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Diversification, Differentiation, Grounded Experience are New Factors Driving Modest Growth in Venture Capital Industry; Long-term Outlooks, Timely Opportunities, M&A Exits Represent Today’s Expectations; Old School Venture Capital Movement Underway Article Written by Theresa Maloney, Senior Account Manager, Trainer Communications

By Theresa Maloney - August 7, 2003

More than 450 leading national and international private equity investors representing both General and Limited Partners convened in San Francisco June 11th through 13th to participate in IBF Conferences’ 14th Annual Venture Capital Investing Conference at the Ritz Carlton. The halls were filled with an audience of savvy investors – this year some with ties and some without – all hoping to discuss market trends and exchange ideas related to venture capital investing. The big question – and quite a few answers – on everyone’s mind: Are we there yet? “There,” of course, being the “bottom” of a nearly three-year industry decline.

Reporting on the industry has not been very positive since the last part of 2000, when the ephemeral Internet bubble burst and left many VCs wondering just how to salvage their funds in order to please Limited Partners. By Q2 of this year, most industry surveys and benchmarks like PriceWaterhouseCoopers’ quarterly Money Tree Report (http://www.pwcmoneytree.com/moneytree/pdfs/03_Q1_Survey_Highlights.pdf) had not indicated positive movement, or growth, in the industry since 2001 – especially in light of uncertain economic stability and lowered consumer confidence brought on by a series of unexpected travesties beginning with September 11, exacerbated by corporate accounting scandals, and culminating most recently in the War with Iraq. However, positive signs from the industry were heard loud and clear at this year’s IBF Venture Capital Investing event, where the halls seemed to echo a return to tradition mantra as the industry endorsed what appears to be an Old School Venture Capital Movement.

Today’s venture capital investors are older, wiser and far more experienced than they were four years ago. They’ve seen the high peaks and the low valleys, and those who are left are proving their worth through strategic foresight and long-term attitudes toward growth. That said, most attendees conceded that now truly is the time to invest. And investing they are, with most firms forecasting a positive trajectory for investing across a variety of technology sectors. From traditional firms like New Enterprise Associates and Draper Fisher Jurvetson to corporate investors like Intel, the investment pipeline has been filling for at least eight months and flow will continue at a steady pace without signs of a slowdown. Many VCs are ready to raise their new funds in order to support what appears to be a reviving market.

Venture Capital: A Force that Finances Change

Stewart Alsop, general partner at New Enterprise Associates, spoke with great candor on the second day of the conference when he announced that things really aren’t as bad as they may seem. Mr. Alsop suggests that when you eliminate the false positives (peaks of the late 90s) and false negatives (valleys we’ve seen thus far in the 21st century), it’s fair to forecast modest growth – whether you are measuring dollars raised, invested, made or distributed. In his opinion, which was shared by many of his colleagues, the industry has matured. That maturity, or experience, is bringing us back to the basic fundamentals of investing: long-term outlook, experienced management teams, real products, and realistic exit expectations that now focus on M&A rather than premature and inflated IPO events.

“Maybe what you can see,” said Mr. Alsop, “is a recovery to what is fundamentally a long-term trend toward venture capital becoming a more and more important segment of the equity markets. Venture capital is a force that finances change in our national economy, one that promotes the adoption of new technology and innovation in our workplace and homes and schools. That the Internet suddenly created the biggest boom that led to the biggest bust since the 1920s does not mean that the venture investment system has been decimated or invalidated. It’s just a monster cycle.”

Differentiation, Diversification Increasingly Important to the Fund

What we have now is an industry that’s weathered a storm, with most of the smaller, less experienced firms already fallen off the landscape. Still, venture capitalists are expecting to see even more consolidation among firms, continued scrutiny from LPs and an increasingly more difficult fundraising market for firms. Fortunately, most of the VCs we talked to at the conference are sitting on a substantial amount of “dry powder” for follow-on investment and will continue to invest opportunistically through the remainder of this year and into the next. The bellwethers we spoke to who are planning to raise a new fund believe their track records, reputations and ability to respond to market shifts through differentiated approaches to their new funds will secure investment.

According to Clay Pew, partner at Draper Fisher Jurvetson, “For a number of venture capital firms, their future is a question mark. For firms with a demonstrably superior and differentiated strategy, the future looks quite bright. As my old consulting colleague Michael Porter has said time and again, ‘Competitive strategy is about being different…about doing things differently than rivals do.’ Past performance does not equal future success, change is constant, and we will see more turnover among established groups at the top of the A-list. Venture is evolving…from a cottage industry to institutionalization. Firms that succeed in this environment…will do things differently.”

