VCs See Bottom, Expect To Do More Deals –

From water coolers to tradeshows, venture capitalists are talking more and more about a “bottoming out” of the economy. While they’re not predicting dramatic improvement in the near future, a growing number feel like they’ve seen the worst of it. A new survey of private equity professionals and an informal survey by Venture Capital Journal show increasing, albeit cautious, optimism.

“Bottom may have hit, but it won’t be a quick return to the glory days,” says Robert Hofeditz, a principal in the San Francisco office of Probitas Partners.

So what does rock bottom mean for entrepreneurs, fund investors and venture capitalists as the second half of 2003 unfolds? A slow, plodding return to normalcy. More deals are getting funded, for starters, especially seed- and early-stage rounds, but the deals are becoming more focused, both by industry and by region. Life sciences and nanotechnology deals are hot, and regional funds are booming. That’s the good news for entrepreneurs. But venture capitalists are still grappling with structural issues. There’s still too much uninvested capital sitting in venture funds, causing frustration among limited partners (see “The Overhang Shrinks, But Does It Matter?”). Tensions will continue until there are clear exit opportunities and returns pick up.

The worse part is that the recovery might be so gradual, subtle even, that you might not even notice. “Investors are not wildly optimistic about the future, but they’re not pessimistic either,” offers Mark Heesen, president of the National Venture Capital Association. “There’s no whiz-bang technology, no golden ring. Investors are taking their time, looking at deals and taking a focused, patient approach. That’s not necessarily a bad thing.”

According to Deloitte & Touche’s 2003 “Private Equity Confidence Survey,” 7% of those surveyed said that the economy would continue to falter, while 38% said they expected to see a recovery in the near-term. A recovery will likely push venture capitalists to get back to doing what they’re paid for: financing young companies. Almost 90% of the survey’s participants said they would spend the majority of their time during the next six months sourcing new deals, and 59% said they expect to do “slightly more” deals in 2003 than last year, and another 9% said they expect their deal volume to be “significantly higher.”

There are signs that more deals are getting done:

* Draper Fisher Jurvetson set an in-house record for new deals in May, adding five companies to its portfolio and beating its March 2003 record of four new portfolio companies.

* Advanced Technology Ventures has funded nine new companies so far this year, a jump from the seven new deals it closed in all of 2002, reports Jos Henkens, a general partner with the Palo Alto, Calif.-based firm.

* Millennia Partners’ Dana Callow reports that his firm plans to fund four to six deals in the second half of 2003, after doing only one new deal in the first half of the year.

“How expensive is rent and human capital? Everything is on sale,” says Steve Jurvetson, an early-stage investor. “If this is defined as a bad time, I hope things don’t change anytime soon.”

Life sciences companies are hot and still going strong, reports Kris Brown, an attorney with Ropes & Gray in New York. Longtime entrepreneur and venture capitalist Larry Bock echoes the same optimism for health care and biotechnology startups. “This is the time to invest,” he says. “I made most of my money from creating companies from the last nuclear winter in biotech that ended up ripening at the next IPO window.”

These days, Bock heads up Nanosys, a Palo Alto, Calif.-based company that closed its second round of funding with $38 million in June and has locked up the intellectual property rights to the patents emerging from the labs at Harvard, MIT and the University of California. Like Bock, investors will scramble into nanotechnology deals over the next six months, predicts Mark Medzelewski, head of the New York-based NanoBusiness Alliance. “Nanotechnology is the buzz,” he says, countering the nano-naysayers. “Real deals are there if you know what to look for.”

Limited partners, too, are diving in. “We are seeing valuations increase from previous rounds and major LPs like CalPERS and TIAA-CREF make direct investments in the [nanotech] sector,” says Peter Hebert, a partner with Lux Capital in New York. “Nanotech has reached a tipping point, as continued corporate investment and venture activity, along with products on the market, prove this is no fad.”

There are bright spots in the venture universe, but the optimism is tempered with caution and little hope of a noticeable recovery until venture capitalists work though the structural issues still dogging their portfolios. “The carnage isn’t over: There’s still a lot of money to be invested then lost in the next three to four years,” warns Thomas Walker, chief financial officer for Hampshire Equity Partners of New York. “Money will be put to work to counter LP discontent regarding payment of management fees and lackluster investment activity.”

Fund-raising will continue to be slow until second half of 2004, as limited partners flock to brand name firms with histories of positive returns. Smaller firms will increasingly turn to the Small Business Investment Corp. (SBIC) to leverage institutional capital commitments at a 2-to-1 ratio. Both are already-visible trends.

Small, first-time funds-Banyan Capital Advisors, GKM Ventures and Psilos Group Managers, for example-have used their SBIC licenses to gain credibility with LPs.

For the rest, fund-raising will be a long and arduous process, says Kelly Deponte of San Francisco’s Probitas Partners. “Funds seeking to raise money in 2004 have to get in the queue now for what is forecast to be another tough fund-raising year,” he says. “Fund-raisings are reverting to their early 1990s form of being in the market for 12 months or more, and the fate of the second half of the year is already set.”

LPs are demanding credibility and a history of profitable investing. They’re looking for conservative financial projections and a team that can execute. The shake-up inside venture capital firms is already underway.

“Problems within venture capital organizations will only get worse,” says one New Yorker who spends his days raising capital for private equity firms. “Economics going forward will not support the existing infrastructure. Funds will merge or shrink. Partners and professionals will be fired or retired to right-size organizations. Fund-raising will be difficult to impossible until improvement in the portfolios is clearly visible.”

It’s bad out there, no doubt, but if the political climate doesn’t get any darker and the economy keeps hobbling along, the venture industry can expect the first signs of recovery to emerge in the second half of 2003. Venture capitalists will juggle portfolios of sinking, dated investments with a slew of hopeful, just-funded startups in the second half of 2003. They’ll work through internal issues to placate the concern of their limited partners before hitting them up for additional investment capital.

And for entrepreneurs? Richard Fetik, chief executive of Silicon Valley’s Wireless Note Systems, sums it up: “It’s painful, but possible now,” he says.