Money flooded at an unprecedented rate into US venture capital funds during 1998 while, armed with more money to invest than ever before, venture capitalists increasingly turned to larger investments in later-stage companies. Venture capital groups raised $24.34 billion in 200 funds last year, according to figures released by Venture Economics Information Services, a Securities Data Publishing group company.
That represents a hike of nearly $10 billion from 1997’s total and is $14 billion more than the figure for 1996 – which, according to updated Venture Economics statistics, was the first year the venture industry breached the $10 billion fund-raising barrier.
It should also be noted, however, that 1998’s tally includes a $5 billion fund raised by Warburg Pincus Ventures Inc. Bowman Cutter, a Warburg Pincus managing director, acknowledges that the firm’s vehicles are difficult to categorise but argues that “venture” is the most accurate definition of the group’s investment approach.
Even without Warburg Pincus’s contribution, however, 1998 would have broken fund-raising records.
Pension funds, which have enjoyed strong performance from both public and private equity markets in recent years, were eager to redeploy their gains in the venture arena. A full 60% of venture funds raised in 1998 came from pensions – double their 1997 commitment level in relative terms. In absolute terms investment from pension funds reached around $14.6 billion last year compared with some $4.7 billion in 1997, a differential that closely corresponds with the overall growth in the venture fund-raising market.
Conversely, although the endowments and foundations dipped last year, contributing only 6% of funds raised – their lowest proportion for five years – in cash terms their investment level declined only moderately to some $1.5 billion from $1.7 billion in 1997. Commitments from corporates accounted for 11.4% of venture fund raising in 1998, down from 12.1% in the previous year, corresponding to an increase of around $1 billion to $2.7 billion in cash terms.
Insurance companies, not a major player in recent years, barely registered in 1998, putting up only 0.3% of the capital raised, less than a quarter of their 1997 cash commitment.
Eric Gritzmacher, vice president in charge of private securities at Pacific Mutual Life Insurance Co., was not surprised that insurance companies provided such as small part of last year’s total. He points to several reasons why insurance companies lag so far behind pension fund, including their higher immediate liabilities, the legal restrictions to which they are subject that discourage venture investing, and the fact that they must contend with ratings agencies, which do not look kindly on high-risk investments.
In addition, insurers must take risk-based capital charges, setting aside equity capital on their balance sheets for each asset they buy. The amount that must be set aside is considerably less for lower-risk investments such as government bonds than for riskier assets such as stocks and private equity. Hence, Eric Gritzmacher notes, it is simply more expensive for insurance companies to tie up money in venture capital.
Despite these contraindications, Pacific Mutual did back two venture funds in 1998: Mission Ventures and Landmark Equity.
Roman Numerals Are Cash Magnets …
Overall, the insurance dollars that did filter into venture capital last year – along with every other investor’s cash – went to the expected places. Not surprisingly, general partners with more experience were rewarded with more capital. Late-stage funds, as in 1997, lost ground – a development that is a little surprising in light of the current drift towards larger, later-stage deals at the disbursement end of the process – while early stage funds’ take increased slightly.
Excluding the Warburg Pincus vehicle (technically categorised as a “private equity” fund), balanced vehicles took a smaller piece of the pie in 1998 than in the previous year, but if the Warburg Pincus money is included, the reverse is true.
Barr Dolan is not surprised by the pattern of commitments. As part of the Charter family of funds, he is a general partner in a later stage fund, Charter Growth Capital, LP, and a managing director of an early-stage effort, Charter Ventures II, LLC, both of which raised money in 1998.
“They’re interested in anything with a Roman number two or more on it”, Barr Dolan says of investors. They are enthusiastic about early-stage funds, but there is a limit to how much they can wedge into those vehicles, he adds.
The launch of a later-stage fund targeting $500 million to $1 billion in 1999 would not surprise Barr Dolan. “The money is there, and these guys want to take it”, he said of his fellow venture capitalists, Charter, however, does not plan to raise such a vehicle.
Looking to 1999
As for this year, Barr Dolan observes venture investors’ strong desire to stuff more money into the asset class. But many of the industry’s most prominent groups raised capita in 1998, leaving fewer big names to come to market this year.
Weighing those trends, Barr Dolan predicts that 1999 totals are likely to match the 1998 figure, if Warburg Pincus’s $5 billion is left out of the equation.
John Mumford of Crosspoint Venture Partners, a firm due to hit the fund-raising trail this year with a $175 million seed and start-up fund, agrees with Barr Dolan. “I’d take $18 billion as a number”, John Mumford says.
