Covered Investors
The Final Policy Statement does not cover all potential investors in a failed depository institution. Rather, it applies only to:

1. Private investors in a company, including any company acquired to facilitate bidding on a failed depository institution, that is proposing to, directly or indirectly, including through a shelf charter, assume deposits, or deposits and assets, from a failed depository institution.
2. Applicants for deposit insurance for a de novo depository institution chartered to acquire a failed institution.

Significantly, the Final Policy Statement excludes from its reach:

1. Acquisitions completed prior to the FDIC’s approval of the Final Policy Statement.
2. Upon application and approval by the FDIC, investors in a depository institution (or depository institution holding company) after the institution has maintained a Camels 1 or 2 rating continuously for seven years.
3. Investors in partnerships or similar ventures with depository institution holding companies or in such holding companies (excluding shell holding companies) where the holding company has a “strong majority interest” in the resulting depository institution and an “established record for successful operation” of insured depository institutions.
4. Investors holding 5 percent or less of the total voting power of an acquired depository institution (or its holding company), absent any evidence of such investors acting in concert.

(Investors that are subject to the Final Policy Statement are referred to in this memorandum as “Covered Investors.”)

Capital Commitment
Under the Final Policy Statement, depository institutions acquired by Covered Investors will be required to be initially capitalized at a minimum 10 percent common equity to total assets ratio for at least three years and at a “well capitalized” capital adequacy level thereafter. This requirement has been substantially eased from the initial proposal in several ways.

First, the 10 percent level is substantially lower than the original proposal of at least a 15 percent Tier 1 leverage ratio for at least three years. Although the Final Policy Statement did revise the test from a Tier 1 leverage test, which permits the inclusion of cumulative perpetual preferred stock, to a common equity test, which does not, the 10 percent common equity leverage test is at least comparable to the 8 percent Tier 1 leverage ratio that newly chartered depository institutions and those that are subject to a change in ownership are typically required by the FDIC to maintain.

Under the Final Policy Statement, depository institutions acquired by Covered Investors will be required to be initially capitalized at a minimum 10 percent common equity to total assets ratio for at least three years and at a “well capitalized” capital adequacy level thereafter.

Second, in contrast to the proposed policy, the FDIC did not retain in the Final Policy Statement the authority to extend the term of this requirement beyond three years (and potentially indefinitely).

Third, where the proposed policy statement provided that the investors would have to agree to maintain the capital of the depository institution at this level, the Final Policy Statement merely provides that the acquired depository institution must maintain the required capital ratio.  As in the proposed policy statement, if the depository institution fails to maintain the required capital levels, it would be deemed “undercapitalized” for purposes of the Prompt Corrective Action rules.  In that case, the depository institution would be required to submit a plan to restore its capital to the required level and, in order for that plan to be accepted by the regulators, the holding company for the depository institution would be required to guarantee the plan in an amount not to exceed 5% of the assets of the depository institution.  (The holding company cannot be required to provide such a guarantee, although the regulators may take other actions against a depository institution that does not submit a capital plan that includes such a guarantee.)  However, it is important to note that the Final Policy Statement does not contemplate that either the holding company or Covered Investors will be required to enter into agreements with the FDIC in which they are legally bound to maintain the capital of the depository institution at a particular level.

No Source of Strength Requirement
The Final Policy Statement does not contain a requirement that Covered Investors agree to serve as a “source of strength” to any failed depository institutions in which they invest—a vague but potentially unlimited obligation to support the depository institution.  Under current law, the source of strength obligation only applies to companies that acquire control of a depository institution.  The FDIC had proposed that such a requirement would generally apply to investors’ organizational structures, but eliminated it in recognition of the fact that private equity funds generally would be prohibited by their fund documents from making an investment on such terms.

