Once Bitten…
For long-suffering private equity investors, the worm may be turning: The IPO and acquisition markets improved through 2003 and are continuing to gain ground. But investors, observers and the venture capitalists themselves say there are still problems to be overcome before the sector is up to speed again. Funds need to cull nearly dead companies—mostly in the telecommunications sector—from their portfolios. And valuations at every stage, from start-up to IPO, need to find a happy medium between the extreme boom and bust levels experienced in the past decade.

Meanwhile, investors appear to be looking to invest in venture capital again. But, still suffering investment hangovers from their venture firms’ boom-time excesses (and their own overindulgence in this risky asset class), they are going out of their way to be prudent about it. They want even favored firms to demonstrate that their investors’ best interests are the top priority, that they can provide reliable performance data, and that they have forsworn the hubris and sloppy investing habits that they succumbed to during the bubble.

“When venture capital firms come around to raise money, people are going to consider whether they’ve done right by their investors,” notes Andrew Craighead, managing director for alternative assets at JP Morgan Chase’s private bank. “That’s not just a matter of returns,” he argues, referring not to investment returns, but to monies returned to investors by venture capital funds that found themselves unable to put it to good use. Attracting investors will also require lowering the management fees that had risen too high, and downsizing the funds that were too big to manage, Craighead says. Investors will also weigh whether the funds delivered bad news in a timely fashion.

The tribulations of Vanguard Ventures—a well-respected seed-stage firm in Palo Alto, Calif., that counts numerous individuals and family offices among its long-time investors—illustrate some of the problems facing investors, funds and portfolio companies. General partner Donald Wood reports that 85 percent of its companies are still operating, and fewer than 5 percent of his investors have tried to sell their stakes on the secondary market. Despite this, it has not been easy-going. The partners had to ask investors in their $100 million 1998 fund for an auxiliary fund when they ran out of money, and their portfolio companies needed additional rounds of funding to sustain them to exits.

Vanguard invests in start-up companies at low prices, helps them grow, and sells equity stakes to bigger venture capital firms at higher prices when the companies reach greater maturity. But those later-stage investors have lately had their own stagnant portfolios to carry, and they have not been seeking new investments—at least not without forcing markdowns in value that might or might not be deserved. “Instead of having A, B and C rounds [of financing], you have A, B, C, D and E rounds these days,” says Wood, and the original investors have to get through each of them without new firms coming in. “So we needed more money to support the companies we still believe are good companies,” he adds, until the firm can find exits for them.

While tending to these companies for longer than they anticipated, the Vanguard team also has been trying to invest the $240 million fund it raised in 2001. As that fund enters its fourth year, it has backed 17 companies, but still could benefit from a half-dozen more to round out the portfolio. Wood says the firm hopes to find those companies in the first part of 2004. But when it does, it will have to nurture them while at the same time trying to cash out on the prior fund’s investments.

TOP VIEW Two dismal years for the private equity industry have revealed the risks lurking behind the formerly outsized returns. Those of us who became embroiled in the technology boom’s euphoria are now struggling to manage underperforming private equity investments. As the market begins to show renewed signs of life, we need to work toward a consensus with the industry over issues such as the appropriate content, detail and frequency of performance and risk-information disclosures.

…Twice Shy
Many of us turned to angel investing for the first time in the boom years of the late 1990s, when levitating equity markets whetted our appetites for risk. Angels invest directly in very young, private companies by themselves or with a small group of fellow angels. Angel clubs are organized in various ways: Some pool their money and make investment decisions together, almost like a small fund. Others simply provide a forum where companies can pitch themselves, and individuals decide whether to invest and whether they want to join in with other members to share the risk. Regardless of the shape they take, these informal private equity groups are facing several of the same issues that confront the venture capital firms.

