The venture capital cutback phenomenon continues, as three major VC firms have told investors that they will reduce their funds. The proposed cuts bring the amount of capital being returned to limited partners this year to $3.18 billion. With so many brand-name VCs trimming their funds, it’s almost a certainty that more will follow.
Austin Ventures is undertaking the most prominent cuts, as it plans to lop off $670 million from a $1.5 billion fund, while Atlas Venture and Meritech Capital Partners will not call down $120 million and $250 million in capital from limited partners, respectively.
“My wife sometimes says she doesn’t understand the numbers I throw around, but she certainly understood this one,” says John Thornton, a general partner with Austin Ventures. “You don’t give back this much money lightly or unadvisedly, but this was what we had to do if we wanted to maintain our early stage regional strategy.”
These latest cuts won’t be the last, as VC market players say the market’s contraction is far from over. Numerous VC firms are considering such a move, says Kevin Delbridge, a managing director with fund of funds Harbourvest Partners and an advisory board member for both Austin Ventures and Meritech Capital. “Now that so many funds have cut, those who haven’t need to come up with a very good reason to justify their decision,” Delbridge says. “I’m in conversations with many firms, and what they are concerned about is how limited partners will view them in five years if they don’t reduce their fund size today. The better ones realize that if they treat the LPs right today, [LPs] will be there when it’s time to raise another fund.”
The reason for Austin Ventures fund reduction is the battered technology/telecom industry and decreased investment opportunities in Texas. Austin originally planned to invest its $1.5 billion fund in early stage software, communications and semiconductor companies over three years starting last July. The collapse in those sectors, however, forced the firm to revise its outlook on how much it planned to spend on tech sector prospects over the next four years.
“We began discussing [cuts] about 90 days ago, and brought it to our advisory board two weeks ago,” Austin’s Thornton says. “People were a bit surprised that we were proposing a 45% cut, but our investors have been very supportive of the move because they understand what’s going on [in the market].”
Austin’s was the second largest reduction on a percentage basis this year, coming in behind Charles River Ventures, which cut its $1.2 billion Fund 11 by 63% to $450 million in May.
Close the Hatchery
As part of the 45% reduction, Austin will re-integrate its $125 million AVLabs software incubator into its main fund. The incubator’s investment staff, Rob Adams and Mike Rovner, will stay with the firm and continue making similar investments. Neither Austin Ventures’ 75/25 carried interest structure nor its scaled management fee (approximately 1.6% over the life of the fund) will be affected by the cuts.
In order for any of this to go into effect, Austin Ventures needs formal investor approval later this month. Thornton says that the firm has discussed the situation with all of its investors and that he believes the vote will be “a formality.”
Limited partners in Austin Ventures VIII LP are a roster of major investors, including AT&T Corp., the California Public Employees’ Retirement System (CalPERS), Cornell University, Dartmouth College, General Motors Corp., Harbourvest Partners, Hamilton Lane Advisors, Harvard University, Lucent Technologies, Nationwide Insurance Co., Virginia Retirement System, Texas Teachers’ Association and The Washington State Investment Board.
On a smaller scale, Atlas cut its Atlas Venture VI LP by 12%, reducing its size from $967 million to $850 million. Following a quarterly cash-flow review of its entire portfolio, the firm also decided to amend the partnership agreements of two other funds: Atlas Venture III LP, a $232 million fund raised in 1996, and Atlas Venture V LP, a $757 million fund raised in 2000.
“In discussions with our investors, we said we thought deal flow and the quality of the deals were as interesting, but the thing that has changed is that we would not be investing the same amount in each portfolio company as we had originally thought,” says Christopher Spray, a London-based principal with the firm.
In a letter sent to investors in June, the firm stated that companies now require less capital to execute on their business plans, so the firm would cut the size of its average investment in each portfolio company from a range of $15 million to $20 million to a range of $10 million to $15 million. The fund has invested approximately $50 million in 14 companies since it was raised last year, deals that will amount to $120 million over subsequent rounds of financing. Following the reduction in fund size, the firm expects to maintain its pace of investment at five deals per quarter.
“We believe we’re in an era where we expect lower valuations in the portfolio and need to review [capital-intensive businesses and how much we’re willing to invest in them] in order to make the same returns,” Spray says.
There will be a pro rata reduction in the fund’s management fee and no change in the firm’s carry. At the same time, Atlas is asking LPs to allow Atlas Venture V LP to co-invest alongside Fund VI in new deals for the next 12 to 18 months. The firm has not allowed funds to make crossover investments in new deals in the past, but it has allowed its funds to co-invest in follow-on rounds. Fund V has invested about $630 million in 50 companies since its inception.
LPs are expected to vote to approve the reduction of Fund VI in late June or early July.
Meanwhile, LPs have already approved a change in the partnership agreement of Atlas Venture III LP, one that would allow the firm to invest up to 110% of the firm’s committed capital directly in portfolio companies. That means Atlas will recycle early returns back into its portfolio, giving it an additional $23 million of investment capital to support maturing portfolio companies in need of another round of private capital. The change allows Atlas to keep its portfolio humming while the IPO and M&A markets remain sour.
Atlas is an international venture capital firm whose U.S. operations are based in Boston. It is an early stage investor in the communications, IT and life sciences sectors. Limited partners in its sixth fund include Alliance Private Equity Partners, Common Fund Capital, Grove Street Advisors, Pennsylvania State Employees’ Retirement System, Virginia Retirement System and the University of Texas Investment Management Group.
The fund reduction by Meritech shows that early stage VCs aren’t the only ones having trouble finding opportunities. The Palo Alto, Calif.-based firm raised its $1 billion second fund in 2000 to invest in later-stage deals for portfolio companies of Accel Partners, Brentwood Venture Capital, Oak Investment Partners, Redpoint Ventures and Worldview Technology Partners. The fund has been cut to $750 million, as limited partners have already approved the reduction.
Paul Madera, managing director with Meritech, says that the late-stage market still has less competition than its early stage peer but that opportunities have slowed nonetheless. He adds that recent decisions by Accel and Redpoint, plus a pending decision from Worldview, to cut their own funds did not affect Meritech’s decision. “We’re really focused on the companies that those firms invested in through this year,” he explains. “The companies they invest in today wouldn’t be on our radar for another couple of years.”
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