Consolidation: Is VC Ripe for MA Frenzy? –

WASHINGTON, D.C. ? By the end of 2000, the number of active venture firms in the country had skyrocketed to 693 from 375 just a decade earlier, according to the National Venture Capital Association (NVCA). While the NVCA is still tabulating the number of active venture firms at the close of 2001, most industry insiders, including Mark Heesen, president of the NVCA, expect to see the number of firms fall.

The question confronting the industry is how this reduction will take place. Will the excess firms follow the traditional final exit path out of the VC business and quietly disappear from the marketplace? Or, will the venture world, like other financial services sectors, see a spate of mergers, as venture firms try to survive by coming together?

There are signs that at least some firms are looking for merger possibilities. ?We were approached by two firms that were looking to partner up. In another case we were approached by the limited partners who were looking to fire the GPs that were managing their money and wanted us to come in and manage the fund. We said no thank you,? said Milton Pappas, a general partner at EuclidSR Partners, which itself was created by the Feb. 2000 merger of VC firms Euclid Partners and S.R. One Ltd. Pappas declined to name the funds or LPs who approached EuclidSR. ?There is activity taking place,? he added.

Indeed, Milestone Venture Partners, a New York-based VC firm, has been approached by two small venture firms looking to merge in the last six months, said Edwin Goodman, a co-founder at Milestone. A Boston-based VC said his firm declined the merger advances of one other Boston-based fund and one Pennsylvania-based firm, both of which were $100 million to $150 million in size. ?They must think that they will not be able to raise their next fund, but we are happy as we are and don?t want to change investment strategy. Therefore, these mergers would not make sense right now,? he added.

The hurdles confronting two groups looking to merge are numerous, noted Joshua Lerner, a professor of business administration at Harvard Business School, who specializes in VC. ?It would be a challenge for two different groups to unify their routines and philosophies to present one approach, as well as personnel issues centering around the fair division of carried interest,? Lerner said, noting the biggest issue would likely be in the firm?s getting their limited partners approval to come together.

?It is a big question firms would have to deal with: would my LPs feel comfortable with these new partners? Do their LPs feel comfortable with me. That is hard to predict,? said Milestone?s Goodman. Firms would most likely not be allowed by their partnership agreements to merge their existing pools of capital and would probably have to raise a new fund, said Jay Rand, a partner at the New York office of law firm Morrison & Foerster. Euclid and S.R. One raised a new vehicle when they came together, EuclidSR?s Pappas added.

In order for a merger of venture firms to make sense, there has to be something linking the firms other than that they are both small, or both worried about their future, he said. ?In our case S.R. One was highly skilled and experienced in biopharma, while we [Euclid Partners] were stronger in the medical devices and information technology sectors, so this gave us a very good match,? he added. Moreover, the two firms were very comfortable with one another?s approach and philosophy, having co-invested together for 15 years prior to the merger, Pappas added. ?I think there are people out there who probably should merge together because they possess compatible skills,? he noted.

For the most part, however, the hurdles involved in putting together a merger of two troubled firms seem to out weigh the benefits derived from bringing together two entities whose main assets are people, a number marketplace insiders said. ?I don?t think VC is like a paper mill with groups merging and benefiting from economies of scale. Consolidation just doesn?t apply the same way here as it would in the automotive industry,? said one industry analyst.

?If a firm wanted to add people to their team from another firm that is troubled, why merge? They could just wait for the one fund to wind down and then just hire the people they wanted at that time,? added the NVCA?s Heesen.

?I think it is more likely that some firms will simply disappear over the next few years,? said Milestone?s Goodman, adding he thinks the number of venture firms in operation may decline by 15% to 20% over the next three to four years.