Long before Clinton Harris became founder and managing partner of Grove Street Advisors, he spent five years as a naval officer on nuclear submarines. Now he’s in familiar territory again with a financial industry looking deep underwater. But Grove Street is a  “fund of funds” and operates in multiple asset classes and regions. From private equity to venture capital and buyout funds, Grove Street plays in diverse pools.

Mr. Harris recently spoke with Red Herring to share his perspective – he’s spent over twenty-five years in private equity – on the buyout boom and bust and the funding drought venture capital firms face. Excerpts from that conversation follow. 

RED HERRING: The venture industry is going to receive about half as much money as last year in the next year, which means there will be much less money for entrepreneurs. What is your take?

CLINTON HARRIS: The amount of money raised this is year is looking like it will be well below half of last year and maybe as low as a third. My guess is that venture capital will do a little better than buyouts, frankly, on a percent basis because I think people are really scared about buyouts. So my guess is that maybe if the buyout industry is down a third, the venture industry will be down a half. This is a tough year to forecast, but it is certainly the way it feels now.

RH: So there’s a lot of money unspent at the GP and LP levels, but it still doesn’t help at the entrepreneurial level because those people who want follow-on rounds are not finding capital at the same pace.

CH: On the GP level, there are funds that have a lot of dry powder. It’s just a function of when they raised money the last time. The ones that are in bad shape are the ones who ran out of money last year and have to raise money now. And the ones who are in good shape are the ones who raised money a year ago. So at the GP level I think the people who have money are being cautious because they know the fundraising market is ugly now and they know they are not going to have any liquidity for a while and so what they want to do is they don’t want to do anything stupid in the near term because they may have to stretch their money for a longer period of time than they had planned. Now I don’t think there is a lot of dry powder at the LP level.

The problem with the LPs is they are very over allocated as a group because private equity has really not come down in value nearly as much as public or other stuff, so just on asset allocation they are running into a problem and the ones that were really committed to putting lots of money into the buyout space are now wondering if that model is broken, so from their point of view, I think I would say, at the LP level, there is not a lot of dry powder. The LPs are simply deciding what they want to do going forward. And it’s a tricky thing because venture on the one hand hasn’t made money for ten years. Venture has not been attractive for almost ten years. And on the other hand the mega buyouts market is in the process of collapsing.

RH: What are some of the biggest problems in the mega buyout market right now?

CH: We’re not an investor, but in the mega buyouts -- since the beginning of 2005 and into 2006 and 2007 -- you’ll see a huge bubble in the 2005-2007 timeframe. The difference is the buyout bubble is probably on the order of eight to ten times as big as the venture bubble. The buyout bubble, we don’t know what the value is going to be. It’s still just coming down. The conventional wisdom, based on market comps, is that a lot of those companies don’t have a lot of equity today. If you estimate what you are going to get out of those companies using discounted cash flow, assuming that the debt is light, and that the companies are big enough to survive the downturn, then the prospects for getting your money back are probably reasonable.

RH: Where would you put the carnage at on the buyout market? What will be the market impact? What will be the mark to market?

CH: Well, if you want to use the mark to market, the value of a lot of these companies is really zero. But on the other hand, if you want to get really bored and go read the textbook on accounting, the market is really defined as “willing buyer, willing seller.” And if somebody goes in to buy a company with a plan to hold it for five years and, assuming the company is healthy enough to survive the economy, five years from now they’re going to pay off half their debt. You know that company is clearly worth more than zero. And you and I would much rather own the company than not own it. So you have this funny debate going on which is what is the true definition of market. My sense is that if you ask me if the economy is on it’s way back now -- and we don’t have a second shoe -- my guess is that the buyout portfolio will be, worst case, 75 cents on the dollar and best case breakeven. On the other hand if the other shoe drops and we have a slow recovery and a lot of the companies today look like they are not going to make it and begin to lose value, then you can be in the 50 cents to 75 cent on the dollar range. Here’s the big thing.

