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Venture Capital Dries Up

Inflows into Venture Capital Funds

Money raised by venture capital firms in the first quarter fell by 56% compared to last year. While this is not surprising given the performance of the stock market over the past two years, there are economic implications that rarely get discussed. The technology and telecom boom of the late 1990s spurred massive investments into venture capital firms as investors anxiously wanted to be on the ground floor of the next Pets.com. Opps - bad example.

Venture capital firms were overwhelmed by the amount of money being raised and ended up funding anyone with a written business plan. As we have now seen many of these business plans were unrealistic at best. This flood of money sparked a surge in technology start-ups that competed for office space and employees. As economics dictate, an increase in demand will cause prices to rise. As landlords increased rents, developers raced to build more buildings. Now the stock market has turned and the lure of venture capital returns has decreased. Not surprisingly this has had a negative effect on commercial real estate. Office vacancies have continued to rise and rents continue to fall.

The commercial real estate market is in its worse shape in years. The Bay area is suffering worse than most other areas of the country. Bay Area real estate is tied to the venture capitalists who invest in new companies. The market is so slow that landlords are offering some extraordinary incentives to brokers. A broker can be driving a new BMW X5, just by leasing 35,000 square feet for 10 years. Sign 75,000 square-feet and you will find yourself behind the wheel of a limited edition Z8. This incentive is for a building in the SoMa district of San Francisco, which is (was) dot-com central. The area now sports a vacancy rate of 49% according to Grubb & Ellis. According to BT Commercial Real Estate, the vacancy rates for the Bay Area increased to 19% during the first quarter, up from 16.6% in the fourth quarter and more than double the 7.6% vacancy rate of last year. Although Drew Arvay, managing partner with BT Commercial, thinks "We've seen the bottom of the economy. What I'm not sure about is whether we've seen the full purge of real estate." This is interesting since it shows commercial real estate will probably continue to languish even if the economy starts to recover. If the economy experiences a "double-dip," commercial real estate will dramatically be affected. Not only are vacancy rates soaring, but rents are plummeting. Average rents in the Bay Area have dropped 45% from last year. In San Mateo County, rents have dropped 60% from the peak in 2000. Philip Mahoney, executive vice president at Cornish & Carey Commercial, think the market will "chug along here for a while until the venture capital community starts to put in more money."

Denver is not much better. Commercial real estate in Denver continues to deteriorate, especially the Northwest corridor, which catered to technology and telecom companies. The Northwest corridor saw total space available reach almost 50% versus 43% at the end of the year. Downtown Denver vacancies, including sub-lease space available rose to 21% from 17% just three months ago.

Around the country, cities are experiencing rising vacancies rates. Not surprisingly, cities with higher concentrations of technology companies are facing tougher times. Boston (19.5% vacancy), Austin (21.8%), Seattle (19.9%), and Dallas (21%) were all breeding grounds for technology / telecom companies.

Compensation packages for technology workers were also bid up during the bubble, which is now deflating. In a poll conducted by trade magazine Information Week, the median compensation package for information technology managers fell 8% from a year earlier. Technology workers experienced a larger decline, 11%. Compensation levels for technology workers are back to levels of two years ago. Most of the cuts are due to lower bonuses and stock options. This type of compensation is usually much more discretionary and easier to change than base salaries. In fact, base salaries have actually increased from last year. The decline in bonuses is happening throughout the economy. This might prove to be detrimental for manufacturers of "big-boy toys" and affiliated retailers. It would be a safe assumption that companies such as Harley-Davidson and Best Buy have benefited from the large bonuses that have been paid out over the past several years.

As commercial real estate has suffered, the residential market has stayed noticeable buoyant. This has obviously helped households whose finances are stretched thin. While several economists have pointed to the recent decline of delinquent mortgages and low foreclosure rates as an indication that households are not overextended, it seems much more plausible that higher housing values have bailed out those with fiscal problems. There is little reason to miss a mortgage payment, when you can refinance and get enough cash back to pay the mortgage for the rest of the year. Additionally, mortgage companies have been more willing to work with those that find themselves in a temporary situation. Lenders have been allowing homeowners to miss payments and just add the missed amount to the end of the loan.

Another study found that consumers were able to maintain their spending spree even as the stock market fell due to raising housing values. In fact, a research paper co-authored by Robert Shiller, of Irrational Exuberance fame, found that an increase in housing prices has a higher wealth affect than an equal rise in stock prices. A $10,000 increase in housing increases spending by $62 compared to $20 to $30 for a similar increase in stocks.

Corporate stock options continue to have the spotlight. Greenspan commented, "The failure to expense stock option grants has introduced a significant distortion in reported earnings and one that has grown with the increasing prevalence of this form of compensation." Stock options are so prevalent that the Federal Reserve estimates that if stock options were expensed, corporate profit growth would have been 2.5 percentage points lower from 1995 to 2000.

A study by Edward Wolff, economist at New York University, shows that near-retirees have not saved enough to maintain their lifestyles. Experts generally recommend retirees be able to replace about 75% of their pre-retirement income. The study found 42% of those 47 to 64 years old don't have enough to replace half. During the 1980s, only 30% of near-retirees were in such straits. Additionally, 20% would fall below the poverty line. Surprisingly, the study found that as a group, only retirees with a net worth over $1 million saw their retirement wealth increase from 1983 to 1998.

401(k) plans took a shot to the chin this week. The state of Nebraska decided to scrap its defined contribution plan. Nebraska has let employees choose between a defined contribution or the more traditional defined benefit pension plan for over 30 years. During 2000, the state conducted a study to determine how well employees did managing their own money. Horrible. Employees averaged 6% to 7% over the 30 years, while the professionally managed pension fund chalked up average gains of 11%. Even more alarming is that state's employees were probably better financially educated than the average worker. The state even allowed time off to attend educational seminars. Florida employees are selecting whether or not they want to opt into a defined contribution plan. So far the 90% that have voted chose the traditional pension plan. If this trend continues, companies might have to scrap their defined contribution plans and start offering pension plans to entice workers.

Berkshire Hathaway held its shareholder meeting last weekend. As always Warren Buffet threw out a few words of wisdom. It appears Mr. Buffet does not like derivative accounting. Actually he said, "To say derivative accounting in America is in the sewer is an insult to sewage." He also said his re-insurer, General Re, was unwinding its derivatives unit.

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