Cover Story: Market at Crossroads – VCs Navigate Uncertain Path to Profitability –

In the early days of 2000 – an across-the-board record breaker for venture capital – most VCs were too busy basking in their riches to even contemplate a downturn in the market, much less prepare for one. Fast-forward a year later, and the landscape changed dramatically: the Nasdaq nose-dived, valuations fell precipitously and capital disbursements greatly diminished. Most telling, fund performance plummeted, resulting in a 2001 first-quarter return that was the worst ever for a 12-month period.

VCs have been sifting through the portfolio wreckage ever since. “There will be some shockingly bad results ahead, I think, as a result of the crazy period coming to an end,” says Pitch Johnson, founder of Asset Management, and a VC since the early 1960s. “The smart VCs will stick with it. The scared ones will bail.”

VC Fund Raising by Quarter* ($ in millions)
Quarter No. of Funds Amount Raised
2Q 2001 66 $9.748.3
1Q 2001 96 15.106.9
Q4 2000 178 25.464.3
Q3 2000 122 27.357.6
Q2 2000 181 31.084.1
Q1 2000 158 22.411.7
Q4 1999 196 29.514.2
Q3 1999 106 11.762.2
Q2 1999 94 9.366.5
Q1 1999 88 9.579.3
*Figures do not include fund-of-funds, generalist private equity or other private equity funds.
Source: Venture Economics

As it has done after other boom-bust cycles, the venture industry will bounce back. But this time around, the industry has suffered perhaps its deepest wound yet, which makes some think the recovery period will take longer than initially expected.

The wreckage has already started to pile up. Since the beginning of the year, firms such as Monarch Capital Partners, Octane Capital Management, Geocapital Partners and Signia Ventures have either closed up shop or started winding down operations. Corporate venture funds have been hammered by the downturn as well, with many units discontinuing operations or severely cutting back. Those corporations with venture arms created in the 1990s are particularly vulnerable.

In fact, many VCs say the market has yet to see the tip of the iceberg. One experienced VC we spoke with estimates that 60% to 70% of first-time funds will be unable to raise a second vehicle. “Most of these funds will quietly dwindle down to one guy left at the firm and then fade into the woodwork,” quipped one Silicon Valley VC.

The editors of Venture Capital Journal talked to several VCs and VC-related professionals to get a reading on the pulse of the industry. What we found is that while the VC game is still being played on the same field, most of the rookies have been benched, the strike zone has gotten smaller, and many of the fans – in this case, the LPs – aren’t coming to the stadium.

Experience Matters

One of the best indicators of future investment activity are current fund-raising efforts. There is no middle ground when it comes to fund raising these days. You are either in or you’re out, and the demarcation line puts the established funds with solid track records in the starting lineup, while the newer, inexperienced funds with no track record have been pushed to the sidelines.

With many LPs scaling back on venture fund allocations, those firms already in trouble are practically blacklisted from new money, thus leaving them little choice but to exit the market. Similar to the dotcom deathwatch, the expectation is that VC funds will fall prey to the same bitter shakeout in the months to come.

Fund-raising figures from the second quarter further point to the beginnings of this trend. Of the 66 funds that raised about $9.7 billion, a mere $911 million was raised by 19 first-time funds. That compares with $2.9 billion raised by 32 first-time funds in the first quarter and $3.1 billion raised by 59 first-time funds in 2000’s second quarter, according to Venture Economics.

But even with an established track record, the fund-raising process is no walk in the park. “I don’t care how successful a track record a firm has, it’s still hard,” notes Erel Margalit, managing partner of Jerusalem Venture Partners (JVP), which is in the midst of raising its fourth and largest fund, Jerusalem Venture Partners IV, a $400 million-to-$500 million targeted vehicle expected to close later this month. The fund, which was launched last fall, held an interim close on $350 million in mid-July.

