Time to give it back?

With Wall Street in crisis and no relief in sight for venture-backed startups eager to sell out or go public, a prominent industry observer is calling on venture firms to return some of their uninvested capital to limited partners, just as they did in the wake of the dot-com bust.

Jeffrey Sohl, director of the Center for Venture Research at the University of New Hampshire, says that in the long run giving back capital could be the best course for hamstrung VCs.

“Return part of what you’ve raised, or don’t call down all of your commitments,” says Sohl, whose research unit’s principal area of study is early stage and angel financing. “LPs will like it. And you’ll get it back when you raise your next fund anyway, probably.”

Such a move is not without precedent. Back in 2002, at least 20 venture firms reduced their funds by $5.7 billion, including Accel Partners, Charles River Ventures, Kleiner Perkins Caufield & Byers and Worldview Technology Partners, according to a VCJ survey at the time. (See table on page 11, February 2003 VCJ.)

Mark Heesen, president of the National Venture Capital Association, laughed when asked if he thinks firms should start giving money back to LPs, particularly those firms that raised big funds in recent years. He points out that the VC industry raised $37 billion in new funds last year and $30 billion in 2006, small amounts when compared to what buyout firms raised.

“Look at what LPs have committed to the buyout community [a record $281.7 billion in 2007],” he says. “That community hasn’t been using a lot of the money it has raised. If LPs go to anyone, it’s going to be to them.”

Battery Ventures General Partner Tom Crotty says that one “obvious problem” with returning cash to LPs today is that “the deals I’m trying to monetize now are deals I did two or three funds ago. If [Sohl] can tell me precisely what the liquidity environment is going to look like five to 10 years from today—and it’s going to be that bad—then fine. I shouldn’t be investing [new] money right now.”

Crotty adds that he doesn’t see many parallels between now and six years ago, when Battery decided not to collect $170 million in commitments on what had been an $848 million fund.

Return part of what you’ve raised, or don’t call down all of your commitments. LPs will like it, and you’ll get it back when you raise your next fund anyway, probably.

Jeffrey Sohl

Early this decade, the issues plaguing the industry had everything to do with portfolio companies that were over-funded, says Crotty. Today, the wider financial services meltdown has “little to do with our portfolio companies and almost everything to do with the real estate bubble bursting and credit markets seizing up, which is basically gumming up the M&A and IPO markets,” he says.

VCs are feeling the impact of the financial crisis that’s happening around them.

Not a single venture-backed company went public in the second quarter, and IT hosting company RackSpace was the only venture-backed IPO in the third quarter. Meanwhile M&A activity has also fallen, with just $3.5 billion in disclosed transactions in the third quarter, compared to $10.8 billion in the same period a year earlier.

Lise Buyer, a former Internet analyst at Credit Suisse First Boston who now counsels companies on IPO strategies for Class V Group, says it would be foolish to ignore the stalled exit market.

“I think the frustration of limited partners who don’t want to pay steep fees when they haven’t seen any returns,” could become a very real issue, Buyer says.

Taking—and giving back—should be part of the ebb and flow of the venture industry, argues Sohl. He acknowledges that with the exit market in rough shape that VCs likely will need additional capital to support their most promising portfolio companies for longer periods. Still, he says that “downsizing may be a strategy that VCs may need to consider, depending on how long the downturn lasts.”

Unsurprisingly, an endowment manager who asked not to be named, says some fund reductions in the very near future would be a rather good idea.

“Let’s face it,” he says. “Right now, a lot of firms are structurally out of balance, their returns are terrible, and these enormous funds [some] have been raising make no sense. In this market, I don’t think [cutting LPs a break] is so crazy.” —Constance Loizos