This summer has been hot – and not just in terms of the suffocating heat wave that has enveloped much of the country for the past few months.
The venture capital industry also was on fire, as 112 firms raised $10.4 billion in the first half of 1999, according to Venture Economics Information Services, a data company affiliated with Venture Capital Journal. The figure represents more than two-thirds of 1997’s $14.1 billion total and indicates that the VC industry is primed to break the $20 million barrier for the second straight year. While fund raising is not on pace to eclipse last year’s record-breaking $26.1 billion, one must keep in mind that 1998’s total included a $5 billion Warburg, Pincus Equity Partners fund – an aberration that clouds the reality that the 1999 market is every bit as scorching as the year before.
General partners in search of capital in the first half of the year found little trouble raising money from limited partners who were more than willing to return and increase their commitments to successful firms. The initial public offering market this year also has returned to its heady 1996 form, allowing VCs to exit investments faster, providing extraordinary returns to limited partners and dramatically speeding the average investment cycle.
While the capital raised so far has not changed much since last year, the machinery behind 1999’s fund raising numbers may be shifting slightly. Corporate investors are providing a bigger piece of the pie, replacing pensions as the number one supplier to the industry’s coffers. Meanwhile, Silicon Valley has slipped from its position as the top provider of industry capital, as new venture firms in search of lower valuations and ignored deals crop up in more remote, non-traditional VC hotbeds outside of Silicon Valley and Boston. Whether this is part of a fundamental shift in the fabric of venture capital or the temporary side effects of robust economy, VC’s hot streak shows no signs of abating.
Coming Back For More
Charles Merritt, the University of North Carolina at Chapel Hill endowment’s investment director, is not surprised at the staggering fund raising pace of the last two years. “If you’re currently in venture capital funds and they’ve done well, you’re likely to recommit,” he says. “There’s a tremendous amount of activity [right now].”
With limited partners jumping at the chance to invest even larger chunks of capital with their favorite VC managers, investors are confronted with new challenges as they try to reach their asset allocation goals. “The big issue is trying to plan for funds coming back to you quickly,” Merritt says. “[The investment] pace has quickened dramatically.”
The result, in many cases, is that younger alternative asset programs have difficulty investing in more established funds. Thus, they quickly re-invest with their best partnerships and enviously eye those limited partners who manage to gain entry to the most attractive funds.
“We’ve got some relationships that we value highly, and we want to stick with,” Merritt said. “For a young program, it’s hard to gain access to the top firms. For old private equity programs, the only worry is How much?'”
General partners are certainly not ignorant to this trend. “The real issue is not how much money is available, but how much money VCs can handle,” said Rick Frisbie, a general partner of Battery Ventures, which raised its fifth fund, the $400 million Battery V, earlier this year.
George Middlemas, managing director of Apex Investment Partners, which at press time was raising its fourth fund, believes that the abundance of capital available may be tying the hands of some firms. “Some [VC] managers are taking more money than they want,” he says.
Some firms such as Kleiner Perkins Caufield & Byers and Accel Partners have had tremendous success raising large vehicles, even while demanding 30% in carried interest, while others are investing much larger amounts of capital in their own vehicles. This practice effectively limits the amount of room to accommodate outside investors in their funds, which poses a moral dilemma, some L.P.s say.
“You’ve mortgaged other people’s capital to create your own wealth,” Merritt says. “[Some firms] have become institutions unto themselves.”
Going It Alone
Perhaps in a reaction to the shrinking amount of space for investors in VC funds, many corporations have taken venture investing upon themselves, structuring their own captive vehicles and setting aside large blocks of capital for direct investments.
Cable operator Comcast Corp., on-line brokerage E*Trade Group Inc. and software developer Seagate Technologies Inc. all adopted the corporate venture strategy in the first half of the year, while Internet portal Lycos Inc. took the process a step further and welcomed outside investors into its corporate fund (story page 8).
A surge in this strategy has pushed corporate venture investing ahead of pension funds in terms of the numbers of dollars invested in 1999, with 30% coming for corporations and 27% from public pensions. (Note: L.P. figures represent only those investors who reported their figures to Venture Economics, and not the total amount of money invested. These figures, therefore, should be viewed as a sample of overall fund raising).
The public pension fund category – comprising some of the oldest and biggest venture investors, such as the California Public Employees’ Retirement System – invested $736 million in 28 funds, while corporations invested $795 million in 40 funds, indicating that pensions make up a larger share of their long-term VC partnerships.
