Third-Quarter Decline Masks Turnaround –

For most Americans, the third quarter was notable for significant gains in manufacturing, consumer spending and gross domestic product. For venture capitalists, however, the period between July 1 and Sept. 30 was marked by a decline in both venture capital disbursements and fund-raising.

During Q3, 667 U.S.-based companies raised $4.21 billion, according to the Money Tree Survey compiled by PricewaterhouseCoopers, Thomson Venture Economics (publisher of VCJ) and the National Venture Capital Association. That’s a decline of 8% from second quarter totals, which had represented the first increase in quarterly disbursements since the first frame of 2000. It also is lower than the total for the third quarter of 2002, when 680 U.S. companies raised $4.41 billion in venture capital.

But before you jump out the window in pursuit of your disbursement tallies, it’s important to realize that Q3 declines are nothing new. In fact, only twice since 1990 has there been more activity in the third quarter than in the second. Blame it on the heat, school vacation or general investor angst, but the recent quarterly numbers are nothing to obsess over.

“The zigzag pattern of the most recent quarters is not surprising,” says Jesse Reyes, vice president of research at Thomson VE. “In most financial cycles, bottoms of cycles are typically volatile like the tops of cycles, as investors try to gauge whether now is the best time to get back into investing. The recent dip in Q3 – like the preceding uptick in Q2 – is not statistically significant as a trend, but is simply an indication of uncertainty.”

Like many GPs, Michael Greeley, a Boston-based managing general partner of IDG Ventures, says the Q3 dip doesn’t reflect his daily experience. “I’m surprised the numbers are down,” he says. “It feels like things have picked up. Maybe it’s a lagging indicator because it takes a while to close a deal, but we’re even seeing dueling term sheets again.”

Inside the Data

The biggest Q3 winner was Reliant Pharmaceuticals Inc., a Liberty Corner, N.J.-based drug marketing company that secured $115 million in the first close of its Series D funding round. The enormous deal included the exchange of $37 million in secured debt and was led by Invemed Catalyst Fund with participation from previous backers Bay City Capital, BayStar Capital, the Pritzker family and the family interests of Dr. Ernest Mario. Reliant closed on a second tranche in mid-November for $100 million, bringing its total to $215 million. It could potentially raise more.

Unlike past quarters when information technology ruled the venture roost, life sciences companies like Reliant were the top recipients of venture capital in Q3. Seven of the 10 largest disbursements went to biopharmaceutical or therapeutics companies, including a $45 million deal for Renovis Inc., a $43.8 million infusion into Tercica Inc. and a $42.7 million haul for GenPath Pharmaceuticals Inc.

The only exceptions were secure remote access provider Fiberlink Inc., with $50 million, network storage company BlueArc Corp., with $47 million, and radio frequency ID developer Alien Technology Corp., with $38 million.

Overall, information technology deals still dominated the middle and lower echelons, with just over 80% of all venture disbursements going into the sector. That percentage was roughly the same in the second quarter, and represents $6.81 billion for 793 companies.

The quarter’s most active investor was New Enterprise Associates (NEA), which participated in 16 deals. Following it up were Draper Fisher Jurvetson (DFJ) with 13 deals, U.S. Venture Partners (USVP) with 12 and JPMorgan Partners with 11. In the previous quarter, USVP ranked on top, participating in 20 deals, while DFJ took part in 19 deals in Q2 and NEA did 17.

Northern California, home of Silicon Valley, continued its perpetual geographic dominance with a 33% disbursement share, followed by New England, Southern California, the New York Tri-State area and the Southwest.

Optimism for Fund-Raising

Like VC disbursements, venture capital fund-raising efforts experienced a third quarter retreat. Only 19 U.S.-based VC firms raised $1.39 billion between July 1 and Sept. 30, according to Thomson VE and the NVCA. That’s down 26% from the $1.88 billion raised by 38 firms between April 1 and June 30, and is off 51.4% from the $2.86 billion raised by 50 shops during the third quarter of 2002.

The silver lining in all this is that a number of large venture capital fund-raising efforts are currently in play, which should significantly boost Q4 fortunes. NEA, for example, was expecting to hold a first close in November on its $1 billion-targeted 11th fund. Other well-known firms trolling the LP waters include Kleiner, Perkins, Caufield & Byers (KP), Charles River Ventures, CMEA Ventures, Novak Biddle Venture Partners, Sevin Rosen Funds and Venrock Associates.

“We didn’t make a single commitment to a venture capital fund last quarter, but we will be making some [in Q4],” says Diana Zaia, manager of treasury operations for the Woods Hole Oceanographic Institution. “There are a number of opportunities out there right now.”

What Zaia and other prospective limited partners are realizing, however, is that some familiar faces will be gone from general partnerships this time around. “A lot of people are starting to drip out of successful funds, and I think it may become a giant flush at the end of the year,” says a state pension fund manager. “You need to monitor each one, but it’s not exactly the cause for alarm it used to be.”

As for new funds in the market, several sources say KP is out gauging interest for its 11th fund. The sources say they have heard that the target will be anywhere from $300 million to $850 million. Kevin Compton, a KP partner, says that anyone who claims to have a number is “lying” and that KP won’t start to formally meet with LPs until early ’04. He declined to give an estimate of Fund XI’s size, but notes that it will probably be in line with the size of its previous funds, whose size he also declined to reveal.

KP’s funds have roughly been about the same since it raised Fund V back in 1989, and the number of LPs in the fund has stayed relatively the same, Compton says. “We’re still the small guys,” he says. Like Sequoia’s 11th fund, KP XI is expected to be highly sought after by LPs. By way of comparison, Sequoia raised $395 million for its 11th fund, but it reportedly had enough interest to close on more than $1 billion.

LPs could face the same difficulty getting into KP XI. Compton says that it’s very likely that “the fund will be consumed by current LPs.”

Fund-Raising Winners

For some venture firms, the fourth quarter will be a time for writing checks instead of soliciting them.

Of the 19 firms that raised capital in the third quarter, six held final fund closings. Leading the pack were ComVentures and Lehman Brothers, which each wrapped up $300 million venture vehicles.

Other third quarter fund closeout winners include Crosslink Capital, with $215 million for its fourth fund, and OrbiMed Advisors, with $200 million for its Caduceus Private Investment II vehicle.

Strong intermediate closings were held by Alta Partners, with $72.4 million on its $250 million-targeted third fund, and ARCH Venture Partners, which added $50 million to its $350 million-targeted fifth fund.

Additional reporting by L.A.

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