Thursday, June 30, 2005

Excellent point made about the importance of client stability.

Boston Business Journal

From the June 27, 2005 print edition
The VC money glut

Loose institutional money chasing weak startups will spell 'day of reckoning' for many firms, say industry veterans
Craig M. Douglas
Journal Staff

Venture capitalists have been regarded for decades as the risk-taking cowboys of the financial industry. Upon further review, it seems many of these early-stage investors are all hat and no cattle.

Since 1990, venture capitalists have raised more than $327 billion from universities, pension funds and a slew of other sources of capital. They have reported returns of only 48 cents on the dollar, according to industry research and statistics from a local, prominent venture firm's annual report.

It is a track record that would quickly put any mutual fund or money manager out of business. But investment insiders say the performance gap is likely to widen as most venture firms and their moneymen continue to pour new capital into the market. The trend has some sages worried that the sector's "herd mentality" of piling into already-saturated industries will only worsen before it gets better.

But while the confluence of money has drawn sneers from virtually all corners of the venture community, few are willing to shoulder the blame when it comes to the industry's excesses. Longtime players point to the market's greener investors; up-and-comers blame a territorial class of old codgers whose best investing days are behind them.

Neither group has struggled when it comes to raising new funds. But the money glut rankles venture veterans, who liken their industry to a wavering house of cards. They claim certain institutional investors, desperate to reap outsized returns, are pumping up hundreds of unqualified venture firms; that money, in turn, often flows to weak startups and flawed entrepreneurs unable to raise funds elsewhere, they say.

The cash seems to be outstripping the entrepreneurial capacity within a host of industries. Local VCs link the imbalance to the "structural issues" baked into the startup community in the late 1990s, when a mountain of risky investments eventually gave way to staggering losses.

A similar scenario appears to be unfolding today, as venture firms universally promote their investing acumen even as many of their portfolios take on water. Industry experts say those losses will eventually drive dozens of venture firms out of business, but not before heavy losses are dealt to their limited partners, namely the pension funds, endowments and corporations that were unable to invest in top-performing firms.

Laggards keep raising funds

The sector's limited transparency is fueling the flames, as laggard venture investors repeatedly raise new investment funds before their records are fully understood. A case in point is Cambridge-based Zero Stage Capital, which raised seven investment funds totaling $450 million starting in 1981. The firm, which is now liquidating portions of its portfolio, made headlines last month when one of its faltering funds was taken into receivership by the federal government.

"It is difficult to know how portfolios are performing during the early years of a partnership," said Timothy Barrows, a venture capitalists since 1986 and a general partner at Matrix Partners in Waltham. "Eventually performance is clear. ... But by then, a second or third partnership may be under way."

The result has been investments in information-technology and life-sciences startups that have vanished into bankruptcy court or dissolution, as venture capitalists dump more and more money into companies vying for scarce market share.

A weak stock market and downward pressure from strategic buyers have compounded the problem, as VC-backed companies have struggled to garner profitable paydays from initial public offerings and corporate acquisitions. "The industry is constipated," said one local investor, whose venture firm pegs the business's 15-year deficit at $170 billion.

That firm's limited partners, some of the largest endowments in the world, derived the shortfall estimate from hard-to-get figures from other venture investors and the National Venture Capital Association, an industry advocate and researcher based in Virginia. Those same sources confirmed the data's accuracy: $327 billion in venture capital raised since 1990, only $157 billion in reported distributions.

The NVCA said the return statistics are correct, but do not account for partnerships that decline to share performance data.

Still, lackluster returns appear to be the norm for most venture capitalists, as only a handful of outfits have generated a majority of the industry's reported profits over the last 15 years, according to analysis provided by those same respected industry experts, who asked to remain anonymous.

"It's a dud of a business. And it's going to get worse, too," said Bill Helman, a general partner at Greylock Partners in Waltham, who agrees that between 15 and 20 firms have likely generated a majority of the industry's returns.

A venture capitalist since 1984, Helman said the performance has left little room for the industry's remaining investors, forcing many to gravitate toward riskier bets in "very early-stage" companies. It is a dynamic that concerns him and other longtime investors, who say the pattern is pumping the economy full of volatility: "I don't think we have a clue about how much risk we're putting into this market," Helman said.

Yet cash continues to pour into venture capitalists' coffers. Last year more than $17.7 billion was raised by new venture partnerships, despite the fact that there was an estimated $54 billion in unspent money sitting on the sideline, waiting to be invested. VCs raised only $10.7 billion in 2003, according to the NVCA.