If you take a look at all the wonderful gains in the market, you know what the buyout industry did in 2002 and 2003 and 2004 – they did that on relatively small numbers compared with the amount of money that was put to work in 2005, 2006, and 2007. I saw a presentation put on yesterday by one our very smart fund managers that said if the buyout industry during the bubble gives you 75 cents on the dollar they will have effectively lost all the money they made in the wonderful time from 2002 to 2005. The industry over the entire period of time from 2002 forward will be break even. There’s a pattern in our industry of people doing very well on a small amount of capital and doing badly on a big amount of capital.

RH: Can you talk about returns on large amounts of capital versus smaller amounts?

CH: Scale can work against you. It’s a lot harder to make a 3x return by doubling the performance on a portfolio of multibillion-dollar companies than it is to make a 3x return by doubling the performance on a portfolio of $100 million companies.  

RH: How do you see the international operators in this market? Are they going to retract or take on different behavior in the international market versus the U.S. market?

CH: That’s a good question. You’ve got to step back and recognize that the underlying trend for the large international institutions is to get more and more comfortable with private equity. You know the U.S. institutions are further down the learning curve with private equity than the international ones are. If you think about it, the first ones to get into the asset class were the big endowments. And then the next group after that you saw U.S. corporations and then the public pension funds. On the international side, the sovereign wealth funds, some of them are just getting started with the asset class relatively recently. China is just coming in. There’s a rumor that Saudi Arabia is just coming in. Korea started just a few years ago. And so on. So there’s a pattern. You can graph over time what percent of the endowment of assets have gone into private equity. And you can draw on the same line what percent of the private pension funds are in private equity. And both lines have been going up. But the private pension funds are probably somewhere between 7 or 8 percent, and the endowments are probably closer to 20 percent. So if you did the same thing for Europe, you’d see a smaller percentage. And if you did Asia and the Middle East, you’d probably see a smaller percentage. So that’s the long-term underlying trend.

And the second piece that’s really important for the international institutions is that venture capital is going to be very difficult as an asset class because it’s primarily been a U.S. phenomenon. And the high-quality U.S. funds are primarily where it is impossible to gain access.  We’re one of the groups that try to offer that access. But what I’m saying is that it’s much harder for a group in the Middle East or a group in Asia to feel comfortable with a big asset allocation to venture. So what happens is this group tended to be more comfortable investing in the real big buyout funds. A because they recognize the names – many times the buyout firms were associated with the big banks – like Goldman Sachs – and they were buying big, stable, safe companies, many cases names they recognized, like Tiffany and Saks, and so on. These big buyout funds were often flying to Asia and the Middle East to raise money. Whereas Kleiner Perkins – and I’m just picking on them -- probably never got on a plane until this year to go overseas to raise money.  

RH: Are oversized funds and management fees prevailing to give fund managers gains instead of compensation based on performance?

CH: The complication is driven by fees and deal fees. There’s no question that in a firm where the average capital per partner is $500 million the firm is going to make a lot more money than the firm where the average capital per partner is $100 million. So what you have on the LP side is they are happy to put the money to work as long as they can get four- or five-hundred basis points better than what they can get in the public markets. And on the GP side, they are happy to take the money because that’s the way they get rich. Now the problem you have if you are trying to do substantially better than four- or five-hundred basis points in the asset class – which is what we are trying to do, and I would argue the endowments are trying to do – is that the longer you stay away from that long-term flood of money, the better. And if that money concentrates itself in the mega buyout funds, by definition we are going to do our best to stay with the small funds and the niche funds that are not over capitalized. And that is a long-term issue, not a short-term issue.

RH: How bad will it be for those venture capital firms trying to raise new money?

CH: A number of venture funds that might have been able to raise money in a normal environment will not be able to raise it now. Some of these guys will hang around until their ten-year funds end. But they are not going to have fresh capital; they’re not going to be out there competing for deals. People don’t go away until their management fees end. But they can stop being a competitor for new deals a lot earlier than that. I think you’re going to see a dramatic decline in the number of firms that really have enough powder out there to be major competitors. And I think that’s a really good thing for the industry.

