Nobody Wins When We Invest Too Much Money
By Dan Primack, Editor-at-Large
Venture Capital Journal
December 1, 2002
Ted Dintersmith is not your typical venture capitalist. A general partner at Charles River Ventures, he has become something of an industry activist when it comes to issues of capital overhang and investment pace. He and his partners jolted the industry in May when they reduced the size of their vintage 2001 fund by 63% to $450 million, by far the most dramatic cut by a billion-dollar fund. Even so, he now wonders if the cut should have been even deeper (more on that below).
To supporters, Dintersmith is simply a plainspoken guy trying to help save fellow investors from their own excesses. To critics, however, Dintersmith is overstating the problem. In a letter to the editor in last month's VCJ, Dana Callow Jr., managing general partner of Boston Millennia Partners, wrote: "Ted has repeatedly been quoted recently highlighting the problems of the industry, and his concerns have been over(duly) [sic] noted." (See Dintersmith's response to Callow's letter in Talk Back, page 52.)
Dintersmith has no intention of clamming up. On Jan. 21, he'll go head-to-head on a panel about the issue of disclosure with the chief investment officers of the California Public Employees' Retirement System (CalPERS) and the University of Texas Investment Management Co. (UTIMCO). "I'm showing no fear these days," he says with a chuckle. VCJ Editor-at-Large Dan Primack met Dintersmith at CRV headquarters in Waltham, Mass., to talk shop over a lunch of chicken cordon bleu. Here's a transcript of the conversation.
Q. You wrote a VCJ Viewpoint in March arguing that the venture capital market had enough cash to last comfortably until 2005. Considering some of the fund cuts that have occurred since you wrote that piece-including the one at CRV-is that outlook still accurate?
A. It's hard to be precise about the exact year the money will be in balance because we don't know how much in new commitments will be made in the remainder of 2002 or 2003 or 2004. I think that trajectory will have a lot to say about when our industry gets back to a healthier footing for generating capital gains for our limited partners.
But if you look at the fund reductions, it's only been on the order of around $4 billion out of the approximately $75 billion that's currently committed to venture firms. It's important for us as a firm in terms of how we run our business. But other than symbolically, it doesn't have a large impact on the overhang dynamics of our industry.
Q. When CRV made its cut in April, you said that you'd probably be back raising your next fund in the second half of next year or 2004 at the latest. Is that still the plan?
A. It's changed. We made the decision to cut back to $450 million over six months ago, and at the time sized it to return to market roughly three years after the original close, which would have been, as you said, 2003 or 2004. Since we made the cut, however, we've redone the analysis of how long the $450 million will last us, so now we'll come back at the end of 2004 or maybe 2005. The reason that's significant is that we made a very large cut of 63% that some people might have said was an overreaction. But, if anything, we actually could have taken it down even more significantly.
Q. There will, however, be some firms, like Battery and Sequoia, that are going to come out with new funds next year. Will the size of those funds and management fee structures set some sort of industry standard that will be important to firms like CRV?
A. I do think that the size of fund they choose to raise and where the funds get capped will have a significant amount of influence over how quickly our industry gets back to a healthy basis. From my point of view here in Waltham, I'm hoping that they come back to market with much smaller fund sizes and a real discipline over how they invest the money. I remain convinced-and I think this is supported by industry data-that nobody wins when we invest too much money. Not the general partners, limited partners or entrepreneurs.
Q. Is there still too much money being put to work, or have folks slowed down?
A. There are two answers to that question. If you look at disbursement levels for 2002, it seems that the number will be in the range of $20 billion to $25 billion for the industry. If you overlay that with how difficult the exit environment is, and the range of annual exit values we've been able to generate as an industry, I can make the case with the math that a $25 billion investment pace is going to be consistent with 20 cents to 60 cents on the dollar. So is the industry investing far too much money? Clearly it is.
I think a lot of [the money] is going to restart large financing rounds of companies that ultimately will fail. In a limited way, that's good news for the industry because it will work off some of the overhang more quickly. But it is far too much money on an aggregate level. I also think you're seeing fewer first rounds being done and increased due diligence periods, which means that there is some good news in this picture.