Second Quarter Breakdown
Venture Firm Age Percent of Fundraising
1 year 5.6%
2-5 years 29.6%
6-10 years 15.7%
11-36 years 49.1%
All Firms 100.0%
Source: Venture Economics

To help combat the rough environment, many firms have had to scale back their target expectations. ABS Capital Partners decided to close its most recent vehicle, ABS Capital Partners Fund IV, at $450 million – $50 million short of its original $500 million target. The fund held a first close in June 2000 and a final close in March of this year. Launched in March 2000, the vehicle was on the road just as the public markets started their first downturn. “We saw people saying we can’t make newer or larger commitments’ or we can only meet our existing commitments’,” says Donald Hebb, managing general partner. “$450 million worked as well for us as $500 million, so there was no sense to pound the pavement. We wanted to get back to investing in companies.”

In addition, Hebb says the firm encountered LPs who committed at one level and then came back and said they had to reduce their commitment level. There were even existing LPs who bowed out altogether.

ABS is not alone. Allegis Capital and BRM Capital also fell short of their intended targets, by a much greater margin. Allegis recently decided to exit the fund-raising trenches with just half of the commitments it originally sought for Media Technology Ventures IV (MTV IV), its fourth investment vehicle. MTV IV was originally scheduled to close in March 2002 with a target of $400 million; however, the firm has changed its plans and decided to hold a final close late last month with just over $200 million in commitments.

“The reality is that weather conditions deteriorated a bit out there earlier in the year,” said Barry Weinman, a managing director with Allegis, in an August interview with VCJ. “We stopped fund raising for a while, and focused back on our portfolio, which needed a little help. [Then] we latched ourselves to the mast and now have tacked into the wind and we’re getting ready for final close. The weather’s looking a little better, but it’s still a little rough out there, so we set our expectations slightly lower.”

In July, BRM Capital capped off its third investment vehicle at $253 million. The fund was originally targeted to close at $400 million, however the firm decided to stop the fund-raising process after a year in the market, largely because of the economic slowdown.

“It became an opportunity cost,” explains Mike Mers, a managing director with BRM. “[When we asked ourselves] did we want to continue spending time raising capital or working with portfolio companies, it became obvious to us that $253 million was a ton of capital, and we didn’t need any more. We also found that the asset class of private equity in many institutions has literally been shut down.”

One of the few debut funds that managed to close was the $1.08 billion Quadrangle Capital Partners LLC. While the fund is an exception to the rule, it also helps to prove that experience matters. Quadrangle Group LLC, a growth capital and buyout firm, closed its fund in late July. There’s no question the firm’s founding partners’ combined 40 years of experience in the private equity and communications markets helped the fund close. However, a source close to the firm noted that even with the partners’ track records, Quadrangle took every investor meeting it was offered.

LPs Have Their Say

LPs say they are slowing their investment pace, in part for being overallocated to the asset class because of declining public markets, and also because venture firms haven’t been aggressive enough in marking down portfolio company valuations. With LPs’ public equity holding having dropped in value, their private equity holdings have come to represent a larger portion of their portfolio, resulting in overallocations.

Add negative returns to the mix and LPs are even less inclined to make new investments, or even commit to existing relationships. In the 12-month period ending March 31, VC firms posted their first-ever 12-month negative returns of 6.7%, according to Venture Economics. The pain of that decline is more acute when considering the high returns of 1999 and early 2000.

VC Disbursement by Quarter ($ in millions)
Quarter No. of Companies Amount Invested
2Q 2001 995 $10,696.2
1Q 2001 1,124 12,162.3
4Q 2000 1,518 21,030.4
3Q 2000 1,813 28,574.9
2Q 2000 1,874 27,270.4
1Q 2000 1,764 26,605.7
4Q 1999 1,623 23,243.2
3Q 1999 1,327 14,076.9
2Q 1999 1,201 12,592.4
1Q 1999 879 7,268.7
Source: Venture Economics

“It is very quiet out there for the better groups [in terms of fund-raising]. Many of the groups now raising money raised a first fund in 1998, 1999 or 2000. These groups will have a tough time making it because their first funds, perhaps did, but do not now have the performance needed to make investors feel at least mildly comfortable about giving them money,” says Gary Bridge, managing partner of Horsley Bridge Partners

The result has been a dramatic re-balancing of the scales, with LPs now carrying the weight in the GP/LP relationship, whereas before LPs were almost begging to be a part of certain VC funds. Not surprisingly, the LP community’s tolerance for pomp and circumstance is at an all-time low.