Cross Support Liability
The Final Policy Statement requires Covered Investors holding an 80% or greater interest (as opposed to a majority interest, as contemplated in the proposed policy) in two or more depository institutions to pledge their interests in each of the institutions to cover any losses to the FDIC’s Deposit Insurance Fund as a result of a failure by either institution.  This provision, which allows the FDIC to seize shares pledged by Covered Investors in a healthy depository institution if the FDIC incurred costs assisting a commonly owned depository institution, differs from the statutory commonly controlled liability rule, which allows the FDIC to assess a healthy depository institution (not its owners) for the costs of assisting a commonly controlled depository institution.  In the Final Policy Statement the FDIC retains the discretion to waive the pledge requirement if it determines that exercising the pledge would not result in a decrease in the cost of the failed depository institution to the fund.  While the Final Policy Statement does not indicate when a waiver would be given, we would expect that a waiver would occur at the time bids are submitted so that a determination of whether or not a pledge will be made can be factored into affected bidders’ financial proposals.

Transactions with Affiliates
Under the Final Policy Statement, a depository institution acquired by Covered Investors is prohibited from making extensions of credit (as defined in Regulation W) to such investors, their investment funds, if any, and any affiliates (defined as any company in which a Covered Investor owns, directly or indirectly, 10% or more of the equity for a period of at least 30 days) of either.  Covered Investors will be expected to make regular reports to the depository institution identifying all of their affiliates.  Existing extensions of credit made by an insured depository institution prior to its acquisition are exempt from the prohibition.

Bank Secrecy
The FDIC will deem Covered Investors ineligible to own a direct or indirect interest in an insured depository institution if they employ ownership structures “utilizing entities that are domiciled in bank secrecy jurisdictions,” unless they are part of a group subject to comprehensive consolidated supervision, as recognized by the Federal Reserve Board, and satisfy certain other requirements.  Private equity investors are not subject to comprehensive consolidated supervision and the definition of “secrecy law jurisdiction” in the Policy Statement is extremely broad.  Under the Final Policy Statement, a secrecy law jurisdiction would include: a country that applies a bank secrecy law that limits U.S. bank regulators from determining compliance with U.S. laws or prevents them from obtaining information on the competence, experience and financial condition of applicants and related parties, lacks authorization for exchange of information with U.S. regulatory authorities, does not provide for a minimum standard of transparency for financial activities, or permits off shore companies to operate shell companies without substantial activities within the host country.

The Final Policy Statement does not list or provide examples of countries that would satisfy the FDIC’s definition and this restriction would appear to implicate a range of tax and other issues for potential bidders that frequently use common off-shore jurisdictions at some level of their ownership structures.

Minimum Term of Ownership
Unless the FDIC gives its prior approval, Covered Investors that have acquired a failed depository institution are restricted from selling or otherwise transferring their securities for at least three years.  The Final Policy Statement provides that the FDIC will not unreasonably withhold its consent to a sale or transfer to an affiliate if the affiliate also agrees to be subject to the same conditions applicable to the selling or transferring investor under the Final Policy Statement.  The Final Policy Statement also provides that the holding period requirement does not apply to open-end mutual funds registered under the Investment Company Act of 1940 that issue redeemable securities capable of being redeemed by investors on demand.

Prohibited Ownership Structures
The Final Policy Statement also considers “complex and functionally opaque ownership structures” to be ineligible bidders for failed depository institutions.  Such structures exist where “beneficial ownership is difficult to ascertain with certainty, the responsible parties for making decisions are not clearly identified, and ownership and control are separated.”  The Final Policy Statement describes structures of this type as typified by “organizational arrangements involving a single private equity fund that seeks to acquire ownership of a depository institution through creation of multiple investment vehicles, funded and apparently controlled by the parent fund.”  Thus, the prohibition appears to apply to so-called “silo” structures in which private capital sponsors form new funds to make investments in failed depository institutions without causing their existing funds to be subject to regulation applicable to depository institution holding companies.  Although reasonable persons may differ on the virtues of “silo” structures, the Final Policy Statement is nonetheless an improvement over the proposed policy in that the Final Policy Statement more clearly describes what structures would raise objections from the FDIC.

Special Owner Bid Limitation
A 10 percent or greater shareholder of a depository institution that fails would not be permitted to bid for the assets or deposits of that institution.

Required Disclosures
Covered Investors in a failed depository institution are expected to provide the FDIC with information about themselves and all entities in the ownership chain, including the size of their funds, diversification, return profile, marketing documents, management team and the business model, as well as other information that the FDIC may request.  Any such information would be submitted on a confidential basis.

