and Business Resources
JULY 18, 2002
VENTURE CAPITAL VCs Don't
Want Your Money Anymore
With coffers bulging and scant prospects for the quick returns
that characterized the boom years, they're returning clients' investments
Venture capitalists have a problem that most anyone
would envy: too much money. During the boom times, VC funds, which finance
startup companies, reaped staggering profits, and an embarrassment of
riches from grateful investors.
What a difference a bear market makes. Now, most VC funds are underwater
and quality investment pickings are slim. Foundations, pension funds,
and endowments--the limited partners, or clients, of VC funds--are getting
really edgy. What's more, nobody is in the mood to tie up money for the
five years or more it takes typically for a high-risk venture to bear
NEGATIVE INFLUENCES. That has set in motion
an unprecedented retreat by the VCs. They are shrinking their billion-dollar
funds, giving back money and forfeiting management fees. It's not that
they're cutting refund checks, but rather releasing investors from their
contractual commitments to fork over more money for future investments.
"It's the moral equivalent of a refund check," says Kirk Walden, national
director of venture-capital research at PricewaterhouseCoopers.
Through June, the givebacks have totaled at least $3 billion. And that's
a fraction of what's to come, observers say. In fact, VCs may end up returning
about $50 billion to investors in the next year. That's roughly equal
to what the global venture community laid out in investments in the four
years through 1998, before the floodgates broke in 2000 and a record-breaking
$105 billion was invested.
Why are the VCs handing back cash that they normally scramble to attract?
"The issue here is the return that you can expect to get on the money
two years from now," says Robert C. Roeper, managing director of Boston
VC Venture Investment Management. "It might just be negative."
MANY UNHAPPY RETURNS. Judging by VCs' recent
performance, he could be right. When first-quarter performance figures
are published before the end of July, 2002, they're expected to show losses.
Last year, VC funds posted a collective loss of 28% -- the first since
1970, when the numbers were first tracked. It's a blemish on an otherwise
stellar record: The funds have earned 26.4% a year for the last decade
and 18% a year since 1980.
Marquee names are leading the charge to hand back cash. Texas-based Austin
Ventures Texas returned $670 million from a $1.5 billion fund in June.
Charles River Ventures cut its latest $1.2 billion fund by more than 60%
just weeks earlier. They followed a slew of venerable Silicon Valley firms
-- Kleiner Perkins Caufield & Byers, Accel Partners, and Mohr, Davidow
Ventures -- that had cut their billion-dollar funds by up to 32%. Cutbacks
at those three firms alone took a total of $800 million out of the investment
To be sure, the refunds aren't about altruism. A firm that gives back
money now will likely have an easier time raising more of it when the
going gets good again. Meantime, they're forfeiting future fees -- of
about 2% a year on collected funds, plus a cut of any profits -- they
would have earned had they called in the money, though they're still getting
paid for idle funds they have in hand. "We're walking away from several
million dollars to make a statement that this business has way too much
money," says Ted R. Dintersmith, general partner of the 32-year-old Charles
River Ventures, whose clients include Notre Dame University, Hewlett-Packard
(HPQ ), and Memorial
Sloan-Kettering Cancer Center. "It's the right thing to do, but it's a
painful thing to do."
QUICK PROFITS? NOT ANYMORE. Even with the
downsizing, there's still too much money in the pipeline. In the first
quarter--the most recent data available--VCs invested $6 billion, equivalent
to a more typical annual investment of $25 billion. But there's still
an $80 billion overhang of uninvested capital from the 1999-2001 banner
years. "There's enough money in the bank to last the industry for several
more years," says Walden of PricewaterhouseCoopers.
The VCs' conundrum is the lack of exit strategies. Even when they find
entrepreneurs worthy of funding, VCs are no longer able to unload their
upstarts quickly and reap easy profits. The stock market is sour on both
initial public offerings and mergers, and the outlook is worsening: According
to Thomson Financial Venture Economics, VCs raised $1.96 billion through
IPOs and mergers and acquisitions in the first quarter this year--a 40%
drop from the final quarter of 2001.
The meteoric growth in assets during the bull market sowed the seeds of
the VCs' current problems. Too much money chased a lot of bad business
models. And those bad deals are still on the books. Dintersmith notes
that few of the 300-odd private optical-networking companies that got
financing have any hope of survival. "I don't think you're going to see
298 become successful," he says. "It's going to be a bloodbath."
SUCH A HANGOVER. Not so long ago, any entrepreneur
with a half-baked idea could raise millions from VCs. Follow-on financing
deals were a cinch. For a fast payoff, VCs pushed companies out assembly-line
fashion to frenzied markets that bid up their shares. Investors couldn't
pile in fast enough. "In the old days, you didn't worry too much about
the fundamentals of the business. The arrogance was unbelievable," says
Peter B. Yunich, managing partner of New York Metropolitan Venture Partners.
"The VCs that raised a lot of money during the halcyon days, to put it
bluntly, have not performed well."
As a result, VC funds are now raising less than their initial targets
for the first time in memory. In June, for example, Murphree Venture Partners,
a venture-capital firm based in Houston, closed its fifth fund at $28
million, well below its $100 million goal. Others are scuttling their
plans altogether: Bank One Corp.'s private-equity arm shelved a $200 million
fund of funds, citing a lack of interest among high-net-worth clients.
Although painful in the short term, the current shakeup will only help
the market, say fund managers. "Our portfolio companies are going to have
to use less cash to get to profitability," says Robert P. Badavas, who
is chief operating officer of Atlas Venture in Waltham, Mass. "We're adding
some conservatism back into the model." Atlas, which has $2.4 billion
of committed capital, cut the size of its sixth fund, the Atlas Fund VI,
by 12%, to $850 million, in June.
HALF MEASURES. New VC financing rounds are
about half the size they were in boom times -- from $10 million to $15
million for each startup. More seasoned entrepreneurs and fewer twentysomethings
are making the grade. "A year from now you'll see a stronger investing
climate, and VCs will be more aggressive in competing for companies with
a strong operational focus," Yunich says. "Innovation doesn't stop just
because the Nasdaq is down."
Venture capitalists, who kept the champagne flowing during the tech bubble,
are now nursing their own hangover. They'll continue to attract a trickle
of money, even during tough times, because they're an important asset
class to big pension funds and foundations. But to persuade investors
to return in force, they'll have to keep sight of the lessons of the bust.
By Mara Der Hovanesian in New York
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