While the venture industry waits to see how this year’s fund-raising environment shapes up, Abbot Capital Management managing director Stan Pratt preaches the gospel of discipline – creating proprietary deal flow, rejecting overpriced deals an being willing to do a quality deal that others have rejected because they think it’s overpriced.
Investors in venture capital funds should not slack off either; they must scrutinise venture firms before investing, Stan Pratt says, warning that too much money is going into untested hands, conjuring up memories of the venture industry’s tough times in the 1980s. “Too many people thought they walked on water, and people were throwing money at them”, he recalls, The lesson, Stan Pratt says, is that walking on water is a good way to get wet.
More Companies, Bigger Deals
Meanwhile, reflecting the growing volumes of capital under management at individual firms, investing larger chunks of equity in a smaller number of companies has become the new modus operandi for many venture capital groups.
According to Venture Economics, of the 2,692 companies to receive venture financing in 1999, only 1,045, a little more than one third, were classified as early-stage. That statistic seems to raise the question whether early-stage investing – once the high-risk, high-return hallmark of the venture industry – is a dying art.
Not necessarily, say many industry insiders. While it is clear that the venture industry has changed dramatically in the past decade or so, its core mission remains the same: to finance companies that will change the future. And while venture fund capital is often not the first significant investment in a promising start-up these days – angels have been able to invest more capital than ever before in companies whose capital requirements fall below what venture capitalists can handle – the industry has found ways to stay true to its purpose. Being a generalist has gone the way of the dinosaur; instead, specialisation, localisation and a more sophisticated approach have secured venture capital’s place on the ground floor of the most explosive and important industries today.
Angels Rush In …
Venture capitalists invested a total of $16.02 billion in 1998, nearly $2 billion more than in 1997 and more than $6 billion over the 1996 figure. The steady increase in disbursements is a direct reflection of venture capitalists’ success in fund raising. With returns to limited partners hovering just below 50% during recent years, venture firms have had little problem either retaining old investors for new funds or attracting new faces.
However, venture firms are not the only ones at present with bulging pockets. Angels have become more abundant and more knowledgeable as a result of a decade of prosperity. While such investors used to invest no more than a few hundred thousand dollars at a time, groups of angels, or particularly successful individuals, have lately been able to commit more than $1 million a pop, moving into a province once reserved for professional investment firms.
Former venture capitalist Ken Deemer founded Tech Coast Angels to encourage co-investment opportunities for investors like himself. According to Ken Deemer, the gap between what a venture capitalist considers a minimum investment and the seed capital requirements of may start-ups is certainly widening – and angel networks are there to fill the gap. While the actual level of money angels have available to invest is hard to determine, since individual network members make investment decisions on a case-by-case basis, Ken Deemer says some experts believe that the level of angel money in the market is almost equal to the amount of formal venture capital.
… Where VCs Cannot Tread
Although venture capitalists have been heard to grumble that the new generation of individual investors often beats them to the best deals, angels undeniably fill an important role.
Draper Fisher Jurvetson, a California venture firm, closed its fifth fund last summer at $183 million, more than twice the size of its previous vehicle raised just two years ago. While the firm continues its long-term commitment to early stage investing, with so much capital to put to work and just four general partners to manage it, the partners know certain concessions must be made. Draper Fisher partner Warren Packard says the sums are pretty simple. “It becomes obvious that you can’t keep adding companies to your portfolio.”
Warren Packard explains that, while firms like Draper Fisher remain committed to seed- and early-stage investing, logistically there is a limit to what they can manage.
“It’s tough for us to do much less than $1 million”, he concedes, saying that the firm generally commits between $1 million and $5 million per round, but its average commitment is closer to $3.5 million.
Yet not everyone is willing to admit that the maturation of angel investors has pushed back the seed market. “I don’t think it’s a matter of venture capitalists shying away from early-stage, but rather being pulled to later-stage”, says Jesse Reyes, managing director of Venture Economics.
Jesse Reyes identifies several reasons for the trend. First, short-term returns are better in later-stage vehicles, allowing fund managers to impress limited partners and earn reinvestments in subsequent funds. Second, as funds become longer in the tooth, general partners are often tempted to make follow-on investment in successful companies in their portfolios. And third, as more investment banks launch their own venture funds, a more valuation-conscious approach leads to later-stage vehicles. “With early-stage, its always about technology, but with later-stage, it’s about price”, he explains.
Satellites: to Win Deals, Divide
Jesse Reyes’ point makes it easier to understand why an early-stage investor like Draper Fisher must commit an average of $3.5 million per deal. Valuations for early-stage Internet companies, fuelled by a cut-throat public market, are sky-high, necessitating larger investments in order to get into the best deals, even in companies at very raw stages of development.