For Ronn Cornelius and Sam Tang, both directors of private equity at Pacific Life Insurance Co., the only issue of importance when choosing a fund is performance results. “Heavy entertaining at the annual meeting with the GPs indicates to us that we don’t want to invest in that fund again, because that’s the LPs’ money being spent on a dinner show,” Tang says.

One pension fund investor says he walked away from some firms where it seemed like the team was changing for the worse, or where compensation came uncoupled from performance.

A number of market players expect the slowdown in fund raising to continue as a result of the huge overhang of capital raised, but not yet committed. Venture Economics and the NVCA estimated that as of June 30, the amount of venture capital raised by funds but not yet invested exceeded $45 billion. Thus, there is not a great need to raise more money for most VC firms. However, on the bright side, VE and the NVCA also estimate that at the current rate total funds raised for 2001 will exceed $52 billion, making it the third-largest year on record for the VC industry.

Investment Pace Takes a Breather

Like the fund-raising market, it’s slow going in the investment arena these days, and most VCs expect the pace to stay steady or even slow down. Not eager to repeat past mistakes, VCs have scaled back considerably with regard to new investments, devoting more of their time to existing portfolio companies, which helps explain increased investments in expansion-stage companies.

In the second quarter, VCs invested about $10.7 billion in 995 companies, a modest decline from first quarter activity, when $12.2 billion was invested in 1,124 companies. However, compare this year’s second quarter with last year’s and you get a 61% decline from the $27.3 billion invested in 1,876 companies.

While it appears bleak, Venture Economics and the NVCA estimate total VC disbursements for 2001 to top out in the $40 billion to $45 billion range. Compared with last year’s $103 billion in disbursements, that’s a 60% drop-off. Again, however, it’s still among the top years for VC investment.

Of the $10.7 billion invested, expansion-stage companies garnered nearly 60%, with Internet-related companies still attracting the biggest chunk of capital, further signifying that VCs’ attentions are on existing investments.

Some leading professionals see a dearth of good start-ups on the horizon. John Baker, a founding principal of Baker Capital and previously a 14-year veteran of Patricof & Co., said with the last two years being so dominant in terms of total dollar flow, the VC industry will be feeling the after effects for some time. Baker recalls the breakneck pace from Q4 1999 to Q3 2000, when 7,077 companies collected $106 billion, according to Venture Economics.

Few of those companies are likely to remind anyone of Microsoft. “For that amount of money to triple in the next five years that means there would have to be $300 billion of IPOs, which is a tall order … so I think we are in a period of reduced expectations in the cycle.”

Despite an uncertain exit environment today, Baker nonetheless says the opportunities to invest have never been better because there is great value for the money. Since there is no need to rush to do deals, there will not be a spike in disbursements, he adds, as most VCs believe deal flow will stay strong and prices will remain low for the foreseeable future.

Corporate VCs Lick Their Wounds

Meanwhile, the subsequent downturn has had a negative impact on many corporations forcing them to write-down large amounts of their investments in technology. It has been particularly painful for the likes of Wells Fargo, Dell, Lucent and others. Wells Fargo announced it expects an after-tax charge of $1.13 billion in the second quarter after writing down its investments. About $1.05 billion of that represents write-downs of investments in its venture portfolio, mostly tech and telecom stocks.

According to a survey released by Bain & Company, nearly half of the in-house venture units started in the past four years have been washed away. Recently, Comdisco, a Rosemont, Ill.-based company, filed for Chapter 11 protection, and reported a $164 million third-quarter net loss. It blamed a “continuing decline in the economic environment for venture capital-backed companies.”

