How Long Will It Take To Completely Recover?
By JANET WHITMAN
Dow Jones Newswires
November 28, 2001
NEW YORK -- Ask a venture capitalist for an outlook on the private equity market nowadays, and you're likely to hear a familiar refrain: "Things are getting back to normal."
Unsaid, however, is just how long this journey back to "normal" is, particularly after the dramatic swell and pop of the Internet bubble. In fact, based on history, experts predict it will take at least a couple more years before the venture business works through the massive overinvestment during the dot-com boom and bust.
Along this road to normality, look for more start-ups to shut down, the disappearance of more venture firms, a longer period of weaker returns and a slower pace of new investment.
"Right now what everyone is doing is triage," said Mark Jensen, a managing partner at accounting and consulting firm Deloitte & Touche. "They're trying to salvage what they can out of their portfolios. They're going to shut down what needs to be shut down, try to merge what's reasonable, reduce burn rates, and get their companies to cash-flow break-even."
In many respects, the situation mirrors the last venture industry collapse in the mid-1980s, when an investment binge in personal-computer and disk-drive companies was followed by a seven-year slump.
"There was overinvestment in certain sectors back then," said Paul Gompers, a professor at Harvard Business School who follows venture-capital trends. "A decline in the public markets and a lack of opportunities to take firms public was part of that problem. Now the degree of that drop is much greater."
Although the industry won't snap back anytime soon, observers and venture-capital veterans don't expect a downturn as protracted as the 1980s and early 1990s. "While I wouldn't say that next year will turn around, I'm not convinced it will take four years to work this out," said Mr. Gompers. "But by, say 2003, the venture market could return to some sort of normal ... [with] a healthy mix of early stage investment."
Time is the enemy of venture funds. With the initial public offering window all but shut and merger and acquisition opportunities few and far between, VCs are finding themselves hanging on to their portfolio companies much longer, with no exit opportunities on the horizon. But as the economy improves, those conditions too will brighten, observers say.
In the venture industry's favor now is the swift adaptation and desire for new technologies. Television, for instance, took half the time of radio to gain consumer acceptance. New technologies like fax machines and cellular phones caught on at a much faster clip. And, although the Internet has yet to live up to its lofty expectations, it is still bound to create plenty of demand for new ventures.
Over the next couple of years, however, the industry will see more fallout. This time around, with billions invested instead of the mere millions back in the 1980s, the stakes are much higher and the pain already greater. A glut of initially funded start-ups created during the Internet boom is making it difficult for those seeking the next stage of financing. Only 9% of all venture-backed companies eligible for a series B round of funding managed to secure financing in the third quarter, down from 12% to 16% between 1996 and 1998, and far from the peak of 22% in the fourth quarter of 1999, according to venture-capital research firm VentureOne.
That is bad news for venture funds that pumped millions of dollars into those companies. For the past 18 months, VC firms have been mulling whether to pony up more cash in follow-on financing rounds to keep the companies afloat or simply let the companies die and write off the investments.
Some experts estimate that trend will take at least another year to work its way through.
Another big difference between the 1980s and now is valuations, particularly for investments made at the height of the Internet frenzy. "If you went back to the mid-1980s, $3 to $5 million for series A funding was considered huge," said Mr. Jensen. "Today, series A is often $10 to $15 million. If you only have $3 million in a company it's easier to walk away from it and move on. That's the biggest difference. Overall valuations have gone out of control."
Lowered Expectations
The current environment has prompted most venture capitalists to lower their expectations for returns from last year. According to a Deloitte & Touche survey on Silicon Valley investor confidence, one-third of venture capitalists have reduced their return expectations by more than one-half. A further third of those surveyed lowered their expectations by one-quarter to one-half.
Market observers don't have high hopes that vintage 1998 and 1999 funds will post much, if anything, in the way of returns to investors. "They invested in so many companies that they forgot the cardinal rule of venture capital: You're managing a company," said Jesse Reyes, vice president at Venture Economics, a unit of Thomson Financial that tracks the venture industry. "There was $100 billion of investment last year. It's either going to be good or bad. My guess is that half is going to be OK, one-third is probably absolutely in the toilet and probably a quarter will be spectacular."
Those odds probably aren't much different than a decade ago, but, again, a lot more money is at stake now, Mr. Reyes added.
Despite the sour returns, experts don't see investor appetite changing significantly. VC Investors, often pension funds or endowments, have a long-term view and are well versed in the peaks and valleys of the business.
Venture returns have slipped into the red at negative 18.2% for the yearlong period through June 30, according to Venture Economics and the National Venture Capital Association. But three-year returns are still up 54.5% and five-year returns are up 40%.
As for VC firms themselves, many newer ones with no track record and nothing to show after three years investment will struggle to raise another fund.
Rather than spectacular flameouts, many of those firms will continue to collect their 2% fees on capital over the life of their funds. Instead, similar to toll booth workers when E-Z Pass came in, some firms will slowly disappear.
Most more seasoned venture capitalists, meanwhile, won't be throwing in the towel. "There was a period up until April 2000 that made this business look very easy and now it has swung dramatically the other way," said Art Berliner, a 27-year veteran of venture-capital investing in the San Francisco Bay area.
Mr. Berliner says the current climate is reminiscent of the period in the mid-1980s. But he hastens to add that his firm, Walden Venture Capital, founded one of its most successful funds in 1984. "I don't think you can look at the whole industry generically," he said.
Venture investment may be at a slower pace and on a smaller scale over the next couple of years, but it is coming off pretty Olympian heights, experts are quick to point out.
U.S. venture-capital investments plunged 73% to $7.7 billion in the third quarter, according to Venture Economics and the NVCA. Still, the pace of venture investing is on track to finish the year as the third highest on record, albeit well behind last year's record $105 billion total and 1999's $56.9 billion.
"There's still going to be a venture industry," said Paul Mannion, president of Hyperion Partners in Atlanta. "People are still enamored with the hope that they can identify the next Microsoft."
Write to Janet Whitman at janet.whitman@dowjones.com |
