An Evolutionary Battle: VCs face vultures, cram-downs and consolidation in an era of diminished expectations

Britt Tunick

Just over a year ago Durlacher Corp. was on a high-literally. With a market capitalization of nearly GBP2 billion, the London-based venture capital firm thought it would soon become large enough to be part of the FTSE 100, the index of the U.K.‘s biggest publicly-traded companies. By the end of 1999, Durlacher’s stock was trading at around GBP4.41 and, like so many high-flyers of the times, its good fortune seemed to have no end in site.

Since then, however, Durlacher’s strategy of investing in Internet companies has seemed less than smart. The company has been forced to sell off some of its investments at bargain basement prices, its shares are worth just a few pence each, and the company is hanging on for dear life. Durlacher is a prime example of what has gone wrong in Europe’s infant VC industry, where many VCs that invested in Internet businesses have been either swallowed up or gone bust. Others are finding a new breed of vulture investors is taking control of their firms, and they worry that a broad consolidation trend is in the making. The big question: Do these trends foreshadow what lies ahead for some VCs in the U.S

As for Durlacher-itself ripe for the plucking-the firm’s story is a case study in bad judgment. The firm, which traces its roots to U.K. stockbroking in the 1930s, turned to venture capital about five years ago, then decided to raise the stakes by becoming an Internet incubator, the flavor of the day in 1999. Such VCs, in hopes of getting a bigger piece of the companies they are financing, offer more than just equity capital to early-stage ventures, providing everything from business plans to office space and management expertise. But they were the first to feel the market’s wrath.

“Incubators in my opinion are sort of a doomed breed,” says Thomas Hoegh, a managing director with U.K.-based VC Arts Alliance. “They often have a very high cost structure and no revenue base unless things go well, so it’s a bit of a pyramid scheme.” A Durlacher spokeswoman declined comment.

While so far the deepest problems have surfaced in Europe, where the VC industry is newer and less heftily capitalized than its cousin across the Atlantic, the U.S. VC community is far from safe. In the U.S., sources point to a few prominent VCs as unable to raise more money to continue to finance the companies in their portfolio. Those named are Geocapital Partners, which focuses on early-stage investments in information technology, Flatiron Partners, a new New York-based VC focusing on early-stage investments in technology, and CMGI@Ventures, theVC arm of CMGI Inc., the Internet incubator with 50 companies in its portfolios that has been one of the worst-performing IPOs of the tech boom. Geocapital, Flatiron Partners and CMGI did not return calls for comment. Even some of the biggest and most prominent players, such as JPMorgan Partners, have been stung by losses.

Many believe the VC world is shaping into a Darwinian struggle. “It is a bit of survival of the fittest,” says Pierre Suhrcke, a managing director with Deutsche Bank eVentures, the German bank’s global strategic private equity unit focused on financial services. “We’re definitely going to see people buying venture capital portfolios like we have seen in the equity derivatives market and the hedge fund market, just like whenever there is any unbelievable hype and then a crisis.”

And while money continued to pour into VC funds for most of last year, the excess capital is having its own problem. “The returns on some of those funds are clearly going to be lower,” cautions Martin Gagen, chief executive of the U.S. operation of 3i Group Plc, one of the U.K.‘s better regarded VCs. “The cash commitments they are going to have to make to companies is higher, and some funds are going to have real difficulty replacing that capital from their institutions unless they can generate very good returns on it.”

While optimistic for the VC industry in the long run, Gagen believes the worst is yet to come. However, he notes that the complicated limited partner structure of many funds makes some acquisitions difficult to pull off, which will likely mean a few funds that suddenly find themselves in financial troubles will simply be left to die, despite any promise they may have.

The vultures pounce

For those who emerged from the tech fallout unscathed funds with balanced portfolios and deep pockets-there is no time like the present. Venture capitalists are predicting that in the near future it will be difficult to distinguish between some of their industry’s biggest players and vulture investors, those that swoop in on distressed companies, either buying up entire companies or dictating such investment terms that they are able to virtually control the company.

