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Venture Capitalists Battle to Keep Portfolios Afloat --- New Investments Buttress Companies Already Launched

04 Jan 2002: | Wall Street Journal | By Suzanne McGee.

Instead of writing checks for millions of dollars to finance new start-up companies, venture capitalists spent last year battling to keep their existing portfolio companies afloat.

Industry professionals calculate that as much as 80% of the new investments made by venture funds last year went to support companies those funds had previously helped launch. That proportion was the reverse of prior years, when venture funds were able to quickly sell their investments at a profit, either through an initial public offering of stock or acquisition by a larger company.

Overall, venture funds invested some $58.73 billion (64.97 billion euros) in start-up companies in the 12 months through Sept. 30 (the latest period for which data are available), down 46% from the previous year. In the three months ended Sept. 30 alone, venture investing plunged 73% from year-earlier levels, according to data compiled by Venture Economics and the National Venture Capital Association.

Still, most industry participants expect that when results for the full year are tabulated, 2001 will be the third-most-active year ever after 1999 and 2000.

But last year, venture investors finally accepted the bitter truth. Their fledgling companies weren't always going to generate triple-digit returns in a mere 18 months; a third or more of their portfolio companies would collapse after consuming millions of dollars of venture investors' dollars.

As recession bit into the U.S. economy, demand for products of many fledgling companies backed by venture investors evaporated. As sales dried up, the demand for capital rose. But public markets were averse to buying shares in start-ups, leaving venture funds with only two options: keep financing their promising companies themselves, or let them collapse.

"The venture world looked like an emergency-room triage section," says Craig Johnson, a Palo Alto, California, attorney for Venture Law Group, a law firm catering to venture-capital firms. "And we still have another year of triage to do before the surviving portfolio companies emerge as self-financing or financeable by other markets or investors."

With lower valuations and a more stable stock market, some see anecdotal evidence of the beginning of a thaw in the investing climate. "In the last six weeks, I've seen more deals announced than in a period of months before that, and some younger companies (are) being financed," said Jesse Reyes, a director of Venture Economics, a division of Thomson Financial, in late December. "The key to this new environment, though, is that the venture investors can afford to be choosy about what deals they do, and they're exercising that right."

Dividing their time between supporting existing companies and trying to ferret out even a handful of promising new investment ideas proved difficult last year and some venture funds weren't equal to the task. Octane Capital Management, backed by institutions such as Goldman Sachs Group Inc. and hedge fund Tiger Management LLC, decided in April to stop making investments and return uninvested cash to its investors. In October, Mohr, Davidow Ventures, one of the most established Silicon Valley venture-capital firms, said it may not tap part of the $850 million investors agreed last year to give it for new investments.

"Already, I'm seeing some more junior venture investors, the guys who aren't partners yet, filling out graduate business school applications," says Mr. Reyes of Venture Economics. "Some funds, no matter how much triage they do, aren't going to be able to rescue their performance numbers."

Venture-capital returns have been slipping steadily since the fourth quarter of 1999, when the average fund returned a record 62.8%, according to Venture Economics. By the final quarter of 2000, the average fund recorded a 12.1% loss, the largest since Venture Economics began keeping track in 1969. In the three months ended June 30, the latest period for which data are available, the average fund recorded a loss of 3.8%, and Mr. Reyes expects more losses for the balance of the year.

"No one is immune to what's happening, even if they managed to avoid the dot-coms," says Steve Dow, a Palo Alto-based partner at Sevin Rosen Funds, a venture-capital firm. "A lot of funds were writing $30 million, $50 million, $70 million checks in some deals as their own fund size increased dramatically. There isn't a winner that's big enough to pull you out of that kind of hole."

Venture-capital firms talked about returning to the discipline that prevailed in their business prior to the exuberance of the late 1990s. "This was the year when people said, hey, maybe those rules set down by more experienced folks before 1996 weren't that crazy after all," says Jos Henkens, a partner at Advanced Technology Ventures in Palo Alto. "It was a wake-up year."

Despite the write-downs and losses, the constraints facing venture-capital funds as they move into 2002 isn't lack of capital. Many raised hundreds of millions, even billions of new dollars before their own window of opportunity closed early this year. But they have been slow to put it to work: Mr. Dow estimates that 80% of the $875 million that Sevin Rosen raised from pension funds, endowments and other institutional investors remains available to invest.

"The scarce resource these days is management time," says Mr. Johnson of Venture Law Group. "It takes a lot of energy to deal with the problem companies."