Venture capitalists will spend 2003 polishing their portfolios--and their images.
By Julie Landry
The Red Herring
November 22, 2002
If 2001 was the year of the storm for venture capitalists, 2002 has been the year to canvas the territory, assess the damage, and decide whether to rebuild or move on. For those that press forward, 2003 will be a return to the drawing board, when VC firms spruce up the looks of existing portfolios and cultivate new images for their next funds.
Although VC funds have ten-year lives, they're designed to make initial investments over the first three or four years, leaving another six for follow-on rounds, exits, and distributions. According to the research firm Venture Economics, VC firms raised $243 billion between 1995 and 2000 to keep up with the frenetic investment pace. However, nearly half of that money was raised for year-2000 funds, just as the investment pace began to slow. Since then, only $50 billion has been deployed, leaving plenty of capital in VC coffers to last through 2003. As such, most firms won't need to hit up limited partners again until 2004.
They'll spend the next year prepping for that process. Some firms are actively seeking sales or mergers of companies in their most recent fund--even if those companies aren't yet mature--just to have exits on the record. Many are also looking to park their remaining dollars in more mature private companies or even the public markets, anticipating quicker returns than with early-stage companies. And a few firms will shift their focus entirely, in hopes of differentiating their funds from the pack when approaching limited partners.
There was little of this strategic thinking during the boom, when limited partners fought for stakes in venture funds, even though many funds had been exhausted so quickly that there were no metrics by which to judge their performance. In August 2000, Redpoint Ventures raised a $1.3 billion second fund (reportedly turning away another $750 million) less than a year after raising its $700 million first fund; it did this largely on the strength of the partners' track records at other firms.
Such fairy tales won't happen this time around. Limited partners say VCs have had enough time to make good on their early bets. "It was hard to see realizations with funds being raised every year," says Gary Hiatt, a managing director in charge of North American investments at Pantheon Ventures, which has stakes in about 20 venture firms. He says that, although there have been few IPOs, many VC firms are scrambling to sell companies--even with little or no premium--before hitting up LPs for new money in 2004. In the first half of 2002, there were 140 venture-backed merger-and-acquisition transactions worth a total of $3.6 billion. That's an average of only $26 million per deal--a fraction of the total capital that many of the acquired companies previously raised.
The new impatience of LPs has clearly driven some of those deals. When OVP Venture Partners decided to raise a sixth fund earlier this year, general partner Chad Waite says LPs first wanted to know whether OVP would be able to pay back its 2000 fund--just two years into the fund's ten-year life. But they're asking that of a lot of venture capitalists, and the answers aren't pretty: LPs expect that only about half of all 2000 funds will be able to do so.
OVP's $148 million fifth fund might well be one of them. Thus far, two OVP V companies have been sold profitably for the fund: Merck snapped up the bioinformatics startup Rosetta Inpharmatics for $620 million in 2001, and Motorola bought the wireless software developer 4thpass for an undisclosed amount in September. Still, in an effort to facilitate raising its sixth fund, OVP narrowed its focus, ending a lucrative 19-year investment history in biotechnology and shifting entirely to IT, particularly software, where Mr. Waite says the firm can deploy less money for greater returns than in biotech.
While larger, better-established VCs will be able to get by on the strength of their reputations and prior returns, smaller firms that want to raise more capital may need to follow OVP's lead and tout focused expertise or particular hits in a specific sector. In October, both Outlook Ventures and Tallwood Venture Capital announced new funds with narrower niches than their previous funds. Outlook's $140 million third fund will narrow the firm's IT focus to just software companies. Tallwood will keep its $180 million second fund dedicated to seed-stage semiconductor investments, after its first five years were spent investing in chips, software, and communications technology. On the fund-raising trail, LPs told Tallwood managing partner Dado Banatao that they preferred to have small funds focus on the technologies they know best.
Even those funds that plan to maintain broader portfolios have been cutting down on generalists and beefing up their benches in high-profile areas like software, security, and life sciences. For example, the IT investing partner Lise Buyer was asked to leave Technology Partners earlier this year when the firm decided to increase its emphasis on medical technology. Other firms--including New Enterprise Associates, Vanguard Ventures, and Walden International--have added life science partners in 2002. Small firms looking for a boost in LPs may even merge with similar firms, as Novus Ventures and Artemis Ventures did in August.
LPs and VCs expect more of the same in 2003, predicting that as long as tech spending remains sluggish, venture investing will proceed at a snail's pace. And when VCs head back out, cup in hand, for more alms, they'll face a much more cautious group of LPs than the last time around. They'd better get those PowerPoint presentations spiffed up.
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