US VCs battle through tough times Ken Ryan reports from New York

Ralph Christoffersen, a venture capitalist with Morgenthaler Ventures, has visited 120 prospective biotech companies since last autumn. His thorough due diligence process involves interviewing management, revenue potential, and taking a close look at the product pipeline, particularly in how far it has progressed through the clinical trials. The 120 companies have one thing in common: they’re looking for venture capital. And yet, only one has been successful. Replidyne received $13 million in a series A round led by Morgenthaler, with investments from two other firms.

The way it is

Despite what US venture firms say is a great time to be putting money to work, most are sitting on the sidelines, either in no hurry to spend other people’s money or too scared to make a mistake or just not seeing what they want to buy. Despite enormous sums of dry powder at their disposal, venture firms are hardly rolling the dice these days.

The exorbitant sum of overhang waiting to be put to work is the result of an investment fund raising binge in the late 1990s. Venture Economics estimates that more than $100 billion in dry powder was left at the end of last year for US venture funds compared with $120 billion for buyout funds. Even by removing 20 per cent to 25 per cent of the capital because of the downsizing of funds that has occurred, Venture Economics data show there is still more than $150 billion available to be invested by the US private equity industry.

VC legend Vinod Khosla of Kleiner Perkins presented some of his own statistics at an industry trade show in June that pegged the oversupply of capital at $100 billion for the next ten years. He didn’t expect much of that to be spent in the short run. From 1995 to 2000, 14,463 companies received VC funding, according to his data. Of those, 978 went public and 1,529 were acquired. Another 1,180 went out of business, leaving 10,776. “It’s a little scary,” Khosla says.

Blame it on the tech bubble?

During the late 1990s, many venture capital firms began increasing fund sizes, management fees and carried interest percentages to reflect outrageous Internet era returns. Once the bubble burst, however, limited partners were struck with those premium fund structure components even though returns had often fallen through the floor.

To appease investors, certain firms began either reducing management fees or simply telling investors that they’d call down less capital than had been originally committed. The first example of the latter approach was Mohr, Davidow Ventures, which in February trimmed its seventh fund by 20 per cent. Next up came a 25 per cent cut from Kleiner Perkins Caufield & Byers, a firm held in the highest possible regard by most institutional investors.

Limited partners took the Mohr, Davidow Ventures and Kleiner Perkins Caufield & Byers decisions to mean GPs finally understood investor frustration with Internet bubble structures being maintained in the midst of an economic downturn. Moreover, the fact that both firms followed a very similar course of action led many to believe that straight-up fund size reductions would be the way of sating investor concerns in the future.

Benchmark Capital is slashing its European fund from $750 million to $500 million, the firm announced last month. The firm attributed the move to more efficient use of capital now that companies can get by on less. “We feel we can invest in the same number of companies with $500 million,” one GP said. In a different twist, Accel has proposed dividing its fund in two.

Tensions between LPs and GPs rising

Lawyers at one Silicon Valley law firm said that prior to this year, they had dealt with only one LP default, but this year there are defaults in almost every single venture fund they work with. High net worth investors who foolishly opined that venture capital was a safe bet commit most of the defaults. Some industry watchers say that desperate LPs may even band together in a class action and sue VC firms for poor performance, much the way shareholders file class action lawsuits against publicly-traded corporations. But in reality, that’s unlikely to happen. After all, the two need each other, in good times and bad.

VCs and fiscal discipline

Firms that aren’t cutting fund sizes or management fees are at least practicing what they’re preaching to their portfolio companies and becoming more fiscally disciplined. Big firms, including New Enterprise Associates, have cancelled big gala events that not only save hundreds of thousands but show they’re not hypocritical. Other firms have reduced travel and relied on technology to communicate.

Some of the smaller firms haven’t been so lucky in these lean times. Scores of firms have simply disappeared or been blown across the landscape like tumble. Indeed, in the next year or so, perhaps one-third fewer VCs than there are today will exist, according to some senior practitioners.

The ones who survive face an uphill challenge, especially with regard to technology spending. Having spurned many of the consumer-oriented start-ups that rose along with the investment bubble two or three years ago, venture capitalists are now looking for more “traditional” companies to back. They want start-ups to provide hardware, software or services that larger companies will want to buy. They want product, they want customers, they want revenue, and they want a path to profitability. They want a lot. Trouble is, there are very few larger companies buying products from the small guys.

Returns, what returns?

According to data by Venture Economics and the National Venture Capital Association, one-year returns on VC investments at the end of Q4 2001 came in at – 27.8 per cent. The biggest losers were early stage venture funds, which reported -33.9 per cent returns. Later stage VCs fared better, showing a -20 per cent return while buyout funds posted a -14.5 per cent return. The released data is compiled quarterly by tracking the performance of 1,400 US-based venture capital and buyout funds formed since 1969. Returns are calculated net to investors after fees and carried interest.