One player that has been benefiting from rivals’ misery is 3i. Originally a U.K.-based venture, 3i has expanded into Europe, the U.S. and even Asia. Since the rout began last year, 3i has already acquired at least four VCs, among them: Technolgie Holding, a German early-stage technology investor; SFK Finance Oy, a Finnish VC focused on early-stage investments within the telecom sector, and Atle AB, a technology-oriented Swedish incubator that is its most recent acquisition.

“This consolidation effect is real and I think there is scope for companies to come together as either joint ventures or for small VC firms to sell out to large and more powerful ones. But you have to have the mindset for it,” says Gagen, who notes that 3i is still on the lookout for investments.

Vulture activity isn’t confined to the old-timers either. New Media Spark, a U.K. Internet incubator which was launched in July 1999 and went public a mere three months later, is one player that quickly turned to vulture-like activity when hardship first hit some of its competitors. Last year it purchased three Internet incubators. In March 2000 New Media paid GBP84 million for Cell Internet Commerce Development AB, a Scandinavian incubator; followed in May with the GBP33.5 million purchase of Plc, an Indian incubator; then an October share-based acquisition of European incubator Internet Indirect Plc.

“We were very acutely aware of the fact that the boom that was happening wouldn’t last forever and, in order to keep things going, knew that money was going to be absolutely essential,” says Joel Plasco, a director with New Media Spark. “Our view from the start was that we had to fund ourselves until we could exit from our investments.”

New Media Spark is still standing (though its stock is off by 50%) in large part due to a financing strategy that prepared itself for the worst. That’s in stark contrast to how most of the newcomers worked, believing that investments could easily be cashed out to raise money for investors. “Increasingly we’re beginning to feel a bit like we’re the only man standing in this space in London,” says Plasco. “What we’re planning for now is to be positioned when the reversal of fortune takes place, which it undoubtedly will at some point.” What’s the strategy? “Number one that we can survive until that stage and, number two, we’ll be incredibly well positioned to benefit from it when it does happen.” Plasco concludes.

The cram-down

While New Media Spark has gone the acquisition route, others have chosen instead just to take control of the portfolios. As more and more VCs see their funding begin to be depleted, they are being forced to watch helplessly as the smart choices they made are taken away by deep pocketed funds.

“There’s no need to buy [VCs] when you can just push them out of business and move in on their companies through liquidation preference or other ways of cramming down the investors,” says Steven Susel, a vp with Boston-based VC Still River Fund. “You can literally be a vulture and pick around at what’s left out there and pick and choose what you like. The advantage that these guys have right now is that there’s no open window on the public markets and there’s no way for these companies to go out and raise money or do an IPO to do expansion.”

For the vultures, specifically those that stayed on the sideline the first time around, buying the companies they view as strong prospects is a win-win deal. The majority of these ventures are available at rock-bottom prices and, having now somewhat proved themselves by surviving the fallout and consolidation within the sector itself, many of these companies are much lower risks than they were when their initial backers jumped in.

As younger VCs enter into third- and fourth-round fundraising, their newest backers are taking advantage of current market conditions and securing such investor-friendly terms that early-stage players are unlikely to reap the benefits of the risks they assumed, not to mention their initial investments. Known in the industry as a cram-down, the practice is becoming rampant, as desperate funds find themselves without any leverage and forced to allow investors to virtually dictate their own terms.

“Everybody’s investments have soared in value in the last 12 to 24 months, right now though everything has come down to earth and they need to write those investments down or write them completely off because the companies have gone under,” says Susel. “In some cases they’re responding by reducing asset allocations to private equity, in some cases they’re not responding at all because they really haven’t gotten that message yet.”

The U.S. connection

With a greater number of older, better financed players, U.S. VCs appear better poised to handle current market conditions than many in Europe. Indeed, a number of funds are sitting on billions of dollars in uninvested funding. Even immediately after the tech shock wave first hit the market, money continued to pour into the U.S. VC market. During the second quarter of 2000, U.S. investors pumped $27.8 billion into VCs, almost a 50% jump from the $18.8 billion committed during the first quarter, acccording to Venture Economics, a unit of Thomson Financial, which also owns IDD. The money flow didn’t subside until the fourth quarter, when only $18.5 billion was committed. to U.S. VC funds.

