2002 In Review: The Playing Field Gets Leveled –

If venture capitalists were treated like rock stars during the Internet age, then 2002 was the year in which they got their very own “Behind the Music” special. First came the predictable downsizing of fortune, quickly followed by the unwelcome disclosure of some dirty little “performance” issues. The future, per usual, would be touted as a time for hard work and redemption.

From the beginning of 2002, venture capitalists seemed caught in a circular web of optimistic rhetoric. On the one hand, they had drawn confidence from the $22 billion in new fund commitments made by faithful limited partners since the start of 2000. On the other, they were ecstatic that the slumping public markets had helped drive down private company valuations. No one-save for some retiring GPs and media pundits-seemed too concerned that venture coffers were growing at the very same time that deal sizes were shrinking.

Until Jan. 22. That was the day Mohr, Davidow Ventures began calling trade journalists with the news that it had decided to downsize its $847 million seventh fund by 20%, or about $170 million. The move was the first-ever reduction of an active fund, and a marked departure for a shop that had once derided capital overhang critics for having “short-term-oriented views.”

While the Mohr, Davidow fund cut- and a subsequent 20%-25% fund reduction by Kleiner, Perkins, Caufield & Byers-were promoted from within, LPs began putting pressure on other large early-stage firms to enact similar measures. The growing din was partially a capital copout by jammed LPs, but venture firms on both coasts were inundated with the question, “Do you think you’re smarter than Kleiner Perkins?”

Unable to both answer affirmatively and maintain credibility, most early-stage firms with active funds worth more than $1 billion began to cut. Redpoint Ventures in March took 25% off its $1.25 billion second fund. Austin Ventures in May slashed its $1.5 billion eighth fund by 45%, quickly followed by Charles River Ventures stunning the market with a whopping 63% reduction of its $1.2 billion eleventh fund. Even Accel Partners, which at first tried getting LPs to agree to an ill-conceived fund split scheme, ultimately bowed to investor pressure by cutting 32% off both its $1.4 billion eighth fund and $200 million side fund.

By year-end, venture firms had used fund size reductions to take more than $5.6 billion off their books.

Not only were VCs losing money due to fund size cuts and other givebacks (like management fee reductions used to offset clawback liabilities), but struggling portfolio companies were also burning a hole through investor billfolds. Rather than just pumping additional cash into struggling businesses, many top investors were being faced with the prospect of having past investments wiped out completely via washout rounds.

Washouts were most commonly found in funding rounds for telecom companies, which were hard hit by customer unwillingness to purchase new technologies.

Caspian Networks Inc., for example, had been valued at $305 million before raising $85 million in 2000. At the time, the San Jose, Calif.-based company only had blueprints of its promised IP super-router. When it returned to the venture market last February with working boxes already sent out, the company was only able to manage a $75 million pre-money valuation on a $120 million deal.

In an even more desperate situation involved Mahi Networks Inc., which in June raised $75 million in Series D funding at a pre-money valuation of just $1 million. While the round served as a steal for new investors like St. Paul Venture Capital and Rho Ventures, it was a complete washout for firms like Benchmark Capital, Goldman Sachs and Sequoia Capital that had participated in a June 2000 Series B deal for Mahi at a pre-money mark of more than $180 million.

The only real exception to the valuation rout rule was on the life sciences side of the ledger. Investors in many of these deals realized that “customer” interest in novel pharmaceuticals or medical devices was prompted by more vital concerns than balance sheet economics. As such, companies like Eyetech Pharmaceuticals Inc. (drug discovery for macular degeneration) and Insulet Corp. (wireless insulin pumps for diabetics) managed to secure new investors without wiping out old ones.

Pushing the Envelope

With fortunes dwindling (in a relative sense), the venture capital industry entered autumn with its dirty performance laundry about to be aired for all to see.

At issue was not that VCs were doing poorly. Everyone with a lick of common sense already knew that. Instead, the question regarded exactly how badly VC funds were doing, and if public institution investments into the worst performing funds had been spurred by poor judgment or by political cronyism.

The first forum for this disclosure debate was Enron-scarred Texas, where a Houston Chronicle reporter named R.G. Ratcliffe had spent months insinuating that the University of Texas Investment Management Co. (UTIMCO) had invested in certain private equity funds as favors to friends of certain university regents. In order to confirm his suspicions, Ratcliffe and his newspaper had filed a Freedom of Information Act (FOIA) request, asking for fund-by-fund performance data on all funds in the UTIMCO private equity portfolio.

The problem, of course, was that UTIMCO had signed confidentiality agreements with almost all of its general partners. Even if it could discard the agreements, UTIMCO CEO Bob Boldt feared that GPs would eventually retaliate by preventing his group from investing in future fund offerings. In addition, he was concerned that reporters and laypeople would fail to appreciate the impropriety of judging some of UTIMCO’s youngest private equity funds on just a few years of activity.

After much hemming and hawing, plus a big push from then-Attorney General and current Senator John Conryn, the UTIMCO board voted on Sept. 18 to release internal rates of return (IRRs) and cash-in/cash-out data for approximately $1.8 billion worth of private equity fund investments. By October 4, the world at large was perusing performance data from such VC heavyweights as Austin Venture, Essex-Woodlands Health Ventures and Morgenthaler Ventures. While there was certainly some embarrassment associated with the release, no legitimate political misdoing was uncovered.

Following Suit

Following the UTIMCO release and FOIA requests submitted in such states as Illinois, Massachusetts and Wisconsin, the San Jose Mercury News filed suit against the California Public Employees’ Retirement System (CalPERS) for failing to disclose once-available private equity performance data. Not only was the newspaper requesting IRRs and cash-in/cash-out data, but a tentative hearing in San Francisco Superior Court revealed that plaintiff attorneys were also requesting fiscal data on underlying assets (i.e. portfolio companies).

Rather than acquiescing without a fight as UTIMCO had done, CalPERS defended its GPs by arguing that both fund and underlying asset information should be protected as trade secret. Judge James Robertson tentatively disagreed with the first part, but the issue was put to rest thanks to a December settlement in which performance data on all direct CalPERS fund investments was released, but underlying asset information remained private. Among the undisclosed underlying assets are nearly 100 venture capital funds CalPERS invested in via a third-party placement group named Grove Street Advisors, which counts former CalPERS investment officer Barry Gonder among its partners.

Epilogue

Populist political candidates on both sides of the aisle often remind potential voters that taxpayers, not lawmakers, ultimately control capital purse strings. While such earnest-sounding platitudes are usually dismissed following elections, many within the venture community seemed to take their version of it to heart in 2002.

In addition to day-to-day changes like increased due diligence and thinner management fee checks, 2002 was a year in which the LPs climbed up the power dynamic ladder and achieved equal footing with GPs. Almost every fund that LPs wanted altered was altered, and no GP sued an LP over disclosing confidential fund performance data.

While it’s easy for VCs to cast a negative light on such developments, 2002 may have helped set the stage for future success. Vocal and active LPs may initially come off as troublesome, but they ultimately are professional money managers devoted to seeing their funds produce strong returns. Moreover, the pressure placed on GPs in both the fund cut and disclosure situations has forced many venture firms to reexamine investment strategies and retool for a new and different economy.

What could possibly go wrong?

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