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Back to the Future for Venture Capital

As the venture capital business mushroomed into a major asset class, it became a victim of that very success. Now its only chance for a future may be a return to the past.

  • Udayan Gupta

In 1958, worried that America was trailing the Russians in the great technology race, President Dwight Eisenhower signed into law a bill he believed would kick-start American innovation and put the U.S. back in the lead. The Small Business Investment Companies Act not only created a unique public-private partnership that reignited the country’s passion for innovation, it also spawned the modern venture capital industry, which would go on to bankroll entrepreneurs’ ability to turn their dreams into reality. Some of the most important U.S. corporate success stories — from tech titans Apple and Intel Corp. and biotech pioneers Amgen and Genentech to more recent e-commerce leaders Amazon.com and eBay and social media darlings Facebook and Twitter — were initially backed by venture capital.

But now, a half-century later, the venture capital industry is struggling. Profits are virtually nonexistent, and for the first time in VC’s history, the ten-year rolling returns will be negative. The innovation that fueled venture capital’s early achievements is being put to the test as industry stalwarts fight to ward off the business’s total collapse.

Venture capital, like other alternative investments such as private equity and hedge funds, is a victim of its own success. Thanks to early outsize returns and aggressive marketing, venture capitalists were deluged by money from endowments, pension plans and other institutions beginning in the mid-1990s, often through funds of funds that promised access to the most successful and exclusive VC firms.

“We went from being a unique cottage industry to a burgeoning asset class,” notes Yatin Mundkur, a managing partner of Artiman Ventures, a Silicon Valley venture capital firm that manages about $360 million in assets.

The VC industry’s strength was its ability to take small sums of money and create large, sustainable businesses through innovation. But the processes that work for dozens of companies cannot be scaled to thousands of companies, especially when they are all in the same sector. Bigger, it turns out, is not better.

Under the weight of massive allocations from institutional investors, the VC industry lost its way. Buoyed by the hype of the 1990s’ Internet bubble and booming stock market, venture capitalists sank money into start-ups at peak values, convinced they would be able to exit through initial public offerings or corporate acquisitions. And for a few years, they were right. But then the bubble burst and the stock market cratered, only to revive for a few short years before taking a worse beating in the Great Recession. Exit strategies disappeared, leaving venture capital funds saddled with mature cash-guzzling companies and next to nil in returns.

Not surprisingly, the new money has all but dried up. Capital committed to venture funds in 2009 was $15.2 billion, less than half of the $28.6 billion committed to them in 2008 and about one seventh of the $105.3 billion VC funds received in 2000, according to the National Venture Capital Association.

“As a fiduciary it is going to be difficult to justify adding to venture capital assets when most of the existing assets are under water,” points out Robert Knox, a managing partner of $1.2 billion-in-assets Cornerstone Equity Partners, a New York–based private equity firm, and chairman of Boston University’s board of trustees. Knox helped create Prudential Insurance Co.’s venture capital program in 1981, which became one of the largest investors in top-tier VC funds. “There will be a permanent change in how major endowments and institutions approach venture funds in the years ahead,” he avers.

Today the VC industry is laboring to adapt to a violent contraction — the reduction in capital flow and the shuttering of funds — even as most venture capitalists agree that this downsizing is critical to ensuring its future. But recovery won’t come overnight. Mundkur says venture capital should never have grown beyond its cottage-industry roots, with funds of funds having transformed it into a run-of-the-mill money management business in which fees are earned irrespective of performance. “We have to return to the past to step into the future,” he asserts.

The shift is already well under way. Venture investing is now more influenced by angels — networks of individual investors who will often invest as much as $1.5 million each in an early-stage company. VC funds are also capping their size and targeting new areas for investment where they may have little direct experience, but which offer greater opportunities. And they are finding strength in numbers and forming communities to share deals.

Venture capital has never been a stand-alone business. It has succeeded in the U.S. because it has had the benefit of an abundance of innovative technology, often backed by tens of millions of dollars in government funding; a group of specialized investment banks that invested in forward-looking companies and helped underwrite their public offerings; stock exchanges that promoted trading in young, often development-stage companies; and a market of investors and corporate buyers that allowed orderly exits for venture capitalists.

To ensure its future the industry needs to capitalize on its historical strengths while adjusting to a new world. There are signs suggesting it will do more than merely survive. The venture investment in September 2009 in Twitter was a bright light for an industry mired in dark times. The San Francisco short-messaging firm raised $100 million in its latest round of financing, giving it a valuation of $1 billion. Twitter has never confirmed that valuation, but it has twitter-thanked the investors in its new round — Benchmark Capital, Insight Venture Partners, Institutional Venture Partners, Morgan Stanley, Spark Capital and T. Rowe Price.