While the figures certainly don’t paint a pretty picture of the VC landscape, they are a bit brighter than were the Q3 2001 results. One-year venture capital returns are up approximately 14 per cent from the previous report, while both buyouts and mezzanine fund returns also improved. Also improving were short-term results for both venture and buyout funds over three-month, six-month and nine-month investment horizons. Longer-term results over the five-year, ten-year and 20-year time periods, however, were down slightly.

The downward trend in venture capital performance numbers seen in recent quarters is “an inevitable result as industry performance returns from the triple-digit returns seen during the last boom period back to sustainable levels that are more in line with historical averages,” said John Taylor, vice president of research at the National Venture Capital Association. “It may be some time until we see signs of recovery in the performance figures. Once the economy improves and technology spending begins to increase, it will take at least several quarters, if not several years for private venture-backed companies to mature to the point that they are ready for an IPO or to be acquired by a larger entity.”

“We still have a way to go,” says Peter Lawrence, managing partner with Stamford, Connecticut-based Flag Venture Partners. “Any continued improvement will be tied to how soon we see customer traction and increased spending in the IT and communications sectors. Only then will we see portfolio companies be [consistently] able to raise subsequent rounds of funding and possible exits.”

Between 2000 and 2001, the number of US venture-backed IPOs fell from 229 to 37 and the amount raised by VC-backed IPOs dropped from an all-time high of $21.1 billion to $3.1 billion. With the IPO window barely open a crack, venture-backed companies tried M&As, And while there were 322 deals done in 2001, up from 299 the year before, the value of those deals fell 77 per cent in 2001 from a disclosed $67.4 billion in 2000.

After seven years of funding ever-larger numbers of start-ups, VCs began to pull back in 2001. They supported 3,643 companies, 41 per cent fewer than they did in 2000. VCs, firm after firm, began admitting that their funds were too large. Mohr, Davidow Ventures told its LPs they were cutting the fund by 20 per cent, or $170 million. Others followed, including big name Kleiner Perkins, which told its LPs they would likely draw down 20 per cent to 25 per cent less capital than anticipated from its $627.5 million Fund X.

A week later, Redpoint Ventures said it would allow investors to keep up to 25 per cent of capital committed to the venture firm’s $1.25 billion second fund. Crosspoint told its LPs in its 1999 fund that no management fees will be collected until the fund returns initial capital commitments.

Following similar moves by US venture capital firms, Viventures has decided to cut its most recent fund by 20 per cent to $480 million. The firm, which is backed by Vivendi and a number of other investors, said it simply had too much money to invest in early stage deals. Moving in the other direction, Skypoint Capital has managed to raise $100 million in a second close of its Fund II. The firm focuses on early stage telecom deals in eastern Canada.

Sector focus

With an ever-increasing population of elderly Americans who are living longer and want new drugs and healthcare services that will keep them healthier and the fact that people are willing to pay top dollar for new drugs, means that any drug or device that solves a significant problem can command premium prices. That’s good news for life sciences, which has been one of the few sectors to excite private equity professionals lately.

What makes life sciences products so enticing is that they have huge market windows and long product life cycles. They are not like IT businesses where competition springs up overnight and the window opens and shuts too quickly. At the core of the new investments is the ability to look at smaller and smaller cells and molecules. Investors are confident that the two new areas – proteomics and nanotechnology – will yield a slew of products and services that will make drug discovery faster and more efficient.

The hottest area is proteomics, the science that attempts to understand the role of the proteins in the human body. Although the field is young and yet to uncover anything of significance, there are an estimated 200 companies or so that label themselves as doing something in proteomics or protein research. Venture capitalists see the area as a more focused attempt to develop drug targets. “It allows you to look more closely at a disease population,” says Whitney’s Jeffrey Jay. While genomics simply identifies and isolates disease-related genes, proteomics can further break down the genes and pinpoint the processes that lead to diseases.

If proteomics is hot, so is nanotechnology, a manufacturing technology that allows thorough and inexpensive control of the structure of matter. The term has sometimes been used to refer to any technique able to work at a submicron scale. Investors are confident that nanotechnology will help create products and devices that will enable them to look closely at molecules, especially in the identification of diseases and discovery of new drugs. The ability to design and manufacture devices that are only tens or hundreds of atoms across promises rich rewards in electronics, catalysis, and materials, VCs say.

The buzz around both proteomics and nanotechnology is big. But everyone involved will tell you that real products and services are still years away. While many of the companies involved are attempting to generate some revenues out of contract research, databases and other related services, the payoff is not in the immediate future.

As venture capitalists and companies hit the road to raise more money for proteomics and nanotechnology they need to learn from the last biotechnology cycle. That was in the late 1980s when venture capitalists, rebounding from computer technology excesses, funded a slew of companies that would discover new drugs and therapies. The promises made and the expectations raised were great but very few companies actually delivered. Not surprisingly, many of the companies soon found themselves scrambling for money and sceptical investors unwilling to ante up.