Personality Profile: LPs Stick With Alex Slusky Through Rapid Evolution

A shift from a venture capital to a leveraged buyout strategy at the beginning of the decade. A dramatic jump in fund size in 2007. The launch of a debt fund this year. Such are some of the main developments in the 10-year history of Vector Capital that might have given backers pause.

But limited partners have yet to lose faith in San Francisco-based Vector Capital, a technology investment shop led by its outspoken founder Alexander Slusky. The firm, which spun out of Ziff Brothers Investments in 1997, closed its first institutional fund, Vector Capital II LP, the next year at $218 million. In 2004 the firm raised $350 million for Vector Capital III LP, whose strategy shifted more toward acquiring technology companies—often corporate orphans—that are undermanaged and undervalued and that require support from investors who understand the business. And in 2007, Vector Capital made a huge jump in fund size, raising $1.2 billion for Vector Capital IV LP.

For LPs a great track record tends to trump all, and that certainly appears to be true for Vector Capital. As of Dec. 31 2007, Vector Capital II had generated an investment multiple of 2.10x and a net IRR of 15.9 percent for backer California Public Employees’ Retirement System. That’s considered excellent for a vintage year in which the technology bubble killed many venture capital funds. Return figures for Fund III are hard to come by, but considering that LPs—including CalPERS, which committed $25 million—lined up to invest in the dramatically larger successor last year, it follows that Vector Capital is doing something right. “They’ve yet to have a fund that wasn’t exceptional,” said Clint Harris, a founder of fund-of-funds firm Grove Street Advisors LLC, which has invested in each of Vector Capital’s institutional funds.

In fact, Grove Street Advisors is now considering the latest Vector Capital product—a maiden debt fund that would be used to lend money to technology companies to finance add-on acquisitions, recapitalizations and other strategic initiatives; to finance technology buyouts led by other firms; and to buy debt on the secondary market. To date the San Francisco shop, which has 17 investment professionals, has raised $200 million for the debt fund from a single investor. In the future, the firm may invite other LPs to contribute to the fund. Vector joins a host of other buyout shops whose debt funds are seizing on the retreat of banks, including Thomas H. Lee Partners, Audax Group, The Blackstone Group, TA Associates and Summit Partners.

Why raise a technology debt fund? Three main reasons, according to Slusky: The credit crunch has left few lenders willing to provide junior debt to technology companies, Vector Capital professionals know technology inside-out, and there are good returns to be had in the mid- to high teens. “Since we’re value investors, we have all the skill sets to evaluate the risk,” Slusky said.

Strategy Shift

LPs generally like firms to stick to their knitting. But over the course of Funds II and III Vector Capital successfully transitioned from venture capital to buyouts.

Slusky’s key insight was to recognize the large number of older, established technology companies that had grown too far from their core strengths and needed to divest neglected assets—a trend he felt would continue for decades. “I had a strong belief that the technology industry was going to exit the growth stage and enter a consolidation stage,” said Slusky, who got his start working in a computer store during high school in Seattle in the 1980s and eventually worked as a product manager at Microsoft Corp. “I think that decision was proven to be correct.”

Indeed, the firm found itself with so much deal flow that it began teaming with its limited partners and other firms to co-invest in increasingly larger deals. Among its signature transactions, Vector Capital in 2005 teamed with two hedge funds to take, a domain name registration company, private for $200 million. The following year it teamed up with Francisco Partners to pay $151 million for WatchGuard Technologies Inc., a company that provides security for businesses that rely on e-commerce; and in its largest deal yet, that same year LPs and a venture capital fund helped Vector Capital buy SafeNet Inc., a company that makes encryption technologies to protect electronic communications, for $634 million.

For Vector Capital’s next round of fundraising, an encouraged Slusky decided to go big—much bigger. The way Slusky saw it, the firm was already doing deals big enough for a $1 billion-plus fund, and it would free the principals up from having to corral co-investors. “We simply wanted to do a greater share of our own deals,” Slusky said.

LPs eventually bought into the logic, though not without expressing some concerns. “From our own selfish standpoint, we were unhappy,” said Steve Blasnik, president of backer Perot Investments, pointing to the loss of co-investment opportunities with the $1.2 billion fund Vector Capital raised in 2007. “But from the standpoint of the fund, we didn’t see a problem with it because they essentially sized the fund to match the deals.”

