Fund-Raising Cloud Hovers Into New Year –

Although a few firms were able to sneak past the scrooges to convince a few limited partners to open their wallets, 2002 will be remembered as a dud by fund-raisers. Forecasters predict the gloom will continue through 2003.

Life sciences investors, regional funds and international players were among last year’s winners. They’re likely to hold sway with investors through 2003, along with brand-name firms and the ones that can capitalize on the economic downturn-the distressed debt, secondaries and special situation funds.

“This difficult period is going to continue into next year,” says Anthony Romanello, director of investor services with New Jersey research firm Thomson Venture Economics (publisher of Venture Capital Journal). “More of the institutional money is going to continue going to established groups with a long track record. This is not a time for first-timers as we’ll see more interest from limited partners in the secondary arena, in energy and other special situation funds for diversification purposes.”

U.S.-based venture capital funds raised $7.24 billion last year, an 80% decline from the $35.8 billion raised in 2001 according to preliminary data from Venture Economics. Fund-of-funds, too, were slowed by reluctant investors. By the end of the year, 22 fund-of-funds had raised $4.2 billion. In 2001, 78 fund-of-funds raised $14.2 billion.

Part of the problem is that there’s too much uninvested capital in the market-too much money chasing too few quality deals, as the saying goes. Venture Economics estimates the overhang to be worth $90 billion. Some firms have slashed the size of their funds, while others have decided to put off fund-raising for another 18 months, or at least until they sort through the last vestiges of their troubled portfolios.

More Fund Cuts Ahead

Jim Breyer, Accel Partners’ managing partner, says he expects to see more funds reduce their size this year and doesn’t expect most firms to begin fund-raising until 2004 (see Q&A). Boston’s Charles River Ventures, who last year said it would begin raising a new fund, has pushed back its plans indefinitely to 2004 or 2005.

Overhang and triage are not the only things holding back new funds. There’s an industry-wide shakeout going on, and firms that can’t point to a winning track record and a set of solid investments, those that jumped on the venture bandwagon in 1999, aren’t finding a welcome mat at the doors of limited partners.

“Stability and consistency of strategy and of the partner group are critical,” says Jim Tullis, whose Greenwich, Conn. firm Tullis-Dickerson closed its third life sciences fund with $122 million in October. “There’s a lot of stress in this market and people are facing pressures that are new and different. As an investor it’s very nerve-wracking to invest in people who did not have direct experience investing venture capital money.”

First-time funds struggled to meet their fund-raising goals. Just 37 of the 142 venture funds raised in 2002 were first-time funds, a 20% drop from the percentage of first-time funds that came to market the previous year. Quaker BioVentures, a Philadelphia health care and life sciences fund, hit the market in January 2002 hoping to hit its $300 million target in 12 months. After a year of fund-raising, the firm held a $170 million first close on its debut fund January 31.

“Fund-raising has been more difficult than we expected,” says Brenda Gavin, a managing partner with the firm. “We’re six months behind where we thought we’d be. Maybe we went out more optimistic than we should have been.”

The firm has secured commitments from public pension funds, a university endowment and a family trust. Still, Quaker BioVentures’ debut fund will remain open until the end of the year, hoping to reach its target.

While venture firms used 2002 to re-jigger their partnerships, a new breed of venture capital investors took hold of the market and venture capitalists are waiting to see how they impact the market. While pension funds continue to be the biggest players in private equity-and at least six pension funds in the last year have said they will spend $1 billion in first-time commitments to the sector-some of the sectors’ longtime investors are pulling back. Yale University, which has a 30-year old private equity program worth $2.6 billion, said in December that it would scale back its private equity investment by $800 million. The corporate players are also backing out. Corporate investors like CBS and Novell have cut their venture capital programs, as have firms like St. Paul Cos.

Health Care Still Hot

Still, there are still sectors that have continued to draw dollars from institutional investors. Health care and life sciences funds were last year’s biggest draw.

MPM Capital closed 2002’s largest venture fund in with $900 million. Not only was it the year’s largest venture fund, but it was also the largest fund ever dedicated exclusively to health care and life sciences investments. The fund will invest worldwide in biotechnology products, platforms and medical technology. Investors in the fund included California Public Employees’ Retirement System (CalPERS), Canadian Pension Plan, Danske Private Equity Partners, Grove Street Advisors and Itochu Corp.