And, so it goes, many firms are doing things differently. Some are applying different criteria to the stages in which they invest – many firms that once invested only in early stage companies are now investing in later stage companies and all seem to be contributing follow-on financing to aging portfolio companies. Others are applying different strategies to their investment approach, like moving into new regions or taking a more multi-national approach. Whatever they are calling their differentiators, most venture capital firms agree they must meet the same harsh criteria to secure new funding from LPs as their portfolio companies looking for an A or B round of finance from them. “It’s difficult to get investors’ attention in the current environment,” said Mr. Pew. “I’d say it’s as difficult for GPs to get an LP’s attention as it is for an entrepreneur to get most GPs’ attention. But it’s not impossible – if you target GPs carefully and present a clearly differentiated story.”

The industry may be changing, but in many ways it is returning to its roots. Old School venture firms, for the most part, followed a diversified approach. It wasn’t until the “bubble years,” when firms wanted to cash in on the Internet, that VCs moved to a more focused strategy.  Now there seems to be a growing appreciation for how diversification can protect on the down side while affording the ability to achieve strong gains on the upside. While few firms in the last half-decade were diversifying broadly across stage of investment, sector of investment, and geography of investment, one firm consistently followed that approach. According to Jonathan Flint, co-founder and a managing general partner at Polaris Venture Partners, diversification is nothing new. “The cornerstone of our investment strategy has always been diversification – first by industry, with about two-thirds in IT and one-third in the life sciences sector. Then we are highly diversified within the IT and life science sectors. Our investments also are diversified by stage – seed through development and including the revenue stage, where we invest in companies that have not yet received capital from other investors and have operating income from $1 to $10 million.” 

Intel, which emphasizes an international approach to investing with portfolio companies in over 25 countries, last year invested 60 percent of the organization’s investment capital in companies outside the U.S. While many sectors within the IT industry are considered hot, Intel has publicly committed $150 million to focus on Wi-Fi investments, believing that sector is one with significant growth potential presenting a strong opportunity for Intel to positively impact the market. Bare in mind that $150 million is jut a portion of Intel’s investment arm. Except for a few highly focused firms that specialize in targeted industry segments, most venture firms were following the trend of market diversification, spreading their investments to minimize risk and maximize returns.

Institutional LPs More Cautious but Committed

While none of the VCs we interviewed had any reservations about the return of institutional investors to the private equity market, all agreed that they, too, would be more scrupulous in their investment choices. Reputation alone, while still an important factor in deciding whether to invest in a venture firm, will not guarantee a firm receives money from LPs. Today LPs are looking at differentiators in fund strategy, unique qualities of the General Partners, and experience in long-term cycles.

According to David Spreng, managing general partner at Crescendo Ventures, “The biggest trend in private equity will be changes in the way that LPs evaluate funds. Historical benchmarks looked at investment performance. Today investors realize that anything in the last five years is not predictive of the future. Investors are now looking at subjective decision-making factors. A big factor will be communication with GPs – are they open, or non-communicative and difficult. They will look at strategy, business model, team and process, and – one that I would highlight – risk management.  The venture industry hasn’t spent time looking at the downside, but there is a lot that can be done in risk management – from vintage year, sector, and portfolio management – to make more informed decisions.”

Multi-nationalism and Long-term Commitment Gaining Way

Joseph Tzeng, founder and managing director at U.S.-based international venture capital firm Crystal Ventures, agrees the industry is changing and he believes globalization is driving a multi-national approach to investing. Mr. Tzeng says this change will impact how venture capitalists approach the business of venture capital in the future. He explained, “Venture capital is going to change from the conventional way of finding a good bet, which involves putting money in, assisting them passively, and exiting. More successful firms will have a diversification of skill-sets that includes strong operational abilities, traditional venture capital investing experience, and the ability to close deals – not just venture deals, but actual business development and sales deals. Location will move from regional to multi-regional and cross-border environments. Small private companies are becoming cross-border operations, multi-regional and global in their approach. Therefore talent-recruiting, business plans and modeling, and the level of strategic partnership will change. Investors now must prove they are in it for the long haul.” Crystal will address these changes as it launches its next fund.

