PE Week Wire, Oct. 13, 2006

Last month, I spoke to a class of MBA candidates and fellows at MIT’s Sloan School of Management. The topic was the interaction between businesspeople (i.e., the future them) and business journalists (i.e., the present me). One point I emphasized was that they should always try to get out in front of a breaking story – particularly if the story is negative or could be misconstrued negatively. Putting one’s head in the sand only provokes reporters to begin kicking up the beach.

No one from Sevin Rosen Funds was in the classroom that day, and they needn’t have been. It seems they already had internalized the lesson.

Last week, SRF spoke with New York Times reporter Gary Rivlin, who in 2004 had profiled the firm in a piece titled “Why Venture Funds Don’t Want Your Cash.” That article had come just as SRF was closing a new fund at $300 million, despite over $1 billion in verbal interest. The more recent conversation was of a similar vein, except that SRF now told Rivlin that it was postponing a new fund close that had been slated for this week.

Rivlin directed the firm to a Silicon Valley-based reporter named Miguel Helft, who spoke with SRF partner Steve Dow, and who also was given an explanatory letter that had been emailed to prospective LPs. Last Saturday, Helft penned an article that portrayed SRF as being one of the few firms with the courage to pull its money from where its mouth was. Similar press coverage soon appeared elsewhere, as Dow was extraordinarily accessible (as was the letter). He spoke with the Wall Street Journal, CNBC and myself, among others.

I don’t know who organized this press strategy – Dow? SRF marketing director Jennifer Michalski? – but it was extraordinarily effective. Stories like this usually begin with a trade reporter getting a copy of the letter, and then the firm refusing to discuss “confidential correspondence with its LPs.” The result is journalistic suspicion of internal firm trouble, whether it be partnership discord or fundraising difficulties. Those suspicions are almost always confirmed.

In this case, however, SRF got far enough ahead of the story that almost all the coverage was positive. There was some published doubt from the blogosphere, but even a cynic like me was relatively charitable (although I did express some disagreement with SRF’s basic premise).

Good for them, since that will be where they story ends for most casual business news consumers. But the reality, of course, is a bit more complex:

Back Story

SRF genuinely believes that the VC model is damaged. It is not spin, nor is it an attempt to cover up its own inadequacies.

Steve Domenik, for example, was quoted in a January 2005 BusinessWeek article that it would be “hard for the VC industry to make money if it’s deploying more than $10 billion a year,” (VCs disbursed over $22 billion in 2005). During this past May’s annual LP meeting, John Jaggers gave a presentation in which he displayed multiple graphs about how the market was raising more capital than it could responsibly invest or exit. In short, SRF has given this matter an enormous amount of thought.

During that same meeting, however, SRF told investors that it was going back to market with a ninth fund that would raise between $300 million and $350 million. The contradiction apparently didn’t faze too many LPs, who had seen plenty of similar situations play themselves out in the past.

“Sevin Rosen was basically telling us that there are some fundamental flaws in the VC business model, but that they’d be smart enough and diligent enough to sidestep them,” says one attendee. “Even the best of the top-tier funds tell us that.”

But the bigger problem for Sevin Rosen was that it was no longer in that crème de la crème category. Its first five or six funds – dating back to 1981 – had been absolute knockouts, but its more recent efforts had flagged.

Part of this was simply a result of industry cycles, and Sevin Rosen’s continuing emphasis on the troubled communications and chip sectors (although its portfolio is more diverse than some have claimed). There also was some occasional strategy drift, as best evidenced by last fall’s decision to lead a $26 million Series D round for Firefly Mobile, which provides cell phones for pre-teens and their parents.

Not only was FireFly’s consumer-facing strategy a bit outside of Sevin Rosen’s traditional competency, but it also was a late-stage deal at a pre-money valuation of around $100 million. SRF was still upbeat about Firefly during last May’s LP meeting, when it gave out the company’s handsets to attendees. Nine months later, however, Sevin Rosen wrote off the entire investment, after deciding to not participate in a company recapitalization. There have been a series of other severe write-downs or write-offs in recent months.

