Is the Private Equity Bubble About to Pop?

Maybe it's my paranoia.

But when I read over the weekend that venture investment in 2007 was up 11% to $29.4 billion -- a six-year high -- I got really nervous. Seven and eight years ago, VCs were pumping money into businesses that had no business being in business. Six years ago, they stopped, and a bloodbath ensued.

Forty-seven companies filed for bankruptcy from January to October 2001. Among the more high-profile failures that year was virtual grocer Webvan, whose shutdown came less than two years after a $375 million IPO.

Here's why this should matter to you: Even though 2007 was a banner year for public offerings and VC investments, financiers cut their private equity commitments by 8% from the third quarter to the fourth quarter. That's not necessarily a bad sign, but it isn't a good one, either.

It makes me wonder if any of 2007's top IPOs -- VMWare (NYSE: VMW), JA Solar (Nasdaq: JASO), MercadoLibre (Nasdaq: MELI), and Yingli Green Energy (NYSE: YGE), for example -- will be the next Magma Design Automation (Nasdaq: LAVA), which nearly doubled in the weeks following its November 2001 offering only to produce a seven-year total return of ... negative 35%.

Perhaps 2008 won't be a repeat of 2002. But many fear that the recession we saw back then is once again upon us, including, apparently, the Fed, which yesterday chopped key interest rates by 75 basis points.

As an investor in tech highfliers and recent IPOs such as SuccessFactors (Nasdaq: SFSF), I take all this as a warning. You should, too. Keep away from Mr. Market's flavor-of-the-month club. Focus instead on tech businesses that have:

1. Defensible competitive advantages.
2. Excellent management.
3. Limited, or inept, competition.

That's a strategy that works in any market.

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