For its part, Grove Street Advisors worried that Vector Capital would not have a large enough staff to manage such a large fund. Slusky “either has to work more hours than he’s already working, which in this case I think is impossible, or he has to have some [more] people to work with,” Harris recalls thinking at the time. “He’s got some real high quality people who are coming on nicely. But he’s not over-staffed.”

Helping to allay those concerns, Vector Capital ended up boosting its number of professionals from 10 to 17. Among the hires: David Fishman, principal, a former managing director in Goldman Sachs’ technology mergers and acquisitions team, who joined to lead M&A activities for portfolio companies. The firm also brought in David Baylor, the former CFO and chief operating officer of Thomas Weisel Partners Group, as COO, a new position at Vector Capital, to manage the firm’s growing internal operations.

Love For The Complex

Vector Capital’s record is not flawless. The firm lost $13 million on Phase2Media, an Internet advertising company it spun out from a public parent in 1999. Vector Capital tried to take it public just as the technology bubble burst, and the company did not have a solid customer base on which it could rely. “What that experience taught me is that we have to look for companies that have long-term relationships with existing customers,” Slusky said.

But such misfires have been rare. Ultimately, what won LPs over to a much larger Fund IV was their belief that Slusky and his team could continue to wring returns out of incredibly complex situations, often involving prolonged deal negotiations.

In one of his most famous tussles, Slusky battled through some 10 months of negotiations over intellectual property and other thorny issues to close the deal for LANDesk Software Inc., Intel Corp.’s software products and services decision, in 2002. Intel lacked experience spinning out divisions, Slusky said, and the corporation did not want to license LANDesk any patents that it had developed under Intel’s ownership. Vector Capital and Intel eventually agreed to a broad license to a variety of sensitive Intel patents, which could not be transferrable if Vector Capital sold LANDesk to a designated list of Intel competitors.

A further complication was that LANDesk did not have any of its own infrastructure, such as accounting systems, staff, offices, and computers. In response, Vector Capital negotiated a complex Transition Services Agreement, or TSA—the first Intel ever agreed to, according to Slusky—that obliged Intel to assist the company with these functions for the first three to six months. “It took us months to get Intel comfortable,” Slusky said.

The hard work and creativity paid off. Vector Capital ultimately scored 12x on its investment when it sold LANDesk in 2006 for $416 million. “One thing I’ve consistently uncovered in my diligence on him and the firm is he’s in there for the long haul,” said Marcia Haydel, managing director of Performance Equity Management LLC, an investment manager and fund of funds that invested in Vector Capital’s funds, referring to Slusky’s patience with complex deals.

Also crucial to Slusky’s success has been the high expectations he places on his portfolio company managers. Executives working for Vector Capital companies portray Slusky as having an aggressive personality that combines a close partner’s generosity and support with a detective’s ceaseless probing.

Joe Wang, whom Vector Capital recruited as CEO of WatchGuard, recalled a meeting following a quarter in which WatchGuard missed its profit goal. Slusky demanded the company leave more capital as a cushion, while Wang pushed for growth. “He said, ‘Joe, you missed your bottom line and you don’t have any credibility,” Wang recalled, laughing. “That was very hurtful. I thought he wasn’t appreciative—one quarter and I don’t have any credibility anymore!”

Needless to say, credibility is something Slusky will have to maintain with his own investors as he strives to keep his firm on an evolutionary track. Looking ahead, Vector plans to move beyond its traditional focus on software—about 80 percent of the firm’s investments have fit the bill—to expand further into network communications, computer security and Internet services. The firm also is looking at some “Old World” media opportunities, such as trade publications that can take advantage of business opportunities created by the growth of the Internet, Slusky said.

And then there’s that new debt fund the firm hopes to grow beyond its initial $200 million funding. Grove Street Advisors’s Harris said that Vector Capital is perfectly suited to raise a technology-focused debt fund given its deep knowledge of the industry. “I would call it sort of a complementary product line in the same strategy,” he said. “There’s no question that the debt market is so paranoid. I think it’s a wonderful time to be filling the void.”