Q. Is the disbursement slowdown because firms like CRV are much more picky, or is there an overall decline in startup entrepreneurship?
A. I think that the number of really distinctive, high-potential early-stage companies out there raising money is cycle independent. There are always going to be certain entrepreneurs who see a great opportunity and just want to go for it without paying attention to the Nasdaq or venture capital investing levels.
What investors are wrestling with, however, is when a team of these entrepreneurs comes looking to raise $5 million to start a software company. They now have realistic expectations on pre-money, so the good news is that we're down to $4 million pre, $5 million in, and $9 million post. They'll also need to raise more money in 18 months, when they should have a product in beta and early signs of revenue at $1 million to $2 million annualized.
So, an investor [like me] has an opportunity to write a check for $5 million, work like crazy for 18 months and, if they hit their plan, see my original $5 million turn into a $1.5 million credit in the pre for the next round. And so that's slowing a lot of investments down, and I think you see a lot of people dealing with that math on a company-by-company basis. It doesn't necessarily mean that you're stepping away from the industry, but there is a sort of disconnect at that level.
Q. Is there any chance the early guys will start doing later-stage deals to work through their funds faster?
A. History, I think, shows that the groups good at one thing executed the other thing quite badly because they were late to market without much expertise. If I were an LP, I'd be very concerned if the fund-size tail was wagging the investment-strategy dog.
Q. There was a huge fund cut spurt back early in the year, but there have been very few since the summer ended. Why the slowdown?
A. It's hard to speak for other firms, but it may have something to do with the fact that a lot of firms raised funds at around the same time. I think that the later you are in your fund's investment life, the harder it is to reduce the fund size and not be left with a very difficult management fee issue. For argument's sake, if you are five years into a fund and reduce its size by half, you may have actually drawn your entire management fee in the first five years if you weren't being careful about how you managed it.
Or, you may have to go back to your limited partners and double the management fee ... and that would not be a popular move. At the end of the day, I think the more tenaciously you adhere to a big fund, the higher the bar being placed on yourselves and your LPs in terms of being able to generate capital gains for the fund.
Q. Speaking of capital gains, will the likelihood of additional disclosure by public pension funds and their ilk affect how funds are managed?
A. I think that the way in which the Freedom of Information Acts are being applied to public entities that invest in venture funds has the potential to have a profound affect on our industry. I don't think the first response from general partners will be in changing how they manage their funds, apart from possibly reconsidering the makeup of their limited partner base going forward.
From our point of view, there are gradations of concern. First, we provide all of our LPs with quarterly information on how each portfolio company is doing, and we'll fight to the death to prevent that information from being made public. We think that there's a reason private equity is called private equity. There is no benefit to anyone in the universe, from what I can tell, to publicizing the financial valuations of private companies. I don't think it helps the pension participants, the fund managers, attorney generals or the guy who wants to build a database.
Second, interpreting fund performance is very challenging. You can have two groups that each raise $500 million funds at the same time, and both be negative 40% on a value-to-cost basis three years later. So you look at it and think that both funds are performing the same, but they could be quite different because of the underlying securities.
Even a fund that is, in theory, fully matured with an IRR of 52% might not tell everything that needs to be known. When we go out to raise a fund, the smart LP wants to know not just what our "in-theory return" was, but if they had held the stock what it would have been. So you have an entirely different as-held calculation that a lot of LPs might actually put more weight on. Well, that's not part of the Freedom of Information Act petitions, but it's a very important complementary piece of information. So what sounds really simple-"We want full disclosure when a public entity is investing in a venture fund"-actually has a lot of sensitive and potentially dangerous issues.
Q. Should there be any disclosure?
A. We do believe there should be full disclosure if there is a conflict of interest, because there's a relevant tie between our firm and someone in a pension fund. Our attitude about fully mature funds is that it's kind of like having your grades posted online. We're really proud of our grades and have worked really hard for them, so that part is partially who cares, but it also seems a bit like an invasion of privacy.