Awash in Cash
There is little doubt that the economy’s strength over most of the last decade, coupled with a hot IPO market, has helped change the way venture funds are raised. With more opportunities for portfolio companies to go public, VCs have provided investors with extraordinary returns and a yearning for more.
“All of the investors in alternative assets have made so much money in this stock market … they want to put twice as much money in [a firm’s] next fund,” Middlemas says.
This is not an entirely new phenomenon. A strong public market for venture-backed stocks in 1986 and 1987 helped whet investors’ appetites for venture capital, but the 1987 stock market crash cooled fund raising numbers through 1991. As the economy slowly but surely climbed out of recession in 1992, new venture firms spun out of more established parent firms, and fund raising levels began to rise modestly for the next several years.
A hot stock market in 1995 and 1996 again led to a frenzied VC fund raising environment, in which the industry cracked the $10 billion barrier in 1996 for the first time and climbed almost another $5 billion in 1997. When the IPO market slowed a bit in 1997, mergers and acquisitions picked up the slack and the fund raising total climbed above $20 billion for the first time. The question remains, however: does the trend witnessed in the last five years point to a more fundamental change in the venture industry?
Professor Josh Lerner of Harvard Business School says that 10 or 15 years ago, a company took an average of four years between its first round of venture financing and its IPO. “That’s come way down [today],” Professor Lerner says. “It reflects the appetite for [Internet stocks]. It’s clear that there has been an acceleration of technological change.”
Times Are Changing
The Internet has had a profound impact on the venture industry and even the economy as a whole. While no one expects the current frenzy for Internet stocks to last forever, most agree that the emergence of cyberspace will have a long-term impact.
“I don’t think [the Internet boom is] going to end …but the feeding frenzy is going to subside,” Frisbie says. “When that happens, the fund raising pace will gradually tucker down.”
Limited partners note the importance of placing their trust in the right VC partnerships. “You must be sure you’re investing in people you have confidence in,” Merritt says. “Does Internet mania make sense? No. There’ll be a handful of big winners. Hopefully, we’ll get a couple of them.”
While searching for a ground floor home run investment opportunity, more than 40% of the 112 funds that raised money in the first half of this year have an early-stage focus. An almost proportionate percentage of the capital raised, however, is earmarked for these early-stage funds – 32%, or $3.3 billion. In comparison, 34 balanced stage funds commanded $3.0 billion, or 28%, and 22 later-stage funds raised $2.8 billion, or 27%.
The abundance of capital for early-stage opportunities has changed the way venture capitalists conduct business. With more money to manage and a limited amount of investment professionals to manage it, VC firms are deploying larger chunks of capital per deal, making co-investments with other firms less likely.
“With the basic proposition that funds are larger and now must put more money to work, the death of syndication is an inevitable part of the story,” Lerner says.
The reluctance to share deals also has forced VCs to make investment decisions faster.
“Established firms are raising substantial amounts of money and investing it aggressively, and new firms are coming along and doing the same thing,” Frisbie explains.
The capital bounty is so plentiful, entrepreneurs clearly have the upper hand in negotiating private equity financing. “In talking with our VC managers, there’s a real land grab in the real early-stage,” Merritt says. “There’s incredible competition among VCs. Entrepreneurs are jockeying for position with the best funds.”
Thus, getting a company off the ground these days takes a much larger capital commitment than ever before. Establishing a brand name is costly, and skyrocketing salaries also drive valuations up. “Ten years ago, entrepreneurs were willing to take significant cuts in salary for large ownership pieces,” says Bob Palluck, managing general partner of Centerpoint Ventures, which closed its $100 million second fund in June. “Now they expect both.”
Shopping Around For Better Deals
Since competition and valuations have grown so out of control in traditional VC hubs like Silicon Valley, many new firms have set up shop in more remote areas of the country, where they hope to find a less crowded market and a few bargains for their portfolios.
California, which raised $3.8 billion from 33 funds, is still the undisputed superpower of the venture world. But the Northeast, paced by Massachusetts and New York – far more associated with later-stage, buyout investments than start-up financings – jumped ahead of California in terms of the number of funds raised and dollars collected.
Eighteen Massachusetts-based funds attracted $1.9 billion, followed by $1.8 billion raised by 11 New York funds. The emergence of New York’s “Silicon Alley,” the downtown stretch of Manhattan that has produced Internet winners such as 24/7 Media Inc. and DoubleClick Inc., has played a key role in the Northeast’s rise as a hotbed for venture capital.