As investors and corporations try to emerge from the global credit crisis, the PE funds have moved from the fund-raising stage to the investing stage. And experts say there are more than enough deals to go around.  “It is a phenomenal time to invest,” says Marc Lasry, co-founder of New York City-based Avenue Capital, which manages more than $17 billion, 90 percent of it in private equity or lock-up vehicles. “There are a lot of distressed opportunities.”

Of course, it is not surprising that fund-raising tailed off late last year as the credit crisis intensified. This year, just seven funds raised a mere $1.1 billion, according to Preqin. However, PitchBook Data, a Seattle-based private equity research firm, recently noted that Oak Hill Capital is seeking $1 billion to invest in distressed debt. It added that the new fund, OHA Strategic Credit Fund, would continue the firm’s strategy of investing in nonperforming and distressed loans, high yield bonds and other securities.

Most of the investors in the distressed private equity funds are institutions and endowments, which, like most other investors saw the value of their portfolios deteriorate last year. “Institutional investors don’t have money,” says Kelly DePonte, partner at Probitas Partners, a placement agent for alternative investments. “All areas are down about 60 percent from where they were in 2008.”

As global economies recover in general and the credit environment begins to ease somewhat, experts expect these private equity investors to return to the market later in the year as they become less concerned about liquidity. And they will especially look to those funds that specialize in the securities of, or the acquisition of, troubled companies. In fact, at least 54 funds are currently on the road seeking to raise as much as $52 billion, according to Preqin. “I think [fund raising] is likely to go back up to levels we saw a couple of years ago,” says Tim Friedman, head of publications and marketing at Preqin.

“It is a phenomenal time to invest. There are a lot of distressed opportunities.” -Marc Lasry, co-founder of Avenue Capital

Why is Friedman so confident? He cites the historic track record for distressed private equity funds. Investors are mindful that distressed PE funds with vintages from 1999 through 2004 racked up double-digit returns, including 30 percent for the 2002 funds. That year’s first-quartile performers generated, 46 percent returns on average. (There is no performance data for funds created after 2006.) Since many distressed asset funds operate on a  J-curve, with most deals in private equity losing value initially, Preqin won’t typically start looking at performance until around three years into the life of the fund at the earliest.

Indeed, in a recent survey of institutional investors, Preqin found that about one-third believe small- to mid-market buyout funds are particularly appealing, followed by 31 percent, which singled out distressed private equity, including distressed debt, turnaround, and other special situations funds.

DePonte, however, says it typically takes five to six months to get to the first close and 12 to 18 months in total. These days, funds are looking at the longer end of that range and are raising less than they had hoped. In fact, he says many funds that planned 2009 fund raising are pushing back the timetable to 2010.

While investors have taken a pause, the PE fund managers haven’t. “All distressed funds are incredibly active,” says Jonathan Henes, a partner in the restructuring group at the law firm Kirkland & Ellis LLP. He says earlier this year managers were mostly loading up on senior secured debt as asset values were falling and companies were increasingly filing for bankruptcy. “That was the in-the-money security,” he says. Now, as asset values have moved up, distressed funds are looking at high-yield bonds.

PE managers are not so much looking at specific industries for value. Rather, they are looking for what they deem to be an inherently good company with a bad balance sheet that they can fix and then grow in value. Then they are going after the capital structure they believe could give them control of the company. “The goal is to find the fulcrum—the instrument that converts to equity,” Henes stresses. “The downside is we get par and the upside is we get substantially more than par by converting a portion of our bank debt to equity,” Lasry says.

In the past, Lasry says the fulcrum was in the unsecured or subordinated debt. However, these days he is finding it in bank debt because companies are still having trouble refinancing their debt. So, he is buying bank debt and being paid off at par or getting equity, which enables him to wind up owning the company.

Currently, he sits on the creditor’s committee of four companies, including: Six Flags, which runs amusement parks; casino operator Trump International; Spectrum Brands, a global consumer products company; and Ion Media Networks, a network television broadcasting company that owns and operates 63 broadcast television stations.