Sandy Miller, Managing Director of 3i’s U.S. operations, agrees that a long-term view and international perspective on investments is important. “Venture capital will continue to be the key engine for driving early stage technology companies and will play as vital a role as it has historically,” said Mr. Miller. “The whole market now is about ‘back to basics’ in terms of valuations and approach, and patience in terms of investment horizon and exit strategy. Valuations have decreased though there is a fair amount of capital available for investments. Activity will increase but valuations won’t for a while. There will be a big need for VCs to add value to their portfolio companies. All of this will create a real challenge for the VC industry. It puts more pressure on VCs to come up with a new model – most U.S. VCs are very cottage industry, localized businesses, but need a more international mindset. The environment for the next decade will be more like the pre-bubble period. There will be good returns, but holding periods will be five to eight years for early stage investments and two to three years for late stage.”

Mr. Miller and his counterparts believe that a key difference in venture capital going forward will be in expectations around exit strategy. While optimism favors the IPO market’s return, most VCs are betting on industry consolidation and a good M&A strategy – even for their most successful companies. Most VCs are not expecting an immediate swing-back, or recovery, from the market. Contrary, they are investing for the long-term, hoping for a few good M&A events, and holding low expectations for public liquidity events in the next two years.

Back to Old School Venture Capital

“There are likely to be more M&A transactions than successful IPOs in this market,” Robert Ackerman, managing director at Allegis Capital, told us, chiming the sentiments of his peers. “Today there are very few IPOs. We’ve moved back to an environment where the focus is on building a sustainable company. If you achieve that, the liquidity will follow.  We were in a time when building that company was lost, but we’re back to basics – and it’s a good thing.

Wael Aburida, senior manager, mergers & acquisitions at Intel, offered a complementary view on investing from the corporate perspective. “Exits for technology companies will continue to be tough as long as the outlook for IT spending remains unclear. We are starting to see some positive signs – for example, recent successful IPOs and positive earnings trends – that bode well, but until we see a real commitment for companies to invest in technology, portfolio companies will need to be ready to survive on private funding or on positive cash flow. Obviously an assumed exit in the ‘99/2000 time frame was IPO. I don’t think we will see activity at the ‘99/’00 levels for some time for a number of factors. The more likely exit will be through an M&A event as companies look to expand their product offers, channels, or customer base once corporate spending creates that demand.”

As part of this Old School Venture Capital Movement, investors are forging relationships with potential buyers, and corporate partnering is playing a role in how some VCs approach the market. Mr. Ackerman and his firm have been playing the corporate partnering game for some time, so this approach is nothing revolutionary in their books. In fact, Allegis derives over 50 percent of its capital from corporate investors, who then work closely with their portfolio companies to develop sound strategies based on real market data. “We work with our corporate partners to understand the dynamics of emerging markets, competitive dynamics of those markets, timing and value of those markets, and due diligence. It’s a strong partnership approach that strengthens our portfolio.”

Intel and a number of corporate investors at this year’s conference put their stakes in the ground, indicating they, too, are committed to the market and are actively partnering with venture capital firms to bring innovative technologies and ideas to market. It seems the traditional firms and their corporate counterparts have found ways in which to collaboratively advance technology, opening even more doors for tomorrow’s entrepreneurs.

It seems the venture capital industry has matured. No longer an adolescent trying to prove its predecessors wrong with revolutionary ideas on making money through quick-turn-around, inflated IPO schemes, those investors still standing firmly in today’s market are returning to a more traditional way of doing business. They are partnering to advance technology, and they are setting realistic expectations for their portfolio companies. Experience has taught them well.

“We’re seeing a return to the value placed on the operating experience of venture capital investors,” Mr. Ackerman said in a statement that best mirrors the tone of this year’s venture capital investing event. “We’ve returned to historical norms of rational expectations and returns for building business. We’re encouraged, but above that we still have a venture capital industry that needs to rationalize itself further and that process will take another two to three years – about that time we’ll begin to see a more steady state return. In terms of today’s environment for new venture capital investments, it’s as healthy as it’s been in years.”

IBF Conferences would like to thank the following venture capital firms for contributing their thoughts to this story: 3i, Allegis Capital, Crescendo Ventures, Crystal Ventures, Draper Fisher Jurvetson, Intel, New Enterprise Associates, and Polaris Venture Partners. The continued support of leading venture capital investors and their candid opinions are what make IBF forums worthy of discussion and attendance. IBF Conferences can be reached at www.IBFConferences.com.   

Theresa Maloney, Senior Account Manger at Trainer Communications, works with venture capital firms and their portfolio companies to launch innovative companies and ideas into the marketplace. For more information on Trainer Communications, visit www.trainercomm.com.