“Some more dollars have come to the Northeast because there’s good deals there,” Middlemas says, noting that early-stage funds have materialized in response to the deals coming out of Silicon Alley. “Silicon Valley has never been the be-all, end-all of the venture industry.”
Other areas have showed promising signs as well, such as the Midwest, in which 11 vehicles raised $1.1 billion, and the Mid-Atlantic region, in which 10 funds collected $459 million.
Is this a long-term trend, however, or will these funds disappear when the market dries somewhat? Sources offer a myriad of responses.
“Competition and the feasibility of doing technology anywhere makes it possible to go to non-VC hotbeds,” Lerner says. “I think there’s a lot of optimism … for [VC’s] long-term prospects.”
Others, however, are more cautious. “In an environment where it’s easy to raise money … investors are less discriminating,” Frisbie says. “When things slow down you’ll see a trend back to what we’ve seen in the past.”
Either way one perceives the market, however, it is purely speculation. And for the foreseeable future, we’re in for an Indian summer.
Early-Stage Vehicles Lead the Way
PERIOD AMOUNT
NUM TOTAL AMOUNT RAISED
Fund OF TARGET RAISED TO DATE
State Region FUND ($ MIL) ($ MIL) ($ MIL)
Multi-Stage 34 3837.0 2959.6 62924.5
Early Stage 46 4475.0 3308.3 32143.9
Later Stage 22 2416.0 2810.6 27581.8
Seed Stage 3 40.0 52.0 1523.7
Unknown 7 1090.0 1260.0 2620.1
TOTAL 112 11858.0 10390.5 127203.1
Source: Venture Economics Information Services
1999 First-Half Fund Raising by Region
PERIOD AMOUNT
NUM TOTAL AMOUNT RAISED
Fund OF TARGET RAISED TO DATE
State Region FUND ($ MIL) ($ MIL) ($ MIL)
Canada 1 100.0 59.5 1213.2
Foreign 3 315.0 192.2 3156.3
Mid-Atlantic 10 1035.0 459.4 8222.8
Midwest 11 1008.0 1098.3 11186.5
Northern California 27 2915.0 3430.5 29918.6
Northeast 37 4596.0 4410.1 57851.2
Northwest 3 105.0 35.4 1606.9
Rocky Mtn. 4 525.0 157.9 1510.9
Southern California 6 565.0 332.0 4407.4
Southeast 7 559.0 177.0 3920.4
Southwest 3 135.0 38.2 4208.9
TOTAL 112 11858.0 10390.5 127203.1
Source: Venture Economics Information Services
1999 First-Half Fund Raising by State
NUM PCT SUM PCT AVG MED
Fund OF OF INV OF PER PER
State FUND FUND $MIL INV FUND FUND
California 33 26.40 3762.5 32.78 114.0 50.0
Massachusetts 18 14.40 1866.4 16.26 103.7 23.1
New York 11 8.80 1751.7 15.26 159.2 38.0
Illinois 6 4.80 832.8 7.26 138.8 50.0
New Jersey 3 2.40 383.1 3.34 127.7 139.0
Connecticut 3 2.40 282.0 2.46 94.0 127.0
Pennsylvania 4 3.20 236.4 2.06 59.1 12.7
Foreign 3 2.40 192.2 1.67 64.1 87.2
Minnesota 3 2.40 160.5 1.40 53.5 50.0
Maine 2 1.60 126.9 1.11 63.5 63.5
Colorado 3 2.40 113.4 .99 37.8 23.0
D. of Columbia 1 .80 102.0 .89 102.0 102.0
Georgia 3 2.40 94.0 .82 31.3 30.0
Maryland 3 2.40 75.0 .65 25.0 35.0
Ohio 1 .80 65.0 .57 65.0 65.0
Ontario 1 .80 59.5 .52 59.5 59.5
Florida 1 .80 47.0 .41 47.0 47.0
Virginia 2 1.60 46.0 .40 23.0 23.0
Michigan 1 .80 45.0 .39 45.0 45.0
Utah 1 .80 44.5 .39 44.5 44.5
North Carolina 3 2.40 36.0 .31 12.0 4.0
Texas 2 1.60 30.0 .26 15.0 15.0
Oregon 1 .80 30.0 .26 30.0 30.0
Hawaii 1 .80 10.0 .09 10.0 10.0
Arizona 1 .80 8.2 .07 8.2 8.2
TOTAL 112 10390.5 92.8 404.0
Source: Venture Economics Information Services
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