The last two years have brought many angels down to Earth. John May, managing partner of New Vantage Group, which manages a handful of more formal angel funds in the Washington, D.C., area, has been involved in the venture and angel communities in the Mid-Atlantic region for years. He headed recently to a meeting of the Washington Dinner Club, one of the groups New Vantage manages. The club has a limited amount of money set aside for “follow-on” investments, he says. “So the point of the meeting was to go over our portfolio and make some tough choices about which companies we would keep alive and which ones we’d have to walk away from.”

“The folks who became angels during the boom are depressed and turned off because things aren’t panning out as quickly as they expected,” May notes. As an experienced angel, he knows how to be patient. But with no new investments likely to happen until he and his fellow angels get some money back, even he is itching to do less financial engineering and more company building.

The Logjam Bursts
While it is not clear exactly how things will play out, 2004 is shaping up to be the year the gridlock eases. Most fundamentally, observers see the economy improving in ways that matter to young, growing businesses. Notes Anthony Hoberman, head of venture capital investments for Alliance Capital Management, “Inventory levels are falling and corporate purse strings are opening up. The rate of technological change remains high, and America still maintains the edge in technology by a wide margin. These things are all good for agile venture-backed companies.”

Five years ago, a 2 percent per annum management fee would have been considered aggressive, but during the boom years that followed, it became common. Some funds charged as much as 3 percent. Will firms now retreat to the more traditional 1 percent to 1.5 percent range? This year’s fund-raising efforts will tell.

These positive economic trends Hoberman sees should pave the way for May and those like him to pour energy into growing their most viable businesses. More companies should be able to get the revenue and cash flow they need to hold up under the scrutiny of an IPO or acquisition. 

Moreover, as business conditions improve and valuations begin to rise, expectations for investments made during the market’s peak have lowered. As a result, investors harbor more conservative expectations that venture capital firms believe they can meet.

The revival of the IPO market is also salving our nerves. A growing number of venture-backed companies went public in each consecutive quarter of 2003, for a total of 29, up from 24 in 2002 (but still down, of course, from 245 in 1999), according to the National Venture Capital Association, a trade group, and Thomson Venture Economics, a data vendor. Mergers-and-acquisitions ran a little behind 2002 at the end of the third quarter of last year—215 deals in 2003 versus 230 the previous year—but this number usually fluctuates from quarter to quarter.

More important to us as investors is the fact that valuations finally appear to be firming after bottoming out in 2002. The average size of the deals in which values were disclosed was $61.4 million for the first three-quarters of 2003, up from $54.7 million in the year-earlier period, according to Thomson Venture Economics data. This also suggests that more whole, viable companies are being sold—rather than assets of businesses about to go under, as had been the case for a time. “Acquisitions are how most of the exits happen, so the fact that there have been some interesting valuations suggests things are getting better,” Wood says.

Valuations and Trust
Financial advisors report that some of their clients have been inquiring about ways to get back into private equity, venture capital and related investments, and at a recent conference VentureOne held in New York, institutional investors also indicated they would welcome the venture firms that come to call later this year. That does not mean fund-raising will be easy. The industry as a whole still has missteps to account for and trust to earn back. In particular, firms need to improve how they evaluate and report their performance if they want our money.

In a strong market, venture capital firms typically spend the first three years of a fund’s life investing, years three through six or seven doing follow-on financings, and exit in years four through eight. Completely unwinding a fund can take 10 to 12 years. But in the last several years, it has taken funds much longer to invest their capital, and exits have been scarce.

“Venture capital firms were too aggressive in valuing companies up during the bubble, and didn’t write them down quickly enough when things fell apart,” says Jesse Reyes, director of the U.S. branch of Thomson Venture Economics.

This happens more easily than one might expect. A company will raise money, generating an overt agreed-upon market value, every two or three years. In the interim, venture firms have to trim that company’s value if certain definitive events occur, such as the loss of a key patent. But short of a few defined events, investors are relying on their venture capital firms’ best judgment in raising or lowering values as a company evolves.