Dell Ventures, the private-equity arm of Dell Computer Corp., has been shaken up from the top down. The two executives who helped build the fund – Thomas J. Meredith, the company’s former chief financial officer who moved over to Dell Ventures in March 2000, and former Treasurer Alex C. Smith, who helped start Dell Ventures in April 1999 – announced their retirements.

Lucent Technologies, the beleaguered telecommunications equipment company, is considering the sale of its private equity and venture capital portfolios. The company is reported to be selling a number of its pension fund’s private equity interests, and is also considering selling its corporate venture businesses, the New Ventures Group and Lucent Venture Partners.

Aversion to Risk?

Two years ago, a venture firm investing in four start-ups in the space of two weeks would have seemed pretty normal and perhaps a little slow. Now it’s fiscally responsible. There are still plenty of deals out there, but VCs have tempered their investment pace conducting lots of due diligence and making extensive risk assessments.

“We’ve gone from having too much money to too little because people are too cautious,” notes one Silicon Valley-based VC. “If investors lose money they get shy and cut back on risky investments.”

In those instances when they do make a new investment, VCs demand specific requirements be met before any money is disbursed. During down rounds, for example, VCs are securing full-ratchet anti-dilution rights rather than the weighted-average anti-dilution rights prevalent during the heady days of the Nasdaq’s peak.

“Investors want to see more boxes checked than a year ago. Last year, if one or two criteria were met, it was enough. Now all the criteria need to be met in order to get deals done,” says Scott Van Gorder, an investment banker in the equity private placements group at Dain Rauscher Wessels in San Francisco.

One of those boxes is an experienced, prudent and thrifty entrepreneur.

“[VCs are] looking for a new breed of entrepreneur, a cost-conscious breed,” says Promod Haque, a GP at Norwest Venture Capital. “Over the last five years, the culture has really changed, it became one of instant gratification, and spend! spend! spend! Now the pendulum has shifted in the direction of keeping cost structures low because you just can’t raise another $50 million, and you can’t have the all of the perks and the lavish office.”

Venture-Backed IPOs by Quarter ($ in millions)
Quarter Number Offering Size Post Offering Valution
2Q 2001 10 $817.7 $4,684.7
1Q 2001 11 929.5 4,522.0
4Q 2000 24 2,228.1 8,271.4
3Q 2000 78 7,168.5 33,666.3
2Q 2000 51 4,027.8 24,195.9
1Q 2000 80 8,544.2 45,475.2
4Q 1999 87 7,490.4 48,306.7
3Q 1999 80 5,658.8 36,404.9
2Q 1999 69 5,214.0 33,465.6
1Q 1999 26 1,743.0 10,247.5
Source: Venture Economics

Translation: the older, experienced veterans aren’t being passed over for young tech-heads anymore. “Entrepreneurs with a proven track record where they’ve clearly executed on a similar venture are getting a welcome response,” says one Silicon Valley investor. “In this market, management comes first, and then the question of a large addressable market and a unique business plan.”

Another box to be checked is modest capital requirements. Capital-intensive businesses like communications, which tend to require between $200 million and $300 million before they’re ready for a liquidity event, have fallen out of favor. Now VCs are looking for companies that require $30 million to $50 million over the investment’s life span.

“Absolutely, this trend of getting back to the $30 million to $50 million range is correct,” says Elizabeth Morgan, a senior analyst at Voyager Capital. “When we look at applications in the client server space, we look at companies that fit the $50 million space. It gets back to getting big fast and market adoption with a smaller amount of capital to take it to an exit or profitability or sustainability. We’re trying to do more with less.”

VCs are also getting more comfortable with longer gestation periods for their investments – almost by default given their current lack of exit options. That helps to explain why life sciences has seen the largest increase in investment dollars, attracting 13.8% of VC money in the past quarter, up from 11.2% in the first quarter and 3.95% in the second quarter of 2000.