You'd hope that the people petitioning for this information would have the intention of benefiting the pension funds, but I think they'll actually just cause a lot of problems for the funds. You have an environment where fund sizes are shrinking, so top-tier firms are going to have to decide which LPs they keep and which just don't make sense anymore. A lot of these groups may have 150 LPs in their current fund, but only need 75 in the next one. You may really like the people at the pension fund and you might really like the cause and want to do a really good job for the participants ... but if you can't make sure that critical information is safeguarded ...
Q. And the confidentiality agreements don't seem to help.
A. Right. So if that's just going to be ignored, then our strong bias is going to be to concentrate our limited partner base on people who can safeguard the information. So then the public pension funds are largely going to be unable to invest in the top-tier private equity firms. Is it a good outcome for those pension funds to invest in middle or low-tier private equity funds? Probably not. Is it good for them to not invest in private equity? Probably not, again.
Q. So did firms like Kleiner Perkins and Greylock have the right idea by excluding public institutions from their funds?
A. It's hard to answer for other groups. But to say that not having public entities in your limited partner base is categorically a good idea would not be consistent with our experience. We've had some great long-term limited partners that are municipalities around the Boston area or retired government workers or firemen or policemen.
We did a very good job for them in our sixth, seventh and eight funds, and it was exciting to go to their annual meetings and have someone stand up and say: "We were able to increase pension payouts to our retired firemen by 15% this year strictly because of your performance." So, I'm very glad to have had that. Would I be disappointed if I couldn't have that going forward? Yes, but my first priority is to my entrepreneurs and, as a firm, we won't do anything to jeopardize the private relationship we have with the entrepreneurs we back.
Q. Would CRV sue one of its public LPs to prevent the release of information you believe is covered by a nondisclosure clause?
A. Currently, we're right in the middle of those discussions, and I can't comment on what we would or wouldn't do.
Q. Since there are no industry standards for venture firm performance reporting, will some firms be tempted to alter their accounting practices so as to look better on paper if, and when, their IRRs are published?
A. I'd certainly hope not. I think there's a balancing act between your LPs and newspaper readers in this case. If you take actions that your LPs think are unproductive or unrepresentative of what's going on in your portfolio, you may have won a public relations battle but lost the real war.
The problem is that an LP can receive three different reports on the same company if three of their general partners invested in it. One firm might carry the company at the price of the last round, one would carry it at cost and the third might carry it at what looks like an arbitrary number in between. I think VCs have been trying over the past two years to deal with some of these problems, but the truth is that no one really knows what a company is worth until you are actually paid cash for it.
Q. Last word?
A. There is an opportunity at a challenging time like this for our industry collectively to exert leadership and to really focus on the right things: an appropriate but not excessive amount of capital, a tight alignment between LPs and GPs and a real focus on growing strong business that can generate capital gains.
Ted Dintersmith
General Partner,
Charles River Ventures
Born: June 15, 1952
Education: Bachelor's, English and Physics, College of William and Mary, 1974; Master's in Applied Physics and Ph. D. in Engineering-Economic Systems, Stanford University, 1982.
Work History: Staffer focused on science, technology and environment, U.S. House of Representatives, 1976-78; Marketing Manager/GM, Digital Signal Processing Division, Analog Devices, 1981-87; General Partner, Aegis Venture Funds, 1987-1996; General Partner, Charles River Ventures, 1996-present.
Investment Focus: Early stage software and information services companies.
Investment Hits: IPOs for Be Free, Flycast, Ibis Technology, Individual, NetGenesis, Software Quality Automation and Vignette. "High-multiple acquisitions" for Novera, PCs Compleat and WebSpective.
Board Seats: Bowstreet, Compete, eDocs, Netezza, Trellix, Ximian and the National Venture Capital Association.
Personal: Married with two kids.
Recently Read: Daniel Mason's "The Piano Tuner"
Most Admired Movie: "Schindler's List"
Did You Know? He was the quarterback of two intramural co-ed champion football teams at Stanford, including one captained by Jeff Raikes of Microsoft fame, "who was an awesome split end!"
Copyright 2002 Securities Data Publishing |