Most venture capital firms get around this by holding the company at “cost,” or the value ascribed during the most-recent funding round, until there is another round. They argue it is the most conservative strategy and the best way to manage investor expectations. In an up market, it is. After all, if a venture capital firm has been understating a company’s value, and it is actually worth more than it has indicated, what investor is going to complain? But, “if a company is declining in value and you’re understating that, then you’re fooling people,” notes Antoinette Schoar, an assistant professor of finance at MIT’s Sloan School of Business.

“When venture capital firms come around to raise money, people are going to consider whether they’ve done right by their investors.” — Andrew Craighead

For the past few years, that has been the more likely scenario. Three-year net returns were running at negative 20 percent, according to the most recent data available from Thomson Venture Economics, and the shuttered IPO and acquisition markets have prevented the quick markups and exits on which some venture capital firms had been counting. All in all, we have been justified in wondering how many companies were being held at cost too optimistically because the venture capital firms overpaid for them to begin with.

The Association of Investment Management and Research (AIMR), an international trade group for investment professionals, and the Private Equity Industry Guidelines Group, a U.S. organization put together to address the valuation issue, are developing reporting guidelines that encourage firms to more actively use fair value instead of cost. But both groups acknowledge that using fair value is tricky. AIMR notes in a recent report, “The move toward a fair value basis has been gathering momentum in most areas of financial reporting. Particularly for early stage venture investments which may not achieve profitability for a number of years, practical problems remain and the utility of the fair value basis must win over greater support before a consensus on detailed guidelines is likely to be possible.”

According to Reyes (a member of AIMRs standards committee) and John Taylor, director of research at the National Venture Capital Association, the really pernicious problem is that valuing a company that has no profits—and perhaps no revenues or even products—is more art than science. Across-the-board, hard standards are not realistic for the proverbial three guys in a garage with an idea, so we are always going to have to trust our venture capital firm’s best effort.

There is also the question of how venture capital firms report results to both current and prospective investors. “Some firms have a meeting once a year and give a handout. Others provide incredible detail about every company in their portfolio,” says Schoar. To make matters worse, two firms holding the same company can value it differently, based on both technical issues, such as the terms for the round when they came in, and their judgment of how events have affected a business. Third parties such as Thomson Venture Economics provide benchmarks, but no data on individual firms or performance rankings. So to assess how a fund is doing, especially compared to peer firms, an investor’s best bet is to gather as many reports or prospectuses as possible and pick them apart, something not all of us have the time or inclination to do.

So those of us who are heading back into the fray are doing so more soberly than perhaps we might have a few years ago. We are exercising more caution and diligence than in the past. We are favoring funds with longer track records, and even then we are asking for former and returning investors and portfolio companies to provide references. And we are demanding more data than ever.

Intersouth, for example, always invites potential investors to its offices when it raises a new fund. “Previously, your old investors wouldn’t do the site visit, just the new ones,” says general partner Dennis Dougherty, but when the firm raised its 2003 fund, “every single investor came.” And the firm had scores of spreadsheets ready. “We explained how we calculated returns, provided lists of deals that worked out and that did not. If they didn’t, investors wanted to know why not.” When they were through there, several investors visited the portfolio companies to see for themselves how things were going.

About five family offices that had invested in several of Intersouth’s prior funds opted to sit out this cycle, at least in part because they did not want their commitments to get ahead of their available cash. But the firm replaced them with institutional investors whose regular firms were not raising new money or had shrunk the size of their funds. Dougherty wondered whether such small firms and individuals would easily be able to come back in when they are ready, or whether the bigger players would push them out. Others wondered whether small investors without a well-staffed research team would be able to acquire and take apart the information they need to make savvy investment choices in this new environment.

The excesses of private equity’s last few years are lingering but gradually “wringing themselves out,” as one institutional investor put it. And the environment for making investments is, by most accounts, improving. “If you have cash, this is a great time to put it to work,” notes Liz Hart McMillan, an active angel investor in the New York area. It remains to be seen, however, if 2004 is the year that venture capitalists and angels break the congestion and get private equity moving again.