It will help the industry overall. What drives our industry overall is the ratio of capital to deals. If the capital goes down that ratio gets better. The less money you have in the venture business the better people in the venture business will do. That’s why some of these really high quality venture firms that have no problem raising money are happy to say how bad the industry is, because the more money they can scare out of the asset class, the better.

RH:  How far is this going to retract?

CH: It’s a little bit of a function of what happens in the next year. It actually looked like the IPO window was going to be pretty wide open in 2008. If you go back to 2007 people were fairly optimistic about the exit window for 2008. The bankers were active. People were teeing up companies. There was a demand in the public markets for small growth companies. And all that became collateral damage.

This time around the tech industry was not the cause of the problem. And the window was shut for a set of reasons they had nothing to do with. The question hanging out there is whether the IPO window will begin to open back up. The optimistic outlook for venture is that the industry has bottomed. The optimistic scenario is that the IPO window opens up a little bit now and then in 2010, and you have a nice year in 2011 and you begin to see some nice returns in the venture industry, combined with the fact that the amount of fresh capital goes down because of the current shortage. The people that have access to those good funds continue to play and do well. The mega buyouts won’t be the best place.

RH: Do you have any predictions for what sectors or geographies will beat the averages?

CH: It’s pretty clear that if you look at the global venture capital industry, a couple of good European venture capital firms have emerged where five years ago people would argue there was no great institutional firm yet. It’s also pretty clear that the Chinese venture capital industry, at least to date, has done better on its small base than we’ve seen in the U.S.

RH: Will the U.S. continue to have the best infrastructure to invest capital?

CH: What the Chinese market has is this: They consider a recession at where you’re growing at 8 percent. The average private company is growing at 15 to 20 percent. You can do pretty well as a venture capitalist. A lot of people don’t realize that there are some things going on in China – there really is some world-class technology. The technology fits the Chinese market. It really might not work so well over here though. For example, if you take the mobile telephone sector. In the U.S, if you don’t essentially get AT&T and Verizon to use your phones and use your services, you know they create a huge barrier to entry. Whereas in China you’ve got hundreds of telecom companies. You know something new and innovative can be implemented much, much faster than it can be in the states.

RH: A centralized government can, no doubt, speed things up as well, right? 

CH: The funny thing is the centralized government is sort of letting the tech sector do its own thing. They seem to be paranoid about letting KKR or Goldman Sachs buy a dairy company, but they seem to be allowing the high-tech stuff to actually be relatively unregulated. We have probably more regulation on the mobile telephone industry than they do in China. All I’m saying is that if you look at the past five years, China has been pretty attractive. Europe has actually gained a little bit of share. One the buyouts side, I think the big question has not been geographically.

RH: If you had a hundred dollars you had to invest today, where would you invest it?

CH: The way we look at it is there are probably 20 to 30 funds globally that if you can invest in those funds those are going to be attractive investments.

RH: And if you can’t?

CH: You probably shouldn’t put your money in venture. Now the list – those 20 to 30 funds – isn’t fixed; one to two new additions come in every year. And one to two new ones drop out. Right now what we’re telling our clients is that we probably do 75 to 80 percent U.S.-North America and the rest is split half on China and Israel.

RH: Do you guys see Israel as a real opportunity?

CH: It’s been a real opportunity for a while. Today I think there are a couple funds in China and a couple funds in Israel. That’s the way I look at it.

RH: Who are some of the rising star funds in your view?

CH: In the buyout world, where we’re obviously focused on and think the rising stars will be, the guys that make their money by having a positive impact on the companies after they buy them. You don’t win on transaction skills and financial engineering, you win on finding ways to add value to companies post-investment. I think in the long run that is a lower risk way to make money and in the long run, particularly in the smaller funds, you can make a higher rate of return that way.

Red Herring’s Scott Martin and Lalee Sadighi contributed to this interview.