The biggest U.S. VC fundraisers in 2000 were Warburg Pincus International Partners LP, which raised $2.5 billion in new funding; New Enterprise Associates X LP, which raised $2 billion; TA IX LP which raised $2 billion and Spectrum Equity Investors IV LP which raised $1.8 billion. Another 16 U.S. funds raised more than $1 billion each, with countless others raising totals in the upper millions of dollars. Even new players kept getting in on the action. Throughout 2000, 542 new funds were created, raising a combined total of $92.6 billion in funding.

The huge amounts of cash that have been raised pose their own problems, however. Now some VCs are passing up investment opportunities because they are afraid the investments don’t need the huge amounts of funding that would make the time involved in backing them worthwhile.

The pullback in investing by VCs came during the fourth quarter, when U.S. VCs invested $22.5 billion, a 23% decrease from the $29.4 billion they invested in the third quarter. In first-quarter 2000, VCs invested nearly $24.8 billion into companies, with the amount rising to $27.5 billion in the second quarter.

Illustrating that pots of money have their own problems, in early December Crosspoint Venture Partners, a 28-year old Silicon Valley VC abandoned fundraising efforts for its Crosspoint Venture Partners 2001 fund, a megafund it had been planning to launch. Despite having already secured commitments for nearly $1 billion, the VC pulled the plug because of what it claimed were inflated valuations among early-stage companies that would leave investors with unrealistic expectations for returns.

Still River Fund’s Susel says that a lot of what will happen going forward will depend on the kind of pressure VCs get from their investors. At present, despite widespread apprehension toward the market, investors have generally remained enthusiastic about venture capital.

For funds with a history and solid track record, investors are most likely to simply ride things out. But for newer funds, where returns are not living up to promises and many investors themselves are less experienced, expectations tend to be a bit more unrealistic and based on the highs seen at the height of the tech frenzy. And across the board, despite the age or experience of funds, if returns prove too disappointing for too long, pressure from investors could keep VCs on the sidelines even longer, for fears that any additional company investments might only draw down their performances further.

“VCs and some of their limited partners who expected a quicker liquidity event are not getting it, and they don’t have the patience or the capital to stick with the companies that they’ve invested in for another three, four or five years, which was the VC model before this latest boom,” says Andy Thompson, a managing director with Primedia Ventures, pointing to simple impatience as yet another reason for recent trends. “A lot of VC money has come in the last couple of years and is less accustomed to that cycle and is less patient with it, so they are driving a fair amount of consolidation among portfolios.”

“Starting when the Internet hit, many had fantastic returns that they could go out and raise huge funds on,” says Arts Alliance’s Hoeg. “The ones that have been the absolute best are the ones that went out and raised huge funds but have been sitting on their hands for a year, but very few of them have and most of them made lots of dumb investments.”

As a result, he believes there will be a lot of forced consolidation in the near future. “We will see a lot more in the next six to 12 months in both Europe and the U.S. as well… but in the US it’s probably going to be on a bigger scale.”

Indeed, sources say that some of the newer funds, and specifically those heavily invested in Internet companies, have been having trouble raising additional funding. One they point to is Geocapital, which took public such companies as Inc. and Inc.only last week informed that its shares are subject to delisting from Nasdaq over failure to meet the minimum bid price-has already thrown in the towel on plans for a new fund, claiming that returns would drop as a result.

“Last year people went out and raised a billion dollars, got very arrogant with it and thought it was easy, but now a lot of the institutional investors into VC are becoming much more selective,” says one industry source. “Institutional investors are now realizing that there is a difference between the top-tier VCs and the rest and what you’re seeing is money being redirected by those institutions toward the top tier again whereas the lower funds that thought they could raise further funds from them won’t be able to. Geocapital is just a current example.”