Computer software and services received far and away more venture money than any other group in 1998. The sector witnessed 855 companies attract $5.43 billion of funding, each figure constituting nearly one third of all venture capital disbursements. The average deal size of $6.35 million per Internet company was bettered only by the equally hot communications sector ($7.81 million per company) and topped the traditionally pricey medical/health-related sector ($6.12 million per company).
As a traditional early-stage firm grows larger, it must choose between several strategies, Warren Packard says. The firm can put a limit on the amount of money it raises, thereby keeping its capital pool at a manageable size for smaller early-stage investments, or it can continue to raise larger vehicles and add more staff to manage the increased number of investments. Another option is to begin to segment the firm’s funds as they become larger, earmarking a certain proportion of capital for different growth stages and managing each pool separately.
And, finally, the firm can try “franchising”, delegating capital to independent managers who invest the money as a separate fund.
To combat increasing competition from more aggressive angels, as well as to better manage smaller investments in far-flung deals, some venture managers have taken a cue from fast-food chains and “franchised” their operations. While the idea is not necessarily a new one, firms with growing pools of capital under management have increasingly tried this strategy by opening satellite offices in remote locales. overseen by local managers. The logic behind such operations is that they provide greater access to local markets and an ability to make earlier stage investments.
Upper Lake Growth Capital, a $35 million St. Paul Venture Capital Satellite fund closed in January, is an example of this trend. Minnesota-based St Paul, an early-stage investor with around $800 million under management, last year announced plans to back several smaller early-stage funds in San Francisco, Minneapolis and another East Coast location, run by local managers.
Upper Lake, which has a medical focus, was founded by David Stassen, a VC-turned-entrepreneur who ran a St. Paul portfolio company before returning to the investment side to manage the satellite fund.
By virtue of its size, Upper Lake is better able to make a seed investment and commit the time necessary to nurture it than the managers of the much larger St. Paul. If and when one of the fund’s investees continues to show progress and needs another round of financing, St. Paul is waiting in the wings.
The result of this arrangement is that firms do not have to worry about missing a good deal that is uneconomically small for their fund. “Larger funds look for fully-baked ideas”, David Stassen says, “but we look at concepts”.
Draper Fisher is pursuing a similar strategy. In January the firm opened Draper Atlantic, a satellite fund on the East Coast, and in recent years has also launched funds in Los Angeles, Utah and Alaska. “It makes a lot of sense to have your money out there in areas [that are not traditional venture capital hunting grounds]”, Warren Packard says. “There are entrepreneurs in all these areas.”
Millennial Misgivings
All these industry developments – growth into new areas, the continuing fund-raising boom and the rise of angel investors – are products of the US’s miraculously vibrant economy. The entire structure could crumble at the first sign that the bears have finally awakened from their long hibernation.
The public market downturn at the end of the third quarter of 1998 was very nearly that moment. As the initial public offering market dried up, venture capitalists grew conservative in order to preserve capital for their existing portfolios in what many were concerned was the beginning of a long-feared correction.
In the fourth quarter of 1998, venture capitalists invested only $3.53 billion in 666 companies, compared with an average of $4.17 billion in 935 companies for the first three quarters of the year. While the investment pace in the final quarter is traditionally slower because of the holidays, the drop-off cannot be ignored.
Had Wall Street not bounced back late in the year, the effects could have been even more dramatic. Angel money would probably have dried up, limited partners might have grown disillusioned by diminished returns and venture capitalists could have had more difficulty raising money. And although these problems were largely avoided in 1998, they are inevitable once the cyclical economy takes a more prolonged turn for the worse.
“I’ve been saying for five years, fund raising has to slow down,” says Jesse Reyes, explaining that the public markets cannot sustain the rates of return limited partners have grown accustomed to and which have fuelled the growth of venture funds. Emphasising that he does not want to sound like a prophet of doom, Jesse Reyes is quick to acknowledge that the number of venture-backed mergers and acquisitions has risen in recent years, helping somewhat to offset the effects of a slower IPO market. However, later-stage vehicles, their portfolios heavy with listed companies, are especially dependent on the public market to provide good returns, he adds.
A prolonged downturn could be especially disastrous to first-time funds that are investing their maiden vehicle as the bad news hits. A first time fund’s limited partners are attracted to its promise, whereas second- and third-time vehicles rely on their predecessors’ performance. “Investors don’t make the same mistake twice”, warns Jesse Reyes.
The venture industry, however, does not seem over-anxious at present, with most venture capitalists content with the status quo and not anticipating any major concerns in the near future.
“I suspect we’re going to see a very strong [first] quarter”, Warren Packard predicts.
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