Jim Perry

The Capitalist

The last 18 months have produced one of the most dramatic reversals the venture capital market has ever undergone. For a time, it seemed that VCs would invest in any company with a PowerPoint presentation and a cool idea. Some niches saw so much money that the market, even in the best of times, could come nowhere near supporting everyone that received funding.

According to Jim Perry, managing director of Madison Dearborn Partners, many VCs — including his own — got caught up in a false sense of success.

“Valuations got way out of whack a year and a half ago when everyone thought that within six months you could go public even if you hadn't proven anything in terms of a business model,” says Perry. “We were all seduced into thinking you had something with value way above what you paid for it.”

Madison Dearborn was founded in 1993 with a fund that reached $550 million. The company, which has segments focusing on consumer, healthcare, financial services, basic industries and communications, has since raised three other funds, the latest closing in the first quarter at $4 billion. About one-third to one-half of that will be invested in communications.

Currently the firm has stakes in more than 40 communications companies. Included in the list are solid names such as 360networks, Allegiance Telecom and Nextel Communications.

Perry sits on the boards of many of the companies in which Madison Dearborn holds a stake and preaches conservative use of capital and attention to the fundamentals. “We learned the hard way to remember that capital is dear, spend it wisely,” he says.

According to Bob Taylor, president and CEO of Focal Communications, a competitive carrier in which Madison Dearborn invested $15 million in 1996, “the good news Madison Dearborn brings is patience. Run the business. Don't run Wall Street. If the business is good and you deliver on the numbers, you don't need to cus on anything else because Wall Street will come.”

Despite the solid advice, not all of Madison Dearborn's investments are succeeding. Though none have closed up shop, a few are “on the cusp” of going out of business, Perry says.

The questionable decisions Madison Dearborn made, he says, were a result of getting caught up in the times. “You see your competitor make an investment that within six months is worth 15 or 20 times what he paid for it — it spurs you to do irrational things.”

Any bad investments Madison Dearborn has made, however, have the potential to be balanced out in the current capital market where VCs are no longer competing to get stakes in companies. According to Perry, the economic slowdown and tighter capital markets mean that VCs will act more slowly and deliberately when making investment decisions.

With a new fund and a market that has slowed enough to allow for more deeply researched investments, Perry says there is significant opportunity for Madison Dearborn to make good investments in good companies.

“We look at our $4 billion as a great strategic advantage we have. We expect that five or 10 years from now we'll look back and say, ‘Wow, this was a great time to invest in good management teams and good ideas, to acquire solid assets.’”

The slowdown in the economy will, of course, affect what Perry looks for in potential investments.

During the economic downturn, he says, businesses are less likely to try a new service or product. Companies that provide basic services such as telephony and basic data are most likely to do well and therefore have an advantage with VCs.

With capital markets having tightened, VC's will also seek out companies that are looking for a final round of funding before becoming self-sustaining, Perry predicts. VCs will stay away from companies that assume more funding will be available down the road.

Not all the money Perry invests will be in new portfolio companies, of course. Some will go to companies in which Madison Dearborn has a stake. Many companies in Madison Dearborn's portfolio will continue to receive support, and others that have been unable to prove themselves will probably be cut off, he says.

Asset validation will play a role in some of these decisions, says Perry. If a company is unable to raise funds from another VC, then “we have to make a judgment about how much we believe in the business ourselves — believe it to the extent that we think the rest of the market doesn't see it and are prepared therefore to support it ourselves without outside validation. Those are the tough ones. It's easier in a healthy market.”

The market, however, probably won't be healthy again until “well into 2002,” says Perry, who also predicts repeats of the boom and bust cycle in the future.

“Any market that grows as quickly with as many new ideas and opportunities as this industry will go through swings. The pendulum is swinging as radically in the opposite direction as it swung a year and a half ago. We expect this to be more of a common feature for the next 10 or 15 years in the sector.”