Can the Fund-Raising Rebound Be Sustained? –

For nearly two years, venture capitalists have predicted that late 2003 or early 2004 would herald the arrival of a fund-raising renaissance. Since we’re nearing the end of that time frame, it’s safe to say that they were right.

Forty-four venture firms raised just under $5.16 billion in the fourth quarter, in what was the largest quarterly take since 63 firms pulled in $5.84 billion during in the third quarter of 2001. The fourth quarter haul represented 2.5 times more capital than was raised between July and September of last year, and comprised more than half of all VC fund commitments in 2003. Moreover, several firms closed on new funds in the first quarter of this year and dozens more are expected to follow suit.

In the midst of all this activity, however, some VCs are beginning to wonder whether the rebound signals the start of a sustainable trend or whether it’s just a temporary bump forged by circumstance.

How Did We Get Here?

VC fund-raising volumes began their descent in the third quarter of 2000, but the exact bottom is more difficult to pinpoint. Many researchers cite the paltry $1.16 billion tally from Q1 2003, but a more legitimate nadir can be found during the second quarter of 2002.

It was during that time that market watchers began to differentiate between “gross” and “net” fund-raising. The former is the industry standard that lends credence to the Q1 2003 argument, since VC firms raised more than $1.19 billion during Q2 2002. The latter, however, incorporates fund-size reductions, which were all the rage two years ago among brand-name venture shops. Taking these permanently uncalled commitments into account, the tally for the second quarter of 2002 was actually a negative $976.1 million.

When VC firms began to reduce fund sizes, they also promised investors that new funds would be coming within two years. This next-generation of funds was supposed to feature smaller capitalizations, more streamlined partnerships and nascent portfolios unsullied by overvalued Internet investments. Some limited partners voiced concern that general partners were trying to time the market, but most accepted VC calendar-gazing as little more than the mathematics of dry powder.

A steady trickle of these next-gen funds began to appear early last year, including a $395 million vehicle from Sequoia Capital. By summer, dozens of shops were in the market, including New Enterprise Associates, ComVentures and Venrock Associates. By year-end, firms such as Charles River Ventures, Essex Woodlands Health Ventures and Kleiner, Perkins, Caufield & Byers all had joined the fray.

Equally important from a supply-and-demand perspective was that limited partners were buying. NEA held a $994.6 million first close on its way toward $1.1 billion, while Venrock scored a $500 million final close. Even relatively young firms like Kodiak Venture Partners and General Catalyst Partners were able to score $300 million apiece for new vehicles.

Still Hungry

LPs’ appetites remained strong in the New Year, with Technology Crossover Ventures closing on $900 million for its fifth fund in the first week of February. Likewise, Essex Woodlands Health Ventures is seeing very strong demand for its sixth fund, which has already held a first close on $268 million.

“The fund is almost mind-numbingly oversubscribed, and a number of existing LPs even wanted the hard cap to be $425 million instead of $400 million,” says a source familiar with the fund-raising. “But there already is a very big difference between the $280 million raised for Fund V and the $400 million for Fund VI.”

Dale Meyer, a partner with private equity fund placement agency Probitas Partners, says he has seen “a lot of pent-up demand” in the market. “There were some deals that we had been working hard and making progress on for a while, but all of a sudden we got a major rush in December,” he says.

Disclosure Blowback

The causes for this demand have been twofold. First, smaller fund sizes have meant reduced investment opportunities for LPs who participated in previous funds. The majority of returning LPs have been unable to secure ask prices, and some have been shut out all together. For example, Charles River Ventures opted to exclude all public LPs from its most recent fund. (For all the particulars, see late-breaking news story, page 16.)

CRV followed the lead of Sequoia, which last year booted two of its long-time public LPs from its 11th fund – the University of California and the University of Michigan. It’s too early to conclude whether the moves by Sequoia and CRV prove that most VCs raising new funds will reject public money because of concerns about public LPs making private equity returns public.

CRV raised $250 million for its 12th fund, after having originally raised $1.2 billion for its eleventh vehicle in 2000 (before later reducing the fund size to $450 million). Even though it didn’t allow public LPs and some new money into the new fund, the Waltham, Mass.-based firm still didn’t have enough capital to satisfy all interested parties.

“We had some LPs who are used to putting $15 million to $20 million into a fund, but the most we could give anyone was $12.5 million,” explains Bruce Sachs, a general partner at CRV.

The second factor driving buy-side demand is that while fund commitment sizes have shrunk, available LP capital has grown. The majority of this new money has come from overseas, with institutional investors in Europe and Asia finally opening up to alternative asset classes (see “Foreign Aid” cover story, June 2003 VCJ). In addition, many domestic LPs are playing with inflated checkbooks due to recent gains in the stock market. For example, the gains from the stock market have made a pension fund that was valued at $1 billion swell to a value of about $1.3 billion, and its 5% private equity allocation now allows for $15 million in additional investments – from $50 million to $65 million.

“You have a lot of inexperienced people raising a lot of money right now, which might mean that we’re creating another overhang situation,” says a New York-based LP who participates in several venture capital and buyout funds. “The older firms like NEA and Charles River and Sequoia are all raising smaller funds – which still may be too large – and then you have these emerging managers like Kodiak and General Catalyst who are for some reason raising larger funds. I think it’s being driven too much by LPs that are desperate to put money to work.”

A fellow institutional investor also expressed concern about the potential for another bubble, but he says that the real problem is continued investment in fund managers whose track records indicate a propensity for losing money. “A lot of LPs right now seem to be investing in hope over reality, which is a bandwagon strategy rather than a smart strategy,” he says. “They’re treating private equity as if it were a cosmetic industry, which it is not.”

What, Me Worry?

Despite the misgivings of several limited partners, there is no reason to expect any fund-raising slowdown over the next two or three quarters. Thomson Venture Economics (publisher of VCJ), which released a Q4 fund-raising report last month in conjunction with the National Venture Capital Association, is currently tracking at least 50 VC firms that either are in the market now or will be soon. Among the firms expected to come out before year-end are Benchmark Capital, Battery Ventures, InterWest Partners, Oak Investment Partners, Onset Ventures and Sprout Healthcare Ventures. Some of those firms are even coming out earlier than expected, in the hopes of striking while the LP iron is hot.

“I feel that we have a blue chip base that continues to tell us that they want us to save space for them in our next fund,” says Stephen Holmes, an administrative partner with Menlo Park, Calif.-based InterWest Partners. “I’m not too worried about raising the next fund.”

The real worry should begin in 2005, when the supply and demand curves will likely be out of sync. Limited partners will still be looking to put lots of money to work – especially ones from overseas – but most large VC firms will have already raised funds that will take them through at least 2006 or 2007. What’s left will be relatively small emerging fund managers, many of which are being launched by veteran investors who left their old firms during their recent fund-raising drives.

Rob Coneybeer, for example, was one of three IT-focused partners to leave NEA, and now is in the midst of launching a new fund. Ditto for Terry Garnett, formerly of Venrock Associates and David Helfrich, formerly of ComVentures. Their new firm – a middle-market technology buyout shop named Garnett & Helfrich Capital – already has received around $90 million in cornerstone investments, and hopes to close on between $200 million and $250 million by year-end.

Such first-time vehicles will certainly keep LPs busy, but the offering memoranda won’t be large enough to maintain current fund-raising levels into next year. Some press reports will probably characterize these inevitable declines as a sign of market weakness, but that would be a mistake. Instead, they should be viewed for what they are: a reflection of the fact that VCs will have raised plenty of capital in Q4 2003 and 2004, and can get on with the business of making new investments.