE is that it will never have a value of $0 whereas playing in the financial markets can actually result in < $0. I'm way off the subject matter of your post but that is what was on my mind :)
Thanks!

[mbmccall]

If you jump into Real Estate, just be careful about leverage. I started my Wall Street career in RE Merchant Banking and when things go bad, not only do you lose your investment, but the lenders come after the other assets!

All this above just goes to say, as you imply, that everyone should use common sense and do their own homework in matters of money.

[Egbert]

The problem with the AEI deal was not just that they peddled bad deals or overpromised. It is that they violated securities laws in a variety of ways.

a) They mass-marketed private placements by sending out literally hundreds of PPMs. (The standard rule of thumb is no more than 99.)

b) Unsuitability: they placed PPMs in accounts that should not have had it as an investment.

c) They solicited new clients with private placements (again, a violation of securities regs).

The amazing thing to me is that these guys have been around as long as they have. In my opinion it is a classic case of the Illinois securities regulators and NASDAQ and SEC regulators being asleep at the wheel.