Altogether, more than $5 billion of completed and announced bankruptcy acquisitions have occurred since July 2008, according to Adley Bowden, managing editor of PitchBook. While 2008 saw just $875 million of completed bankruptcy acquisitions, there have already been $4 billion worth so far in 2009—a 350 percent increase.

There is also another $750 million of pending bankruptcy acquisitions. “There are no other investors right now providing nearly this amount of capital to these distressed and bankrupt companies,” says Bowden. “I believe as the economy continues to stabilize the number will only increase.”

And Lasry reasons there are more than enough deals to go around given the amount of capital recently raised in this space. For example, the American Bankruptcy Institute (ABI) shows that the number of businesses that filed for bankruptcy in the first half of this year totaled 30,333, a 64 percent increase over the previous year’s total of 18,456. Chapter 11 business reorganizations increased 113 percent to 7,396 during the first half of 2009 from 3,470 in the same period of 2008. Chapter 7 business liquidations increased to 20,375 in the first half of 2009, a 57 percent increase over the 13,002 business Chapter 7 filings during the same period in 2008.

Meanwhile, the number of companies with deteriorating financials has surged in the past year. So far this year, at least 205 global corporate issuers have defaulted—that’s four times the 54 defaults reported at this time in 2008, according to Standard & Poor’s. The number of bankruptcy filings has also surged to 53 issuers so far this year, exceeding the full-year 2008 total of 49 bankruptcy-related defaults. More than half of the defaulters this year either had or continue to have private equity involvement, S&P points out.

Meanwhile, the number of fallen angels—entities that moved to speculative-grade territory—has topped 62 affecting rated debt worth nearly $222 billion, according to S&P. In all 0f 2008, the fallen angel total came in at $226.42 billion. Says Lasry: “The amount of supply dwarfs the amount of demand.”

The SEC’s proposal, if adopted, would forbid private equity funds from using third-party placement agent services to solicit investment dollars from state and municipal pension plans, thus bringing to a halt the widely practiced use of such agents. The proposal would also block political contributions from parties seeking investments from those government entities, a shadowy, but not altogether uncommon, practice among private equity firms. “There are just a few small players in the country that have the political connections to do this,” says Charles Eaton of placement house C.P. Eaton Partners. “If the SEC bans political contributions, we would be happy to see these two-bit finders go away.”

The use of placement agents has become commonplace in private equity, with 54 percent of PE firms using their services in 2008, up from just 40 percent two years previously. The agents, who deduct their fees from the firms themselves, are responsible for a large portion of the investment that has flowed through private equity in recent years—illiquid “alternative assets,” which include PE deals, composed about 18 percent of U.S. pension fund assets at the end of last year.

The SEC’s major objective in its controversial proposal is to staunch the prevalence of “pay to play” tactics that have marred the PE landscape in recent years, with the ban on placement agents a largely secondary, but no less crucial, aspect of the proposal. “Pay to play” refers to the use of political donations (or, as in some notable cases, even more blatant financial offerings) on the part of third-party solicitors to curry the favor and investment dollars of state and municipal pension funds, which, nationally, hold $2.2 trillion in assets.

“Private equity is already laying lifeless as it is. If the proposal goes through, it’s going to make it even tougher for PE funds to raise money from governmental entities.”  -Paul Denning, private equity firm Denning & Co.

The SEC reasons that by stopping third-party placement agents, as well as explicitly forbidding political contributions within the investment advisory sector, there will be less of an opportunity for the kind of shady politically linked financial deals that have as late been an embarrassment for the private equity industry. As the SEC announced its proposal, “Investment advisers that seek to influence the award of advisory contracts by public entities, by making or soliciting political contributions to those officials who are in a position to influence the awards, compromise their fiduciary obligations.”

The most infamous breach of such obligations between funds and the solicitors that seek to win their business is that which was uncovered earlier this year in relation to the New York state pension fund. A pair of aides to former New York Comptroller Alan Hevesi are alleged to have funneled millions—including $30 million straight to the pocket of Hevesi consultant Hank Morris—in fees from companies that won pension investment from the state fund. “Morris was essentially masquerading as a placement agent,” says Paul Denning of private equity firm Denning & Co., who notes that Morris’s standards of professional conduct were much lower than industry standard. “Our hit rate is like 7 or 8 percent, whereas Morris’ guys were at 100 percent. There were no standards.”

