With the Free-Wheeling Lending Days a Memory, Business Access to Capital Will Become Harder.

AT the end of 1999, as investors looked out from their comfortable chairs and surveyed the coming year, optimism filled the air. Brand-new companies were getting bushels of cash from venture capitalists. Slightly older businesses were preparing for initial public offerings that promised hefty market capitalizations from tech-loving investors. And banks were competing to lend money to all of the above, even if profits were a distant projection.

Things, to put it mildly, have changed.

Now, heading into 2001, watchwords like potential have been replaced by ones like profits. The turmoil in the stock market that characterized 2000 was felt everywhere from the boardrooms of Fortune 500 companies to the garages of would-be entrepreneurs. Internet content companies are dropping like flies, burning those who invested in them. Banks are reporting higher loan losses, the result of speculative loans often related to the tech sector. Venture capitalists are cutting off funding to previously promising start-ups. And investment bankers are finding it harder to take companies public.

As a result, access to capital for Los Angeles businesses is going to be harder to find in the coming year, making all sorts of financing deals problematic.

"All this affects how people think," said Rick Hartnack, vice-chairman of Union Bank of California. "Availability of debt capital is clearly going to be restricted in areas where financial institutions have been taking loan losses. It's going to be more difficult for entrepreneurs to get leveraged buyouts, more difficult for equity sponsors to do roll-ups of industries and/or acquisitions. This is absolutely as predictable as the sun coming up in the morning."

Nowhere has the recent surge in capital funding been more noticeable than in the venture capital community. The amount of venture money that coursed through L.A. businesses rocketed from less than $30 million in 1993 to almost $2 billion in the first nine months of 2000 alone. The returns that VC firms got from the IPOs or acquisitions of their fledgling companies had institutional investors elbowing each other out of the way to get in on the action.

But the sharp drop in the public markets has led to an equally if not sharper drop in the valuations of start-up companies. And far from taking on more prospects, experienced venture capitalists are feeling like a stingy St. Nick these days, making a list of their portfolio and checking it twice to see which of their existing companies will continue to get financial support.

"When it's tough to raise money in the market, firms absolutely need to make sure their existing companies get financing if necessary," said Brad Jones, managing partner at Redpoint Ventures. "But you can't make the mistake of putting more money in things that aren't going to work. And if you're not going to fund it, you have to sell it, wrap it up, do whatever you have to and get out. If it's not going to make it, it's not going to make it."

Redpoint raised $1.25 billion for its latest fund, but Jones says its investors are putting no pressure on him to put that money to work.

"We're patient. If it takes longer to put the money to work, that's fine. Our investors are probably relieved that we're not throwing money around."

Nor will entrepreneurs find angel investors more liberal with their purse strings. These groups, made up of a combination of professional and non-professional investors willing to put some of their disposable income on very early stage companies are being just as cautious. The Tech Coast Angels, a group with members in L.A., Orange County and San Diego, made 10 investments in 2000, but only four since April. That's from more than 1,100 business plans thrown their way.

"And we're turning away more wannabes even sooner now," said John Morris, president of TCA's L.A. chapter and a managing partner in the L.A. office of investment house Gerard Klauer Mattison. "A lot of entrepreneurs are finding that even with a good idea there's no way they're getting funding."

In many ways, it comes down to investor confidence, and if last week's performance on Wall Street is any indication, that confidence is shaky. As of last Thursday, a day in which stocks generally rose, the Dow Jones industrial index had dropped nine percent on year, while the technology-weighted Nasdaq index had tanked more than 40 percent.

With economic indicators in general pointing to a slowing economy, many investors are looking to U.S. Federal Reserve Board Chairman Alan Greenspan to ease interest rates. Some criticized the Fed's decision not to do so at its Open Market Committee meeting last week, but said an easing was likely soon, maybe even before the next scheduled meeting in January.

"It's a possibility, though not a probability that the Fed will move before (January)," said Todd Morgan, chairman of Bel Air Investment Advisors, a Century City-based fund manager catering to wealthy individuals. "I would encourage them do so, but whether they do or not is different."

Morgan would like the key federal funds rate, now at 6.5 percent, cut by 50 basis points as soon as possible, although he and other market watchers think that is unlikely. Greenspan is known for moving deliberately, and is likely to first cut rates by 25 points and then decide whether to move again.

"That's the way he operates," Morgan said.

What investment professionals hope is that an interest rate cut will set off a chain reaction of sorts, making it easier for businesses to borrow money from banks, buoying the stock market and creating opportunities for worthy companies to go public. This in turn would create more confidence on the part of venture capitalists and other investors to bet on companies, that may have terrific prospects but little else.

"It's going to be up to the Federal Reserve to unleash momentum," said Jeff Hirschkorn, an analyst at IPO Monitor in Los Angeles. "Right now things are in a seasonal lull, but in January it will be necessary to lower rates, which will prompt investment bankers and underwriters to start the road shows of companies looking to go public."

Even if rates do go down, however, Hirschkorn warns that the IPO market isn't going to immediately take off. Few of the prospective IPOs are raising a lot of excitement. The ones generating buzz are telecom and technology infrastructure companies, some of which are spin-offs of industry giants like San Diego's Qualcornm Inc.

But, in a sign that does not bode well for Los Angeles, none of them are local.

"There's really nothing in the L.A. area," Hirschkorn said.

That doesn't mean there won't be successful IPOs from Los Angeles, just that none have raised any interest so far, after a year in which the local IPO market wasn't particularly great. Twelve L.A. County companies went public in 2000, half of which have seen their stock price fall below the original offer price. Many of those were seen as prospective high-flyers, like ARTISTdirect Inc. and Luminent Inc.

On the other hand, half did see their share price rise, led by one that is hardly cutting edge: California Pizza Kitchen Inc. whose share price looked as if it would end the year more than 100 percent higher than its IPO price of $15. And that bodes well for investors looking for hidden gems.

"Did you expect California Pizza Kitchen to do that well?" Hirschkorn said. "Or Krispy Kreme Doughnuts? There's a diverse range of companies that investors look for. It's not all high-tech."

If interest rates do come down, companies who can't access the capital markets will find it easier to get money from banks. But burned by the tech wreck, banks are unlikely to loan to companies that aren't making money.

"Debt capital will be available for successful small businesses," Union Bank of California's Hartnack said. "Debt for higher risk companies, with more leverage and less cash flow is going to be harder to get."

What hasn't changed is that the money is out there. Even as banks report larger loan losses, their earnings are generally quite good, with more than enough cash on hand to cover their problems. Institutional investors have made a killing from venture funds over the last five years, and the funds themselves have more money than ever. But with Wall Street in turmoil over the state of the economy and in a holding pattern until rates come down, raising money is going to be a challenge for some. And investors will have to be patient in picking their bets.

"It is a whole different scenario than it was last year," Morgan said.