Timing was just right for SRF to put breaks on 10th fund

Sevin Rosen Funds recently pulled the plug on a first close for its 10th fund, telling its limited partners that the traditional venture capital model is “severely damaged.” Some VCs and LPs applauded the message, while others carped that SRF was attacking the market to cover up its own inadequacies.

“We are stepping back to try to find different approaches that might mitigate some of the factors we have cited and that we believe can generate the returns that the traditional venture business was historically capable of delivering,” General Partner Steve Dow wrote in a two-page letter to LPs. (Read the letter in its entirety at www.PEWnews.com.)

To get to the bottom of the story, PE Week spoke with multiple sources, including Dow, SRF LPs and others with first-hand knowledge of the firm. Our conclusion? SRF honestly believes that there are fundamental problems with the VC business, but its decision to hold off on Fund X comes at an optimal time because it needs to sort through its own issues, including a lack of a succession plan and poor returns because of its focus on the lackluster chip and communications sectors.

SRF has been preaching the gospel of “too much money chasing too few deals” for several years. General Partner Steve Domenik, for example, said 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 more than $22 billion in 2005.) More recently, GP John Jaggers gave a presentation at SRF’s annual LP meeting in May in which he displayed graph after graph about how the market was raising more capital than it could responsibly invest or exit.

During that same meeting, however, SRF told investors that it was going back to the market with a 10th fund that would raise between $300 million and $350 million. The contradiction apparently didn’t faze 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.”

The bigger problem for SRF 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. For example, Sevin Rosen Fund VIII, which was raised in 2000, had a negative net IRR of 12.3%, as of March 31, according to performance data from the California Public Employees’ Retirement System, an LP in the fund. CalPERS has funded $8.6 million of its $10.3 million commitment to Fund VIII. In return, it has received about half a million in cash back and has about $5.5 million in “remaining value” in the fund.

To be fair, most VC funds from that vintage year are in the red. But it didn’t help that SRF continued to focus on the troubled communications and chip sectors. There also had been some strategy drift, evidenced by the firm’s decision last fall to lead a $26 million Series D round for Firefly Mobile, a maker of cell phones for kids. Not only was Firefly’s consumer-facing strategy outside of Sevin Rosen’s traditional competency, but it also was a late-stage deal at a pre-money valuation of about $100 million. Nine months later, SRF wrote off the entire investment, after deciding to not participate in a company recapitalization.

The firm also was facing some internal partnership problems, including minor discord between its offices in Dallas and Palo Alto, Calif. Specifically, Dallas partners were simply producing better returns than their Silicon Valley peers. For example, Dallas-based GP Jon Bayless has the best overall performance, while Palo Alto-based Domenik has the worst.

With no partners under the age of 40 and just two under 50, SRF also faces some serious succession concerns. Veteran investor Charles Phipps—among the firm’s best performers—said last year that he wouldn’t be part of the new fund. Even with the departure of the elder Phipps, the firm increased its average age in the past year by pushing out three younger partners: Kevin Jacques, David Shrigley and Amra Tareen.

What SRF will look like in a year is still uncertain. Domenik is retiring, which means that the number of current GPs who would presumably participate in a new fund will shrink to eight. Meanwhile, there are rumors that some other partners might soon take new jobs, such as GP Nick Sturiale, who tells PE Week he has no intention of leaving. Asked about the Sturiale rumor, Dow said in a phone interview with PE Week: “We have a mature group, and any time a firm—especially for a younger guy—decides to put things on hold for a while, it causes a younger guy to say, ‘Wait a sec.’ There’s some chance Nick will stay and some chance he will leave. It’s not a big deal to us. You’ve got a firm of eight or 10 people. People leave all the time. I consider Nick a friend and that if he leaves we’ll still do deals together.”

Clearly, SRF will benefit from having the time to figure out where it wants to go next.

Alexander Haislip contributed to this story.