The SEC’s reasoning in its efforts to stomp out pay to play is multifaceted, and largely supported by the private equity community. The effects of pay to play are harmful to pension funds and independent brokers alike—and are more a matter than mere reputation. Qualified advisors and the advisory community at large are hurt when certain parties can simply buy the business of those funds whose investment dollars they seek, leading funds to invest in companies that may not be an ideal match. The pension plans themselves will pay higher fees to compensate for the corrupt advisor’s expenditures—and the advisor has a greater ability to squeeze other monetary rewards out of the pension fund. And, of course, the actual beneficiaries of the pension fund—state and municipal workers—aren’t happy to know that their retirement dollars were pushed in inappropriate investments, especially if these investments underperform.

“The important thing from the funds’ point of view is that they will no longer see many small- and medium-sized fund managers that placement agents do a lot of work for.”  -Charles Eaton, placement house C.P. Eaton Partners.

“The ultimate goal of the SEC’s proposal is to protect public funds from abuse,” says Richard Marshall, counsel at Ropes & Gray. “But the question is whether the approach that they’re taking with this proposal will help public plans or hurt them.” Indeed, the critics of the SEC proposal have come out in droves during the document’s 60-day comment period, with many claiming that such changes will damage an already-fragile private equity climate. “Private equity is already laying lifeless as it is,” says Denning. “If the proposal goes through, it’s going to make it even tougher for PE funds to raise money from governmental entities. It’s also going to hurt those newer funds that don’t have the access to capital that the big guys have.”

Many critics have pointed out that the banning of placement agents is going to have a disparate effect across the PE field, with smaller firms bearing the brunt of the damage. Because the proposal allows a loophole—placement agents are allowed if they have an exclusive relationship with the capital-raising firm—it will be those smaller firms, who cannot afford in-house fundraisers and must outsource, that will suffer. “The rule has an asymmetry,” says Marshall. “And the question is, does this give an unfair advantage to the largest entities?” There is also the fact that placement agents do indeed offer a valuable service to smaller private equity or venture capital groups that don’t have the necessary professional contacts to get an audience with large pension funds, all of which are constantly besieged by deal proposals. “The important thing from the funds’ point of view,” says Eaton, who has spurred a Washington lobbyist group to attempt to stymie the bill, “is that they will no longer see many small- and medium-sized fund managers that placement agents do a lot of work for.”

But the regulatory proposal, however unpopular, isn’t without precedent. A similar pitch, made under Arthur Levitt’s SEC in 1999, would have placed a two-year ban from accepting pension fund fees on investment firms that used third-party placement agents. The 1999 proposal died, but, ten years later, numerous pay to play scandals have forced regulators to consider the harsher measures of its latest proposal. Though the egregious abuses allegedly committed in New York were the most highly publicized, they were by no means singular, with similar cases having been brought to trial in New Mexico, Connecticut, Illinois, Ohio, Florida, Alabama, North Carolina, and other states. The sheer volume of wrongdoing mandates some degree of policy change, says Marshall. “There have been a number of speeches that have been given that have identified this issue as a priority for the SEC. Clearly, the SEC will adopt something.” What remains to be seen—and what depends highly on the influence exerted by private equity groups and their attendant lobbyists—is just what kind of balance can be struck between fair play and a balanced, self-correcting market. The risk of overreaction, says Eaton, could wreak havoc within the industry: “We’re praising the SEC for coming to grips with pay to play, but we’re saying that if you go so far to ban the entire industry, you’re going to have a lot of unintended consequences.”

That’s welcome news for private-equity firms. While the IPO window may be just inching open, the prospects look enticing enough that a number of companies are taking the opportunity to move into the public markets, including a few firms held in private equity portfolios. Over the past several months, Dollar General, Rosetta Stone, and Avago Technologies, among other PE-backed ventures, have completed initial public offerings.

Between July 2008 and June 2009, only 58 companies filed to go public with the Securities and Exchange Commission, according to information from Renaissance Capital, a Greenwich, Conn.-based IPO research firm. That compares with 108 in just the first half of 2008, and 21 in July and August of this year.