SRF also had some serious succession concerns, since it had no partners under 40 and just two under 50. Part of this was exacerbated by a decision within the past year to push out three younger partners — Kevin Jacques, David Shrigley and Amra Tareen – who had joined during the bubble madness.

In addition, there were some exceptionally large track record variations between the firm’s best and worst performers – including a geographic split that saw the Dallas office generally outperforming the Palo Alto office. This sort of thing happens at most firms, but gets amplified at a shop that already is reexamining its entire strategy.

SRF, of course, continued on with its fundraising, and had soft circled over $200 million for this week’s expected first close. Plenty of LPs remained attracted to the brand name, the abilities of certain partners and the basic fact that SRF really did seem to have thought through many of the challenges that lie ahead.

But Sevin Rosen had a change of heart at the last minute. It had continued to crunch the industry numbers during the fundraising process, and had become more and more convinced of its initial thesis. The VC model wasn’t dead, but it was “broken” or “damaged.”

For example, it found data showing that 1997 was the last vintage year when the average value distributions divided by committed capital was greater than one. In other words, it’s been a while since the typical fund has done much more than return committed capital.

After much internal discussion, the firm suspended fundraising until it could come up with a more reasonable investment strategy. It also made a partnership change, with Steve Domenik agreeing to leave the firm. It was at this point that SRF spoke with Gary Rivlin, thus launching the PR blitz. I’m just speculating here, but I’d suggest that SRF will come eventually return to market with a much smaller fund target, and a few fewer partners.

Steve Dow reiterated yesterday that this story is not about Sevin Rosen, per say, nor even if the firm continues to exist. Instead, it’s about the overall venture capital model. But, for trade writers like me, it’s about both of them.

Top Three

Morphotek Inc., an Exton, Pa.-based drug company focused on therapeutic monoclonal antibodies, has raised $40 million in Series D funding. Investor Growth Capital led the deal, and was joined by MDS Capital, Hunt BioVentures and return backers Forward Ventures, Morgenthaler Ventures, SR One, Flagship Ventures, Burrill & Co., CB Health Ventures and Rock Maple Ventures. The company has raised nearly $90 million in total VC funding since its 2000 inception.

Arcap Partners has formed the first private equity fund focused on Afghanistan. To date, it has raised $20.3 million in capital commitments from LPs like The Asian Development Bank and CDC (UK-government-backed fund-of-funds). The fund is led by former McKinsey & Co. consultant Pierre Van Hoeylandt, who previously worked with the Afghan Ministry of Finance in designing Afghanistan’s private sector development strategy.

Mark Warner, co-founder of Columbia Capital and former Virginia governor, said that he will not run for president in 2008.

VC Deals

Reflex Security Inc., an Atlanta–based provider of network intrusion prevention solutions, has raised $12 million in Series B funding. Spencer Trask Ventures led the deal, and was joined by RFT Inv*stment Co., an Internet search engine focused on the Indian market, has raised $7 million from Sequoia Capital India.

Primafuel Inc., a Long Beach, Calif.-based developer of alternative energy sources, has raised nearly $6 million in Series A funding, according to a regulatory filing.

BillTrust, a Windsor, N.J.-based provider of outsourced billing solutions, has raised $4 million from Edison Venture Fund.

EnerWorks Inc., an Ontario-based provider of solar-powered hot water appliances, has raised Cnd$3.65 million in VC funding from Chrysalix Energy Management and Investco Capital.

Xthetix Inc., a Mesa, Ariz.-based developer of ultrasound products for the OTC aesthetics market, has raised $2 million in Series A funding from 3i Technology Partners, according to a regulatory filing.

Circle 1 Network Inc., a Milwaukee-based operator of educational and entertainment websites for children, has raised $1.3 million in VC funding from GCI and local angels.

Greystripe Inc., a San Francisco-based distributor of ad-supported mobile games and applications, has raised $1.2 million in Series A funding from Monitor Ventures, Incubic Venture Capital and WS Investments.

