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Yesterday, I commented on the size of the M&A market for 2006 and promised a more detailed analysis of what it might mean for 2007.  I’m still thinking about that and I’m not ready to take the side of the Bulls or Bears nor am I sure how it will impact the entertainment, media and technology crossover companies that are the  focus of Metue.

Instead of making an unfounded prediction, in the spirit of being cautiously optimistic, I’m going to focus on what happens when money follows money because it represents a risk factor for what lies ahead.

Money follows money: taken literally, the statement is an often unstated, but nevertheless, common behavior in investing.    It makes sense in a simple way – if an investment is providing a good return you’d want to put more money in it and derive even more gain.   It’s the nature of riding the wave.  People follow the trends that are successful.  It’s also part of how investment bubbles are built, and how they burst.

Within the Venture Capital world, or more broadly, within Private Equity markets, there is a limited amount of deal flow that can be managed by Fund Managers in a given time period.  A Venture Capital Fund with 4 Partners might not have the capacity to intelligently invest in more than 5 deals per year (these investments, after all, may take several years of ongoing commitment before liquidity or failure).    If demand for the partners’ investment management services increase, however, something has to change.

Imagine a firm called Bubble Limited Investment Partners (BLIP).  BLIP’s first fund, Bubble I, had the leading Internal Rate of Return (IRR) among similar funds over its lifespan.  The performance was so good, in fact, that other investors want a chance to participate.

So, when the partnership pitches a new fund called Bubble II to their investors, the investors, happy with the return on Bubble I, increase their investment with the partnership, through Bubble II, by 50%.  Additionally, a whole new group of investors that didn’t participate in Bubble I want in on Bubble II.   If Bubble I was a $300m fund, Bubble II is now oversubscribed at $700m. 

Since more Institutional Money is flowing to BLIP’s investment coffers, and the managers can’t handle anymore deals than they had been handling before – they have to make a choice. The can either:

• I. hire new partners (who may not have the same discipline or experience);
• II. Turn away money (which is hard to do when you’re management fee includes 2% of principle off the top ($14m vs. $6m in the example)); or
• III.  Increase the size of the deals they do.     

Many funds put option three as their top choice. Trouble with that is there is a decreasing pool of deals suitable to the increasing scale of investment.  In Bubble I the average deal size was $10m to $15m.  In Bubble II, it now has to be $20m to $30m.   Deals that can provide comparable rates of return on these larger investments are harder to find. 

In addition, there’s another problem – competition.  The simple example doesn’t include the fact that the institutional investors may have diversified their money across 20 management teams similar to BLIP.  All 20 of these other firms may be competing with BLIP for deals.   Failure to generate comparable or increasing IRR’s as compared to their prior funds means BLIP is going to struggle to raise a new fund when the current one is fully invested.  It’s the equivalent to a company missing its earnings forecast on Wall Street. The pressures to prevent that can be enormous.

So when money follows money, the math can get simple:

   Increased fund = larger deals

   eventual bad decisions =  eventual burst bubble

A Post Script:
My example is oversimplified. It is also based more on Venture Capital than the broader Private Equity segment. It has to be considered that Venture capital has its own risk models and strategies which are different than other forms of Private Equity investments.  Still, though risk factors and strategies differ, I use the example because I believe the core dynamic when it comes to fundraising can be similar.

I believe 2006’s high M&A activity and the resultant net returns for Private Equity funds means it’s likely that available capital will be even higher this year for these investments.  More M&A is almost a certainty as is at least a few big scale privatizations.  Eventually, if this trend continues, in a manner not entirely dissimilar from my example, I think there may be an adjustment, but how big of one, whether it’s even noticeable, or whether it occurs this year, or five years off, is unclear.