To be sure, even with this increase, the current rate at which companies are going public doesn’t compare to the headier pace of IPOs prior to 2008. In 2006, for instance, 293 companies filed to go public. That number jumped to 373 in 2007, according to Renaissance.

“The concern with IPOs has always been that you’re really at the mercy of the overall market.”  -Michael Laveman, partner, Eisner LLP

“The IPO market is intensely cyclical,” says Josh Lerner, professor of investment banking at Harvard Business School, Boston, and private equity-backed offerings aren’t immune to larger market forces. If the IPO market remains open, it’s likely that more private equity firms will take advantage of public offerings as an exit strategy for some of their portfolio companies, he adds.

Does this represent a shift in strategy for private equity firms? After all, most private equity investors prefer to sell their portfolio holdings to a strategic buyer, rather than take their chances on a public offering. “The concern with IPOs has always been that you’re really at the mercy of the overall market,” says Michael Laveman, partner with accounting firm Eisner LLP. “Privately negotiating with a strategic buyer offers sellers a greater level of control.”

In fact, private equity investors have targeted IPOs as exit strategies for only about 13 percent of their investments, according to an analysis of some 21,000 private equity transactions between 1970 and 2007 by the World Economic Forum, “The Globalization Impact of Private Equity Report 2008.” Selling to another company was the most common exit mechanism, accounting for 39 percent of exits.

At the moment however, finding buyers has become more difficult, says Jeremy Kloubec, senior client partner for private equity at Infosys Technologies Ltd., a business solutions provider. Private equity mergers and acquisitions in the U.S. this year totaled $13.6 billion through July, or less than one-fourth the amount for the same period last year, according to Thomson Reuters.

The drop-off in deals is due to a mismatch between sellers’ and buyers’ expectations, Kloubec says. In addition, potential buyers aren’t able to use as much debt to carry out acquisitions, which means their purchases are going to be smaller.

The current jump in PE-backed IPOs also reflects the skill of private equity fund managers in timing the market, says Steven D. Dolvin, Ph.D., and associate professor of finance at Butler University in Indianapolis. “They’re very good at coming to market at the best time for a particular sector.”

“When the window is closed, you build up a backlog, and have to release it at some point.”  -Jeremy Kloubec, senior client partner for private equity, Infosys Technologies Ltd.

A case in point is Dollar General. On August 20, the operator of 8,600 discount stores filed form S-1 with the Securities and Exchange Commission to go public. Dollar General is owned by Buck Holdings, a limited partnership owned by Kohlberg Kravis Roberts & Co., L.P.  The proposed offering totals $750 million. “In the case of Dollar General, you can’t be better primed for a down economy,” Kloubec says.

Even as private equity investors decide it’s a good time to wade into public waters, they can’t guarantee that investors will be receptive. Some are going to be concerned that at least a few of the firms are coming to market simply because the fund managers want to get their money out while they can. If that’s the case, they may be bringing companies public that should remain private a while longer. “When the window is closed, you build up a backlog, and have to release it at some point,” Kloubec says.

Others express more confidence that the firms coming to market will succeed. For starters, IPOs really aren’t the most effective way for fund managers to cash out, says Scott Perricelli, partner with private equity group LLR Partners in Philadelphia. Even once an initial public offering is completed, the owners can’t sell a significant portion of their holdings until the lockup period expires. Instead, an IPO really is a way of valuing a business and providing it with capital for growth.

Moreover, private equity firms want to avoid a repeat of the kind of experience that Rosetta Stone, Inc., is having. The language software company went public in April, and got off to a great start, with its shares rising from about $18 to $25 on the first day of trading. For a time, it traded at over $30.

Things aren’t quite as rosy now, however. In August, after the company cut its third quarter forecast, the stock fell to about $21 and management pulled a planned secondary offering. As of late August, Rosetta’s stock was trading at about $22.

The challenge facing VC at the moment is twofold: excess capital commitments and investments have clogged the market; and extremely limited returns on this capital have punished investors for their patience. Since 2000, there has been approximately $250 billion in committed capital circulating through the market, with around $25 billion to $30 billion invested during each year in the past five years. These figures dwarf the ten-year period leading up to the dot-com explosion, when total capital commitments hovered around $50 billion, with annual investments not breaking $20 billion until 1998.