Venture proponents say the funding wave has been a boon to the startup community, as entrepreneurs have developed and launched myriad products and services within the information technology and life sciences sectors. Those investments generate jobs, and will eventually create other economic opportunities and returns for venture firms, or so their argument goes.

Technology's old hands see things differently. "If there's too much money around, entrepreneurs think it's a good thing. They're wrong," said Bob Metcalfe, inventor of the Ethernet networking standard and a co-founder of network equipment maker 3Com Corp. in Marlborough. Metcalfe has been a general partner with Polaris Venture Partners in Waltham since 2001.

"At the same time you're being funded, 10 other (startups) are being funded that do the same thing," he said.

Added one manager of a local multibillion-dollar endowment, "There are too many bad companies being propped up by bad money." The investor, who asked to remain anonymous, said he only invests with a select group of venture firms that have returned seven to eight times invested capital over the long term.

The venture sector's capacity problems have reduced his institution's returns to around three times capital over the last few years, he said. He believes a major shakeout among venture capitalists and startups is in order, as the industry's mid- to lower-tier firms have been virtually burning money. "A day of reckoning will come," he said.

No shortage of VCs

Nonetheless, the sector's growth has shown little sign of slowing.

Despite some recent high-profile closures, the net number of venture firms is climbing, says Clint Harris of Grove Street Advisors, a fund-of-funds manager in Wellesley. The trend is being fueled by two factors, he said, as a spike in available cash has prompted dozens of partners at existing firms to spin off and create their own venture outfits.

That theory is backed by the NVCA, which said there were 897 venture firms in the United States last year, an 18 percent jump over the 760 that were around in 1999. The industry's high-water mark was 949 firms in 2001.

Among the old and new venture firms in Greater Boston, similarities abound. Most are filled with white, 30- to 60-year-old Harvard MBAs with a particular fondness for office space along Winter Street in Waltham.

And while some of these newer venture outfits are run by young upstarts who earned their stripes at branded firms, many partnerships are filled with attorneys, investment bankers and former entrepreneurs eager to break into the venture market. Critics say all of those factors have led to a "me too," or "herd," mentality that stifles creativity and limits returns relative to early-stage investing.

Yet principals at these newer firms attribute their fund-raising success to the venture industry's evolutionary cycle, as new investors displace the old by funding novel technologies and unproven entrepreneurs. Those same venture partners interpret many of the dire warnings from the industry's "old guard" as an acknowledgment that their time has passed.

"There's always a need for new blood," says Jeffrey Bussgang, a general partner at IDG Ventures in Boston. Bussgang joined the firm roughly three years ago after a successful run as an entrepreneur, having co-founded college-savings concern Upromise Inc. in Needham.

"There's also a little bit of irony" to some of the complaints, Bussgang continued, adding that many of the region's older firms helped overheat the market by raising funds in the $500 million to $1 billion range.

Cash abounds

The state's Pension Reserves Investment Management Board sees potential in the sector. And to curry favor with top venture firms, PRIM recently raised the amount it can invest in a single partnership from $75 million to $125 million.

The pension board presently has 6 percent of its assets dedicated to venture capital and buyout investments, and hopes to hit 10 percent within the next few years. "I think people take PRIM seriously within the (venture) universe," said Michael Travaglini, the pension board's executive director since 2004.

With $500 million committed to venture capital and buyout firms last year, PRIM reaped $605 million in cash returns, Travaglini said. PRIM was not able to break statistics for venture capital apart from other private equity investments.

Still, some of the area's top-ranked VCs shun money from public pensions, investment advisors and corporations plagued by an ever-changing cast of decision makers. Such instability is considered a turnoff for top venture firms, which prefer backers with long-term commitments and the stomachs to weather the industry's ups and downs, they say.

Josh Lerner, a finance professor and venture expert at Harvard Business School, said that clubby atmosphere has only added to the industry's froth, as top-performing firms have reaped huge cash rewards for their clients, mostly elite-university endowments and affiliated foundations. Their success has only prodded other pension funds and deep-pocketed investors toward the venture table.

Unable to get a foot in the door at "top" venture firms, those eager investors test their luck with less-proven commodities. "There's a little bit of a hope-springs-eternal" mentality when it comes to those outlays, said Lerner, whose research shows that those investors' returns have dramatically trailed those at university endowments and foundations.

In turn, many of those money managers say they have no other option but to invest in venture capital, since they are fearful of concentrating all of their dollars in the public stock and bond markets. Said PRIM's Travaglini, "We have to deploy our money. We don't have the option of going to cash."

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