VCs Should Forget 2002 and Pray for a Much Brighter 2003

Last year was certainly a year VCs are going to wish they could forget. In fact, the venture world got so beat up in 2002 that VCs fondly reminisced about 2001. While in 2001 funds were falling short of their targets and the IPO window was virtually shut, in 2002, VC firms actually returned fund money and the IPO window was glued shut.

VCs complained in 2001 that only 35 venture-backed IPO were completed for a total of $2.8 billion. Last year saw only 22 venture-backed IPOs make it out the door and the period from July to mid-October marked the lowest combined IPO tally since the second quarter of 1978. We all know what the lack of exits meant – more money went into portfolio companies than into new companies.

Additionally, one could say that 2002 may be best remembered as the year of the fund cuts. Twenty-one firms slashed their funds by more than $5.8 billion. However, towards the latter part of the year the transparency debate that plagued LPs like the University of Texas Investment Management Co. (UTIMCO) and California Public Employees’ Retirement System (CalPERS) started grabbing headlines.

The bad news is, most don’t expect 2003 to be much better and many VCs tied the dreary venture conditions to the public markets. And it’s certainly clear that we aren’t on the road to IPO recovery just yet. Only one venture-backed company, VistaCare Inc. (Nasdaq:VSTA), has gone public since the start of the new year. By this time last year there were already four venture-backed IPOs.

“The public markets will continue to remain shut and firms are going to have continue to be the triage unit. The public and private markets are linked. The big collapse of public markets has left everything in disarray,” says Stuart Collinson, a partner with Forward Ventures, an early-stage biotech investor that raised a $250 million fund in 2001.

Bob Pavey, a general partner at Morgenthaler Ventures, adds, “The rule is that things will get overdone and go in a cycles, and that’s what happened with the IPO market. Now is a time to work with current companies and figure who deserves to be funded and what should be wound down or sold.”

John Flint, a co-founder and managing director with Polaris Venture Partners, a Waltham, Mass.-based firm that invest in medical and information technology companies, has a slightly different view. He says now is the time to buy. “In many ways the venture business is at a Darwinian moment. It’s survival of the fittest. For both 2002 and 2003 there was and will be a lot of challenges for the venture industry. We’re living a bipolar existence right now. The exits market is difficult and will continue to be, but the investment side is terrific. Prices are low and terms are great.”

As a result of the challenging environment other issues arose in 2002. It seemed like everyone from Charles River Partners to Kleiner, Perkins, Caulfield & Buyers cut their funds and that trend has already continued into 2003 (See chart, pg. 13).

“More fund cuts will depend on the environment. I would like to see the economic environment improve, it would nice to have an M&A market or public market again so companies can prosper and firms can invest, but it is hard to say right now if that is coming back,” says John Stobo, a general partner with ABS Capital Partners.

Brian Conway, a managing director with TA Associates, went on to say that he doesn’t believe firms are not done right sizing their funds. “There are a number of things coming up. Some firms have a date at which point they can’t make anymore investments out of that particular fund. If they can’t really invest it all by then we are not done with this,” he says.

Collinson agrees. “In general there is a lot of capital in the industry overall. A lot of money was raised in the boom period of 1999, 2000 and 2001, and now it needs to be returned. Forward’s funds are between $250 million to $400 million and that is more than enough in today’s world, unless you do more than just venture like Warburg Pincus and Apax Partners,” he says. “It’s no doubt they invest in a controlled way and are turning more towards buyouts. The high-tech firms where they are sitting on large amounts of cash may spend lots of time looking for worthy investment. In that case it makes sense to return it and they will.”

The firms that have the option of investing in venture deals or buyouts have indeed turned towards buyouts. The numbers tell a grim tale for the venture industry in 2002. More than $19 billion went into buyout deals in the fourth quarter of 2002, bringing the total volume of deals for 2002 to $42 billion – almost double what was disbursed in 2001. In 2001, venture deals brought in $43 billion, however for the first three quarters of 2002 (PE Week will have year-end disburements next week) venture deals only brought in $16 billion.

“In 2002, traditional buyout firms got back to basics. In 1998, ’99 and 2000 they were making minority investments in telecom deals, which is very different from going into a company and restructuring it. You did see people getting back to the business of buyouts and away from PIPEs [private investments in to public equities] and venture-like deals,” Conway says.

Looking at the numbers

Transparency among venture firms became a hotly debated issue in the second half of 2002. It started with a landmark decision from the board of the UTIMCO, which voted in September to unanimously to disclose financial information related to both its public and private investment portfolios. The move was largely prompted by a budding public relations crisis surrounding UTIMCO, and led to the disclosure of performance figures for many of the nation’s leading venture capital and buyout shops.

However, while public funds are now disclosing information about venture capital and buyout shops, portfolio company information has been deemed a trade secret by the judge that presided over the San Jose Mercury News’ case versus CalPERS. What’s more, VCs don’t seem that bothered by the outcome.

“People will have to learn to accommodate this request. Individual portfolio information will not be released and there has been a lot of pressure on both sides on this issue so now at least we’ve hit a middle ground,” Pavey says.

While Forward’s Collinson seems less happy about increased disclosure, he and firm too are coming to terms with it. “I think the problem is the VCs provide more than just IRRs to LPs. If the LPs disclose the IRRs almost by default they have to give other information. Venture capitalists may have to restrict the information they give the LPs or just be vague. But the LP and the VC are supposed to be partners, and it would be sad. We look for a close relationship with our LPs and wouldn’t want to see any action the mess that up,” he says.

Stobo believe the transparency debate will blow over, just like everything else does. “We don’t have problems with the IRRs being released, but this is a long-term assets class and the returns are not objective. Lots of people don’t understand how the class functions over time. The bigger issue would be if the private equity industry was forced to disclose individual information,” he says. “This issue is still being debated, but as the numbers get put on firms’ Web sites, people will find another issue to focus on.”

What’s Next?

No one knows what 2003 will hold, but no one is too optimistic.

“We’ll continue on with business as usual. This industry goes through cycles, venture capitalist were kings at one time and could do what they want. Now things have swung the other way, we have been through this before,” says Pavey.

Polaris’ Flint says, “We’re just in the process of pruning the forest people are going to start investing again. There’s a whole bunch of interesting stuff going on in genomics, medical devices and in the IT space. I think we will look back at 2002 and 2003 and say they were great times to be investing.”

Conway agrees that 2003 will indeed be a time to get back to investing. “We definitely won’t see a robust recovery; it will either be a grinded out recovery or no recover. Assuming we don’t go to war, because that would change everything, we will get a slowing improving environment and more confidence. This year has a chance of being a reasonably good year. And investments made when coming out of the bad time tend to be the best,” he says.

Contact Danielle Fugazy