“A lot of groups feel they’ve under-invested in this segments and over-invested in every other one, like communications and IT,” Tullis says. Health care and life sciences fund will continue to pique the interested of investors for the next year or so, he says, but the fire will die down when this generation of funds completes fund-raising in another five years.

For its part, Tullis-Dickerson’s $122 million early-stage fund will invest biotechnology, healthcare information technology, bioinformatics, medical devices and health care services, with special interest in cell therapies. It plans to finance approximately 15 companies before the fund is tapped out.

Other funds in the life sciences and health care arenas that closed in 2002 include ones raised by Burrill & Co., Healthcare Ventures, Life Science Ventures, Oxford Bioscience Partners and Versant Ventures.

Funds with local or regional flavor also caught the eye of investors.

Some states, like California and Illinois, use private equity as a tool for economic development. CalPERS, the nation’s largest public private equity investor with a $6 billion program, created a $475 million statewide initiative in 2001 to invest in private equity funds targeting the state’s underserved rural and urban communities. Last year American River Ventures in Sacramento and Draper Fisher Jurvetson’s Sacramento affiliate closed regional funds with support from CalPERS’ California initiative.

Other firms’ strategies draw on regional expertise and on being the only private equity investors in a close-knit community. Chrysalis Ventures of Louisville, Ky. closed its fourth fund with $143 million in May. The firm’s three managing directors scout the Midwest for companies in the business services, financial services, health care, media and entertainment sectors.

“There’s a lot of interest in regional funds – if you think about it, all the Silicon Valley firms are regional Northern California firms, but none of them can be lead investors and do the hands-on investing in early-stage companies here. This is an under-ventured part of the country,” Bob Saunders, a managing director with the 10-year old firm, said in May.

While homegrown funds are hot, so too are funds with an international focus – especially those with their eyes on Asia and Israel, despite turbulence in both those regions.

Baring Private Equity Partners closed a $257 million fund in October. Other funds targeting East Asia-Carlyle Group, China Assets Management and Mekong Capital- closed on funds totaling more than $500 million. It’s not just technology that’s driving investment in the region, it’s also the opening of once-closed markets to foreign investors.

The Waking Giant

China, for one, is experiencing explosive GDP growth, making it a red-hot market for foreign investment, says Varel Freeman, a senior partner with Baring Private Equity Partners in New York.

“[The Chinese] have very big plans and those plans need to be funded, especially with overseas capital,” Venture Economics’ Romanello says.

Although fund-raising in Israel has dropped from its $2.5 billion peak in 2000 as the political crisis reached levels not seen since the 1998 intifada, venture capital continues to flow into the technology hotbed. Veritas Venture Partners, a firm with offices in Israel and Atlanta targeting companies in both regions, closed its second fund with $40 million in October. It plans to invest in seed-stage communications, enterprise software, security and medical device companies and secured commitments from investors like Anglo-American Corp., IDB Holdings, Invesco, Old Mutual, Silicon Valley Bank and New Enterprise Associates co-founder Frank Bonsal.

Silicon Valley stalwart Benchmark Capital added $40 million in 2002 to a $220 million fund it closed in 2001 to finance Israeli start-ups.

“We think there is an awfully interesting opportunity in Israel because of people exiting the market,” Benchmark general partner Andy Rachleff said in December. Despite political turbulence, technological innovation in the country has not slowed. The opportunity is there, but not everyone is willing to take the risk. “Few people are willing to lead financings,” Rachleff said.

Light Ahead?

2002 closed on a sour note, and investors predict little will change in the coming year. While top-tier brand name funds will continue to see success alongside of-the-moment plays like life sciences funds, there’s still and industry shakeout going on. Add to that the threat of war in Iraq and North Korea and a worsening economic climate in the U.S., and investors will be opting for safer asset classes like bonds and government securities.

Private equity is a cyclical business, no doubt, and 2002 was caught in the middle of a prolonged down cycle.

“Most LPs with a track record in the industry understand it’s subject to cycles,” the National Venture Capital Association’s Jeanne Metzger says. “They know we’re in the down part of a cycle, and there’s better times ahead. LPs are not abandoning the asset class.’

Maybe not, but they’re not ready to invest billions either. “I’d be lying if I said fund-raising was easy. It was not,” says Quaker BioVentures’ Gavin.