Another example industry participants point to is CMGI, which became infamous for its efforts to set up an interlinking network of Internet companies. “They quoted themselves, went to the market on the basis that they were a dot-com specialist, got a huge valuation on their quoted business, but actually never really had a workable business model,” says one venture capitalist. “The CMGI model, and there are others like them, felt that simply by the virtue that they have shareholdings they could force companies to trade with each other and ultimately merge with each other. But what you do is you just make sub-standard investments if you do that.”

Those who’ve been in the business for a long time point to the newcomers, particularly those who came from investment banking, as unprepared for the vicissitudes of VC. “You saw guys who were bankers and thought Oh, this is like banking and I’ll go and do that,’ but who had no understanding of the marketplace. They also didn’t understand the risk profile of being a venture capitalist and what that meant in minimizing that risk and then also accepting that risk,” says Lucy Marcus, a managing director with UK-based Marcus Venture Consulting a company that specializes in consulting for both U.S. and European venture capitalists and start-ups.

Big guys also suffer

It is not only the smaller funds that are in trouble, either. While the effects may not yet be visible, a number of larger VCs are also experiencing difficulties from tech-heavy or poorly weighted portfolios, with the majority only now entering into their reporting periods for the beginning of the market correction.

“The U.S. has huge funds and some of the very, very well-known American funds massively overpaid for private companies and can’t now refinance them, and these are the most respected funds,” says Arts Alliance’s Hoegh, noting that no one in the industry is immune from today’s turmoil.

One of the largest, JP Morgan Partners, the combination of Chase Capital Partners and J.P. Morgan’s private equity unit, has gotten a lot of attention because Chase Capital partners posted $25 million in losses in the third quarter of last year and $92 million during the fourth quarter, dragging down the quarterly earnings for the parent bank Chase Manhattan. For the full year, however, the unit had a $988 million gain. “The whole Chase Internet investments have been a nightmare,” says one VC player. “It was the first time I’ve ever seen that a big bank reported the primary reason for all of their losses was their private equity investments.”

Chase’s problems may be no worse than many of the big guys. But they differ in two ways. First, Chase says it is the only VC that marks the portfolio to market. That had the effect of boosting the bank’s earnings during the boom, but the opposite effect last year. Second, because the unit-unlike most VC funds-is part of a publicly owned institution, its losses must be disclosed.

“It’s a really distorted view of what’s happening in a broad-based way in our business,” says Shahan Soghikian, a partner with JP Morgan Partners. “Marking to market has nothing to do with whether we as a private equity shop are actually making money on our investments or not.” He argues that the bank’s venture arm is among the few with staying power. “There are a number of things that are going to characterize the winners. One is the tenure of the people and the organizations. There are only a few great names like JP Morgan Partners that are global private equity firms that have incredible staying power across multiple industries and multiple geographies, including the venture side of the business.”

Other venture capitalists agree that those who will survive are likely to be those with the deepest pockets and the longest histories, with experience in both good and bad markets a key differentiator and a necessary tool for longevity.

“We are in no hurry. Opportunity drives our pace,” says Ann Winblad, a partner with Silicon Valley-based VC Hummer Wimblad, one of the industry’s giants. “The venture industry should be a marathon not a sprint.”

While the larger and most well-established funds, such as Hummer Wimblad, or the grandaddy of Silicon Valley VCs, Kleiner Perkins Caufield & Byers, are in the strongest financial position, those a little bit further down the food chain might not be so safe in the future. “Unless they’re up in that top tier, most of the funds [in Silicon Valley] have no real secure future for the next decade-they’re run by people that just don’t want to evolve their business to the next generation,” says the fund manager of one major U.S. VC who asked for anonymity.

“They’re guys in their 40s and some in their 50s who are making stacks of money and I don’t think that they have any succession plans whatsoever,” he suggests. “So, what you’re more likely to see is some of the junior people in the VC industry spin off and form their own new VC brand names… I think you’ll have a completely different list of names with a new generation that will come through and invest in a different way.”

Reprinted from Investment Dealers’ Digest


19 March 2001

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