Buyout Deals

First Reserve Corp. and GenPower LLC have formed GenPower Holdings LP, a joint venture that will develop, own, acquire and operate power generation facilities in the U.S. and abroad. GenPower’s contribution will be a portfolio of projects already under development, including a coal-fired generating facility to be based in Maidsville, West Virginia (Longview). The Longview project will require $1.8 billion in total capital, of which First Reserve will provide the equity.

KKR and Permira are considering the acquisition of a large minority stake in listed French media and telecom company Vivendi, according to La Tribune. If successful, the two firms then would push for a further breakup of the company – although Vivendi reportedly may try staving off the offer by making a bid for Lagarde.

Angelo, Gordon & Co. has acquired a business unit of Citi Cards, which includes United States Auto Club, Motoring Division Inc. and Associates Auto Club Services. No financial terms were disclosed.

PE-Backed IPOs

eHealth Inc., a Mountain View, Calif.-based online health insurance provider, priced five million common shares at $14 per share ($10-$12 range), for an IPO take of approximately $70 million. It will trade on the Nasdaq under ticker symbol EHTH, while Morgan Stanley and Merrill Lynch served as co-lead underwriters. The company had raised around $86 million in VC funding, from firms like Sprout Group, Kleiner Perkins Caufield & Byers, Lightspeed Venture Partners, QuestMark Partners and Lake Street Partners.

Vision-Ease Lens Inc., a Ramsey, Minn.-based maker of polycarbonate prescription lenses and lens treatments, has filed for an $86.25 million IPO. It plans to trade on the Nasdaq under ticker symbol VELS, with JPMorgan serving as lead underwriter. Shareholders include Insight Equity and PNC Equity Partners.

El Pollo Loco, an Irvine, Calif.–based quick-service restaurant chain, has pulled its proposed $135 million IPO, citing “current market conditions.” Banc of American Securities and Merrill Lynch had been serving as co-lead underwriters. Trimaran Capital Partners had acquired the company in November 2005 from American Securities Capital Partners.

PE Exits

Gordon Brothers Group and Monroe Capital have sold Canadian discount retailer The Bargain Shop Holdings Inc. to Genuity Capital Markets. No financial terms were disclosed.

PE-Backed M&A

Abode Systems Inc. (Nasdaq: ADBE) has acquired the vector graphics technology developed by Actimagine, a France–based developer of video and interactive vector graphic software. No financial terms were disclosed. Actimagine is backed by GRP Partners.

Firms & Funds

CalPERS has formed a $500 million private equity fund to support underserved rural and urban markets, primarily in California. Approximately half of the capital will be earmarked for California-based private equity funds, while the other half will be used for direct investments. Hamilton Lane has been chosen to manage the fund, out of its new San Francisco office.

Capital Today has held a $280 million final close on its inaugural fund, which will focus on private equity opportunities in China. C.P. Eaton Partners served as placement agent.

Invision of Switzerland has held a €63 million first close on its fourth private equity fund. Axon Partners is serving as placement agent.

Quintana Capital Group of Houston, Texas is raising up to $650 million for a private equity fund focused on the energy sector, according to a regulatory filing. It already has secured around $424 million in capital commitments.

Black Diamond Capital Management co-founder James Zinni has sold his interests in the firm to senior members of firm management, including fellow co-founder Stephen Deckoff. No financial terms were disclosed. Zinni is forming an independent hedge fund firm called Z Capital Partners, with a group of six associates from Black Diamond.

Human Resources

Nick Gibbons has joined UK-based NBGI Private Equity as an investment manager. He previously worked in various positions at Centrica PLC.

Timothy Spangler has joined the London office of Kaye Scholer as a partner in charge of the law firm’s Investment Funds practice.

John Waller has joined middle-market I-bank Fort Dearborn Advisors as a senior vice president in the firm’s Chicago office. He previously was a vice president at Lincoln International.

Jeff Reinhardt has joined M&A advisory firm Berkery, Noyes & Co. as a managing director in the firm’s B2B communications group. He previously was a senior vice president with Prism Business Media (f.k.a. Primedia Business).