The inflated investment figures have only led to trouble, says Steve Dow, a general partner at Sevin Rosen Funds: “Venture capital is a lot like musical chairs; there’s only room for so many people to sit, no matter how many people are playing.” Indeed, the number of participants in the game—all $250 billion worth—has remained relatively stable since 2001, while the number of winners has dramatically decreased—five-year returns have rotated around the zero percent axis since 2004. When compared to the years leading up to the dot-com revolution—during which investment figures were low, but returns were high—the last five years have marked a remarkable depression from VC’s former profitability. “Before the dot-com bubble, the ratio of winners to losers was such that the winners were making much more than the losers lost,” says Dow. “Now, the sector isn’t so consistent.”

“Venture capital is a lot like musical chairs; there’s only room for so many people to sit, no matter how many people are playing.” -Steve Dow, general partner, Sevin Rosen Funds.

The poor returns for VC stem from a remarkably poor exit market, during which IPOs and M&A transactions have netted very little for the industry’s investors, with the average exits steadily decreasing. “We haven’t had a normal IPO market in a while,” explains Paul Kedrosky, senior fellow at the Ewing Marion Kauffman Foundation, which released a report in June pointing to the need for a “right-sizing” of the VC industry. “Without a solid IPO market, returns in venture are horrible; the exits have been terrible in the public markets and the private markets can’t compensate.” “You’re essentially taking one of two exit routes and shutting it down,” says Matt McCall, co-founder and managing director at Draper Fisher Jurvetson Portage Venture Partners. “You lose half of your ability for liquidity.” While IPO market conditions look to be improving, it may be a case of too little too late for many venture capitalists.

Compounding the weak state of IPOs are tight credit conditions, which have made it more difficult for venture funds to raise money. “VC investors are now worried about the solvency of their backers; they don’t want to make capital calls and find that their investors are backing out,” says Kedrosky. “So, rather than making investments, the VCs are just holding off on the whole thing.”

Clearly, VC is in a perilous state. A poll administered by executive search firm Polachi found that 53 percent of respondents—the majority of whom were partners or managing partners of their VC funds—agreed that the industry as a whole was “broken.” The same poll found that 92.7 percent of these executives said they were concerned about the weak state of exit markets. The consensus view on how to fix VC is that the industry must undergo a real downsizing, with committed capital and new investments both declining to a manageable level.

According to “Right-Sizing the U.S. Venture Capital Industry,” Kedrosky’s report for the Kauffman Foundation, “whether it realizes it or wants to, the venture industry has to change…it seems inevitable that venture capital must shrink considerably.” Such a view is reinforced across the industry, with nearly all VC players gearing up for such a change. “Less funds will be raised,” predicts Dow. “And the venture firms, living off the fees from previous years, will slowly fade away as they fail to raise what they need.”

“Every venture capitalist feels that this [adjustment] should happen, but of course no one wants to do it themselves.”  -Paul Kedrosky, senior fellow, Ewing Marion Kauffman Foundation

The general assumption across the industry is that VC needs to shrink to half its current size in order to remain viable. The Kauffman report concludes that VC investment will fall by half to around $12 billion annually, with committed capital under management dropping about $100 billion from its current level of about $250 billion. Draper Fisher’s McCall predicts that much of the fat will be cut from middle-sized funds of between $150 and $300 million, but that all funds will see their capital pools diminish.

The need for an adjustment in the size of the VC industry is not ignorable, says Kedrosky: “Every venture capitalist feels that this [adjustment] should happen, but of course no one wants to do it themselves.” But, as is the case with most shifts within the greater capitalistic structure, an exit from the VC sector may be inevitable for many. “The dot-com boom was a distortion,” says Kedrosky. “Before long, we’re going to see an inflation-adjusted version of the period just before that.” McCall predicts that stabilization of the industry could take between five and eight years, but that IPOs will likely reinvigorate themselves before then—which means that VC funds will have to maintain a disciplined investing approach if they are to make it to greener pastures. “The industry as a whole fluctuates between fear and greed; when there’s greed, in a strong IPO market, that’s when people start acting unwisely.”