Investment Banks and VC Are Oil and Water –

For investment banks hemorrhaging cash in a down market, private equity and venture capital groups have become neglected foster children. Look no further than Deutsche Bank (DB). It recently “handed off” its private equity portfolio in a management buyout.

The transaction could be the tip of the iceberg. Consider this: The top 12 banking companies with the largest private equity portfolios reported losses totaling $1.93 billion for the third quarter of 2002, according to the Federal Reserve.

DB sold DB Capital Partners (DBCP) to newly formed MidOcean Partners for $1.6 billion. It was the largest secondary buyout ever, topping Coller Capital’s $1 billion purchase of the former National Westminster Bank portfolio in 2000.

Aside from a 20% stake in the portfolio retained by Deutsche, $1.2 billion of the remaining equity was fronted by a seven-member syndicate that included NIB Capital Private Equity, Ontario Teachers’ Merchant Bank, CPP Investment Board, HarbourVest Partners, Bregal, The Yucaipa Companies and Paul Capital Partners. Of these, NIB and Teachers’ Merchant Bank accounted for the largest stakes, with each firm investing approximately $360 million.

Coller Capital, Northwestern Mutual, and Presidential Life, along with management, contributed the remaining equity, totaling approximately $130 million.

The management buyout team was led by Ted Virtue, CEO and managing partner at DBCP. Virtue is now managing partner of MidOcean and was joined by partners Charlie Ayres, Graham Clempson, Diurmuid Cummings, Deborah Hodges, Christian Purslow, Rob Sharp, Frank Schiff, Graham Thomas and Tyler Zachem. In total, 38 DBCP employees made the jump to MidOcean. The new firm formally began operations on Feb. 21.

Deutsche’s portfolio focuses on late-stage deals. It includes more than 80 private equity investments in Europe and the United States, including Center Parcs and United Biscuits in Europe and Prestige Brands in the United States.

“We were attracted to the diversity of the portfolio,” says Iain Leigh, a managing partner with NIB. “United Biscuits and Center Parcs are two extremely attractive franchises that attracted NIB.”

Coller also came in on the deal because of the portfolio’s diversity. “This fund is a healthy mix of European and U.S. investments,” says Tim Jones, an investment director at Coller. “When [Virtue] contacted us, we were delighted to become a partner in the transaction.”

Virtue anticipates that MidOcean will exit some of the larger companies in the portfolio within the next 18 months and that MidOcean will “return a significant amount of capital to our investors.”

The sale of DBCP may be a harbinger of things to come. “Private equity [funds] are not in the core business plan of these large institutions,” says Coller’s Jones. “With the volatility in the last few years, don’t be surprised if we see more transactions of this size involving the big banks over the next year or two. The banks will refocus on being a lender.”

Jim Leech, a senior vice president with Teachers’ Merchant Bank, agrees. “DB was first [in selling its fund], and we think others will follow suit,” he says. “Some of these banks have used private equity investing, in effect, as a loss leader for investment banking fees and to gain access to deal flow.”

“The regulatory environment and the higher capital charge for private equity and other illiquid assets have been catalysts for many banks looking to lighten their exposure to the asset class,” notes Virtue of MidOcean. “The perceived conflict to third-party investors of being owned by a bank goes away. That was not the case at Deutsche, but that concern was still out there.”

As with corporate venture capital groups, many of investment banks’ forays into the VC world have been cut short not necessarily because the banks were bad investors but because of pressures from troubled parent corporations. To wit, the top 12 banking companies with the largest private equity portfolios reported losses totaling $1.93 billion for the third quarter of 2002, according to the Federal Reserve. It should come as no surprise then that the banks’ venture units collectively invested just $3 billion last year, down from $20.6 billion in 2000, according to Thomson Venture Economics (publisher of Venture Capital Journal).

“My sense is that [venture capital] is not at all a priority for any size investment bank,” says Scott Wendelin, CEO of Prospect Financial Advisors and a former investment banker who has worked with Sutro & Co., Salomon Brothers, Warburg, Paribas and Becker. “Right now all investment banks are in a siege mentality about their basic franchise. Their resources are going into preserving the organization.”

“A lot of the banks got really burned over the past few years,” says a former investment professional with a European bank’s American VC unit. “When downtime hit, they looked at an area they could cut and get money immediately. A lot of them made investments right from their balance sheet. They basically threw up their hands and focused on their retail business.”

“I think it’s a question of time,” says Glen S. Lewey, senior managing partner with Hudson Ventures and a former investment banker with Banker’s Trust and Deutsche Bank. “Investment banks are generally large businesses. Their commitment to private equity, venture capital, and prop trading has always fluctuated some. Are they going to reenter the market at some time? Sure they are. Is that going to be short or long? I don’t think any of us know.”

Traditional venture capitalists aren’t saddened by the bad news coming from investment banks’ VC units. Investment banks are one smaller slice in an ever-shrinking pie and tended to invest in later-stage rounds. Their withdrawal is another symptom of market downsizing that leaves well-capitalized VCs in a stronger position.

The fact that investment banks are pulling out of private equity “is a positive,” says Andrew Goldfarb, a senior managing director of Globespan Capital Partners. (Globespan became independent of Japanese investment banking conglomerate JAFCO in January.)

“There’s still a lot of capital available from the traditional venture community. To have less capital available means valuations have come down and you have a more balanced investing experience.”

As bad as things are now, the future is not without a silver lining for the investment professional who has survived this long in an investment bank’s VC group. “Any time there’s a shakeout, you shake out the people who are not committed,” says Wendelin of Prospect. “The ones that already have the history of being in this business and have had an ongoing private equity and VC-type history are the ones that are more likely to stay in the business.”

Being a VC “may be one of the few jobs that’s more painful than being an investment banker,” Wendelin adds. He concludes: “Those people that can hang on two or three more years are going to be rewarded. Those people that thought the VC cycle was three years or less are all going to be gone and you’re going to see a core group of investment bankers find their reward.”

Sample of PE Efforts at Banks

Bank One Despite industry-wide losses and cutbacks, Bank One raised its activity level and made a transition into direct investments beginning in 2001. It brought on former Citicorp Venture Capital executive Richard Cashin to take over the bank’s VC and private equity portfolio. Since then, the $3.5 billion unit has made some high-profile investments, including One Equity Partners’ acquisitions of Polaroid and beTrusted.

FleetBoston It has taken heavy private equity losses over the past few years, and about a year ago it said it would cut its venture capital portfolio by 45% as part of a large restructuring effort. A Fleet spokesperson declined to give any new details.

J.P. Morgan Chase & Co. The bank’s private equity arm, JPMorgan Partners, wrote down $91 million from the value of its $24 billion private equity portfolio in the fourth quarter. J.P. Morgan Chief Financial Officer Dina Dublon has said the bank will “continue to decrease our exposure to the asset class.” It also plans to spin out its Asia Pacific private equity unit in a management buyout.

U.S. Bancorp In late February USB said it would spin off its Piper Jaffray investment banking division to its shareholders. Piper Jaffray began laying off workers two years ago after being hurt by slumping stock prices. It eventually cut 7% of its total staff. U.S. Bancorp Piper Jaffray Ventures has remained strong in the biotech field, although it has taken losses in the communications, consumer and Internet sectors. The venture group has seen the shut down or bankruptcy of portfolio companies AdminiQuest, Neuron Therapeutics, Pluris and Ten Thousand Holdings. -M.S.