Matri-mone: Venture capital firms feel the pull of marriage

By Tom Stein

It’s a classic tale of excessiveness: overzealous investors pour money into a trendy industry, hoping for astronomical returns. The sector becomes flooded with new companies that don’t really know what they’re doing. Then the money dries up, and everyone scrambles for cover. Many firms are faced with just two options: merge or die. You might think we’re talking about optical networking or online pet stores, but we’re not. We’re talking about venture capital.

Faced with one of the worst fund-raising environments in recent history, VCs are now looking to find strength in numbers, through a variety of approaches. Firms trying to raise their second or third funds are banding together in an effort to present a rosier picture to pension funds, endowments, and institutions that invest in venture capital. By combining their respective track records and team members, VC firms believe they’re better positioned to go to the market and raise the $100 million to $200 million they might have been unable to get on their own.

Meanwhile, other firms—especially those that first entered the market when it was white-hot—see mergers and acquisitions as way to exit the industry without losing face. “We’ve had the merger discussion with every single firm we’ve met with over the last year,” says Lucy Marcus, CEO of Marcus Venture Consulting, a consulting firm that specializes in venture capital. “Everybody’s considering the same questions: are you in a position to buy, stand still, or get bought?”

Michael Hoffman, a founding member of Probitas Partners, a private-placement agency that helps VC firms raise money, agrees. Over the past six months, he has played a new role as matchmaker, ultimately uniting more than a dozen firms. “A year or two ago, you didn’t see any mergers, because capital was so plentiful. But it makes sense that some firms are now getting cobbled together,” he says.

For the most part, the big firms with easily identifiable brands and very large funds at their disposal—like Kleiner Perkins Caufield & Byers, Sequoia Capital, and Matrix Partners—are immune to these marriages of convenience. But almost everyone else is prone to them. Recently, two firms in the Seattle area— Encompass Ventures and Digital Partners—came together before attempting to raise a new $200 million fund. “The combined entity gives us a much stronger story,” says Wayne Wager, a managing partner at Encompass. “It will be easier for us to raise money, though I still don’t think it will be easy.”

While such mergers are fairly unprecedented, Mr. Wager says that many firms will soon follow suit. “For one thing, combining our two firms proved relatively simple,” he says. Earlier investments by Encompass and Digital will not be commingled, as previously raised funds will remain separate. Mr. Wager says the merger will only affect new fund-raising and investment activity.

Some critics argue that a merger in today’s venture world is akin to two dogs mating: all you get is another dog. With that in mind, some battered VC firms would rather just sell their holdings outright and exit the industry as gracefully as possible. Accenture Technology Ventures, the VC arm of the management consulting firm Accenture, is up for sale following a string of losing investments. Lucent Technologies raised $100 million by selling an 80 percent stake in one of its venture units to Coller Capital, a British investment firm. And the Barksdale Group, headed by former Netscape CEO Jim Barksdale, announced it would not raise another fund. The firm said it would continue to manage its existing investments, but rumors abound that Barksdale’s Internet-heavy portfolio is being shopped around because the firm’s investors no longer want to pay management fees. “It’s amazing how many VCs are hoping to get bought out just because they think the VC game is no longer fun,” says Ms. Marcus.

Those that remain committed to the industry are starting to get more creative. Over the past year, a raft of funds have turned to the U.S. Small Business Administration (SBA) for a Small Business Investment Company (SBIC) license, which makes a VC firm eligible to receive special long-term loans from the SBA. For instance, if an SBIC raises $50 million from traditional limited partners, it can receive an additional $100 million from the government, putting the actual size of the fund at $150 million. Some of the bigger-name SBICs are Bay Partners, Norwest Venture Partners, and Walden VC, but there are many more. Indeed, many funds have no capital, but they do have SBIC licenses.

On the flip side, other funds do have capital but need more to stay in the game and bail out some of their struggling investments. So VC firms that cannot raise any more money from limited partners are now trying to merge with SBICs in an effort to increase the size of their funds overnight. “VCs should consider practicing what they preach and explore the possibility of hooking up with other firms,” says Alex Suh, a managing director at California Technology Ventures, which is considering merging with an SBIC. “It could enhance the team and bring more money to the table in a difficult environment.”

Industry watchers remain skeptical. “We’ve reached a point where SBICs are now the most beautiful girl on the block because everybody else has been killed,” says Paul Kedrosky, a business professor at the University of British Columbia who teaches a course on venture capital. “Unfortunately, it’s shotgun-wedding season in the venture industry.” Still, marriage is a far better option than death.

Reprinted from Red Herring Magazine


16 July 2001

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