But the preeminent position the life sciences are enjoying today, at the expense of other sectors, may be short-lived, according to practitioners. Tony Hoberman, senior vice-president and head of the VC department at Alliance Capital, argues that VC market will rebound because advancements in technology drive most of the VC business. “Technology is not a fad that can go away,” he says.

Reed Hundt, the former chairman of the FCC and founder and chairman of Sigma Networks, is writing a report showing that despite a financial implosion in the telecommunications sector, demand for broadband is just beginning. In remarks to VCs, he says: “We have not yet gotten anywhere close to delivering the type of services that this country demands, one that’s ubiquitous, that’s always on, that’s multidimensional, reasonably priced, where services are cheap and easy to install.”

Despite the proven financial risk, investment in new technologies drives innovation and entrepreneurship, says Hundt, who clearly worries that the venture community has lost confidence in these investments. “If you have the idea, if you build the thing, the money will come. This is not the pet rock business,” he says. “The demand is there, we just need to maintain the confidence [of all parties].”

Looking for an Exit Sign

Without a clear exit window in sight, companies are increasingly reaching for alternative financing strategies. To delay and possibly avoid downrounds, VCs have enlisted such alternatives as convertible preferred securities – which in some cases, can spell the end for portfolio companies.

P.J. Patel, a director at valuation consultant Marshall Stevens, says he is seeing more convertible preferred securities that guarantee investors their investment. For example, if an investor invests $5 million in a floor-less security in a company at a $20 million valuation, the investor is guaranteed $5 million in return. If the company’s valuation drops to $5 million or even below, all the other investors and the company founders are washed out.

Other VCs report “bridges to nowhere” or bridge loans made without any particular goal except delayed insolvency. In the past VCs would not offer this type financing without an end in mind, and companies would not take financing tainted with potentially fatal provisions. The increase in the number of these financing alternatives only reaffirms that the exit environment must be grim.

What to do? Until the market stabilizes, VCs really aren’t sure, says John Halvey, partner at Milbank, Tweed, Hadley & McCloy and head of its technology practice, noting that the length of instability may be as damaging as the severity of the downturn.

With valuations at their present levels, VCs have less natural motivation to exit their investments. They may gamble in hopes of attracting a higher valuation after the public market rebounds. However, many do not have the luxury of waiting for a rebound as the operational demands of a portfolio company may require a financing event. So, unless they want to sink more money into an investment, selling it-regardless of the valuation-may be the only option.

Not long ago, VCs viewed IPOs as an opportunity for a higher return than an acquisition. Now that the opportunities for reward have declined, acquisitions have an equally desirable attractiveness. “When you ask VCs about their [exit] strategies, you’ll find it to be much more M&A oriented than IPO oriented,” says Austin Ventures GP Ed Olkkola.

David Clark, a partner in the corporate finance group at Deloitte & Touche, expects to see mostly stock-based acquisitions, but these types of deals will be all over the place and very sophisticated. He says some companies have even given up hope for the bridge loans. The difference between now and six months ago is “a lot of [venture-backed] businesses are not looking for alternative financing arrangements but are looking for alternative liquidation events,” he says. In other words, they cannot wait out the market’s recovery. And for some companies-especially blighted dotcoms-those exits will amount to fire sales, creating further losses for their VCs.

Back to the Future

If anything, the past two years have reminded VC veterans, and taught newcomers, that venture capital is, and always will be, a cyclical business, in which the weak get flushed out of the system and the strong flourish.

As they navigate these uncertain times, the veteran VCs say they are getting back to basics, when they could spend quality time growing companies into mature businesses with a clear path to profitability. Many veterans of an industry that has seen its share of frenetic times with disk drives, biotech and dotcom bubbles, say they prefer today’s climate. They say this is a great time to be investing and that some of the success stories of the decade will have been funded in 2001. Only time will tell.

Contact Jennifer Strauss at: