Truth In Numbers? –

J.P. Morgan Chase & Co. is about to put together the largest private equity fund ever, with numbers that put the rest of its competitors to shame. But are the numbers true indicators of how well the bank has done in venture capital? And is the bank’s notion of venture capital a far cry from the way General Doriot and even Tom Perkins might see the industry?

Between Jan. 1, 1984, and July 1, 2000, J.P. Morgan Chase says its rates of return on private equity were 38.9%. Even more impressive was its performance in venture capital: a whopping 88.6% IRR, pretax, compounded annually. The J.P. Morgan numbers, I am told, are higher than nearly all the venture funds out there during the period – better than Kleiner Perkins, Mayfield or NEA, and perhaps only a tad worse than Sequoia or Matrix.

The numbers were attractive enough for the bank last year to make an unprecedented commitment of $8 billion to private equity to be managed by J.P. Morgan Capital Partners. In addition, the partnership is now seeking another $5 billion from outside institutions. The two pools together would form a $13 billion fund that would be the largest pool of private equity ever, eclipsing the massive $6.1 billion fund that Thomas H. Lee recently raised.

J.P. Morgan’s plan to create this mammoth fund raises some troubling questions about the direction the industry is taking. It also brings into question the manner in which investors tout their performance.

Many venture capitalists say it’s inaccurate to compare the J.P. Morgan numbers with the rest of the industry. For one thing, the funds aren’t invested the way most traditional VC funds are, with VC-like management fees and carries. Most significantly, J.P. Morgan rarely originates deals and almost never invests in early-stage technology, a trait that has characterized most of the trailblazers in the industry.

Certainly, J.P. Morgan isn’t your traditional venture investor. While it does have a cadre of investing partners on its roster, it uses a slew of strategic VC funds like New York’s Flatiron Partners – one of 13 such funds – to cover the investment landscape. The strategic partners give J.P. Morgan the breadth it cannot afford to have on its own, says Jeffrey Walker, who heads the 150-professional organization. Indeed, the massive capital pool J.P. Morgan can command it invested a total of $3 billion in 2000 allows it to co-invest in the U.S. and abroad, and across a range of industries and stages.

Walker believes that Chase’s private equity strategy, including VC, is where the world is going. His view is that successful investors have to invest globally and “multi-generationally,” and only a player as large as J.P. Morgan can succeed in this environment. Not only can it efficiently provide the private equity that a company needs, but it also can provide the range of financial services – from debt to M&A – that even privately-owned companies need at various stages of their development.

Still, J.P. Morgan has its skeptics, who feel that the bank has reduced VC into a portfolio management play. Veterans such as Sequoia’s Don Valentine express the skepticism best. In describing the orientation of his own fund – one of the most successful in VC history – Valentine says: “We were going to build companies. We were going to build an industry once in awhile, but we were not going to do anything that required a lot of financial cleverness, because we didn’t have any, and we didn’t need any.” Valentine and others question whether it’s possible to deploy billions of dollars in traditional VC and get the high returns that has characterized the industry at its best.

The J.P. Morgan numbers provide the counterpoint. But they also may be extremely misleading. Here’s what 88.6% compounded annually actually means: Let’s suppose that J.P. Morgan started with a $10 million pool in 1984. That amount, compounded annually at 88.6%, would be worth nearly $400 billion in 2000. That’s more than five times the total market cap of J.P. Morgan at the beginning of April.

There is also the problem of the reference points that J.P. Morgan uses to benchmark its performance. It began reporting in 1984, at a time when the VC industry was at rock bottom. For the next few years, most venture funds were under water. Very few reported returns in double digits. If J.P. Morgan’s performance at that time equaled the industry’s, its subsequent VC performance would have to be in the triple digits to come even close to the 88.6% it claims.

VCs familiar with J.P. Morgan tell me the bank reports its numbers differently from traditional venture firms. (J.P. Morgan, still raising its fund, refused to elaborate on the topic.) Its numbers account for only “realized” returns, not the deals that haven’t been. Indeed, if all its deals, realized and unrealized, are accounted for, how does the bank account for the legions of its own and Flatiron’s deals that have tanked in the last two years or so?

Others familiar with J.P. Morgan say its reporting method exaggerates its VC performance, relative to the way traditional venture funds report. They don’t account for a management fee – ranging between 2.5% and 3% annually – that all venture funds extract. They also may not account for the carry, the VC’s share of profits that is excluded from the overall performance figures.

Whatever the real numbers are, J.P. Morgan’s strategy has struck a chord with large pension funds and asset managers who see private equity and venture capital as simply another financial asset and not the entrepreneurial development tool or strategy for technology transfer and economic growth. But in making this distinction, these investors forget that the real venture returns – and credibility – came from building real companies such as Lotus and Compaq and Sun. The returns naturally followed.

Udayan Gupta is the author of Done Deals: Venture Capitalists Tell Their Stories.