Venture Capitalists Are Alive and, Well, Cautious
Today, Investments Often Come At Later Stages
By Nicholas Johnston
Washington Post Staff Writer
Wednesday, July 3, 2002
Venture capitalists, experiencing the worst downturn in their industry in a decade, are still finding some investments worth making.
Although returns are plunging for venture capital funds that fueled the tech boom in the late 1990s, some firms have raised new money and others still are sitting on billions raised in happier times that they have yet to invest.
Reston's Updata Venture Partners finished raising money for a $67 million fund in the spring of 2001. Since then it has invested about a quarter of the fund in four companies and has already sold one of them. Still, Updata hasn't made a new investment in 14 months, even though John Burton, the firm's managing general partner, estimates that it has looked closely at about 150 companies.
But the company's wallet may open again. Burton expects to close a handful of deals in the coming months. "We are extremely busy," he said.
ECentury Capital Partners in McLean closed a $90 million fund late last year, and although the firm has made a dozen investments, it has committed only $12 million and taken four board seats, giving it ample time and money for new investments.
"A lot of the deals we're seeing tend to be a little later-stage," said Thomas Dann, one of ECentury's managing directors.
That seems to be one of the keys to making a successful deal lately. Later-stage investments in firms with experienced managers who have real products and customers win the venture capitalists' favor.
"The percentage of qualified management teams is up dramatically," Burton said. "They're working on expanding their business model instead of creating it."
Venture funds in the first quarter invested just $5.1 billion, a 53 percent drop from a year earlier, according to VentureOne Corp., an industry research firm. They raised just $2.25 billion in the first quarter, the lowest amount since 1995.
If you look at a five-year period, venture capitalists made a 35.9 percent return on their investments through the end of 2001, Thomson Financial/Venture Economics reported. But that counts the 3,135 still-surviving start-ups that were funded during the boom years of 1999 and 2000, a large percentage of which are expected to fail.
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Venture capitalists attending a prominent industry conference last month said they are bracing for a "traumatic contraction" that could wipe out half of the nation's 800 venture firms in the next few years.
"You can just look at the numbers and see that another day of reckoning is coming," Peter Barris, managing general partner of New Enterprise Associates' Reston office, told the Associated Press recently. "We are going to have to go through another painful trough."
In 2001, the value of early-stage venture capital funds fell 33.9 percent. That means that $100 invested in an early-stage fund on Jan. 1, 2001, would have been worth $66.10 on Dec. 31. Later-stage venture investments fell 20 percent in the same period. The value of all venture funds fell an average of 27.8 percent, marking the first annual loss recognized in any year since the industry began tracking returns in 1980.
So it's no wonder that venture capitalists are looking for bargains that could net bigger returns if the investments are cashed out.
The costs of expanding a business have dropped, costs that venture-financed companies tend to spend a lot of money on before they make a dime in revenue. For instance, office vacancies in Northern Virginia rose to 14.5 percent in the first quarter of this year, the highest rate in three years, making housing for growing businesses cheaper. Labor costs are starting to come under control, too: Salaries have stabilized or dropped, and the labor shortage has reversed.
"It's the cheapest time to put together companies from an infrastructure standpoint that you're going to see," said Burton. "Legal fees, accounting fees, recruitment fees, rent -- particularly office facilities -- there are tremendous values out there."
"The whole thing with venture capital is buying low and selling high and this is a very good time to be buying low," said John Taylor, vice president for research at the National Venture Capital Association.
But venture capitalists earn money by selling companies they invest in to larger companies, or taking them public by selling shares on the stock market. If the seller's market is lousy, the climate for initial public offerings is frigid.
"What we saw in the second quarter was a slow trickle," Taylor said. "It's still way below the pace that we need to sustain a healthy industry."
That also has played a role in making companies cheaper, as opportunities to sell them remain scarce and venture firms are faced with supporting their investments longer than before.
"There's a reason why valuations are low," said Dann of ECentury. "I think that is because the holding period is likely to be longer."
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