Despite a decade of lackluster performance and dismal returns, some venture firms continue to raise large pools of money. New Enterprise Associates, which has offices in Baltimore and San Francisco, announced in January that it had raised $2.4 billion at the first closing of its 13th fund. Khosla Ventures, founded by former Kleiner Perkins Caufield & Byers partner Vinod Khosla, said it had raised two funds: a $700 million pool to invest in clean technology and a smaller $280 million vehicle for start-ups. Oak Investment Partners, reputedly one of the worst-performing funds of the decade, which garnered $2.6 billion in 2006, was working to raise a further $1.5 billion in 2009.

Harvard Business School professor William Sahlman, who has experience working with both venture capitalists and entrepreneurs, has a simple explanation of why some investors continue to invest: “Venture capital is like a second marriage — the triumph of hope over experience. How else could you explain why limited partners continue to invest in firms with mediocre track records?”

Part of the reason may be the often cozy relationships between the limited-partner community of giant funds of funds and endowments with brand-name venture capital firms. Fund-of-funds behemoths like HarbourVest Partners, Credit Suisse and Goldman, Sachs & Co. continue to allocate big chunks of money to venture capital, almost always to large funds. “They have transformed an investment business where most returns are generated by successful investing into a classical money management business where income is generated by fees, regardless of the investment results,” explains William Gedale, a veteran investor with VC firm NGN Capital in New York.

Venture funds receive an annual management fee that is typically about 2 percent of assets. So if a venture fund is managing $200 million, it can take $4 million each year for the duration of the partnership. If the fund makes cash distributions — pays back the investors some of the original capital — the fee is adjusted to reflect the actual amount still managed. In addition, the venture fund also receives a percentage of the profits, called carried interest, of 20 percent. If that $200 million fund generates $100 million in profits, the fund will receive an additional $20 million. Critics note that the mega–venture funds that manage billions of dollars continue to rake in huge management fees irrespective of performance.

But the math worked for large investors. Venture capital partnerships, unlike those in other asset classes, are designed to have a ten-year life but typically last for as long as 14 to 16 years. Institutional investors fund their venture capital commitments through capital calls, which require investors to meet their commitments in tranches instead of all at once. Historically, investors have not had to put up the total amount. Early cash distributions, available when portfolio companies were sold or went public, often helped offset some of the investors’ future commitments.

What followed was that institutions, aided by fund advisers and consultants, purposely exceeded their targeted allocations, convinced that thanks to the avalanche of cash distributions, they could meet their commitments using distributions received and would never have to put up all the money.

But with an IPO window that has been boarded up and a mergers and acquisitions market that is highly selective, few venture capital funds have made any really significant distributions since 2001. As a result, during the recent financial crisis, in which all asset classes plummeted in value, many institutional portfolios were left with huge overallocations to venture capital.

Caught in a cash squeeze and suffering some of the worst overall investment results, many of the most committed university endowments and public pension funds are drastically cutting back on their allocations. The endowments of Harvard, Princeton, Stanford and Yale universities, once among the greatest champions of venture capital, are reported to have put up for sale some of their shares in existing partnerships for as little as 40 cents on the dollar.

The reductions, though, may be just what the industry needs to survive. “The shrinkage in endowment money is something I see as a positive,” says Mitchell Kapor, an angel investor and the founder of Lotus Development Corp. “VC funds had too much money to invest well, and that was causing problems. Now supply and demand are better balanced.”

One industry watcher says getting institutional funds out of venture capital is the first step to its revival. “Venture capital never deserved to be professionalized and treated as an asset class that could take fixed percentages of capital every year from large institutional investors,” asserts Paul Kedrosky, a senior fellow at the Ewing Marion Kauffman Foundation, the largest foundation dedicated to promoting entrepreneurship, with an estimated $2 billion in assets. “It is a small business that sees massive ups and downs, and one whose results are easily squashed when too much capital is routinely allocated to it year after year.”

The numbers clearly bear this out. The increased capital commitments in the late 1990s were a response to the venture capital industry’s ability to deliver superior returns — top funds during the earlier part of that decade had high-double-digit annual returns — but the subsequent decline in performance has occurred at the industry’s highest fundraising levels. “The solution is a return to venture capital, circa 1993,” says Kedrosky. His fix: lots of smaller funds, say $30 million to $150 million, and a few somewhat larger funds, up to $250 million. His prediction: lots of people exiting the business and less money invested per year in both funds and entrepreneurs.

That scenario is already being played out. Venture capital funds’ investments in portfolio companies fell from $28 billion in 2008 to $17.7 billion last year — less than 20 percent of the $94.1 billion the industry invested in 2000. Although big VC funds continue to sit on large pools of capital, nursing existing investments they cannot sell or take public, venture investing is now being influenced by angels and small funds with proven track records.

Case in point: angel investor Kapor, the founder of software company Lotus, which IBM Corp. bought for $3.5 billion in 1995. His San Francisco–based Kapor Enterprises is a vital part of a band of angels that spearheads technology investing across the nation. And Mundkur’s Artiman Ventures, launched in 2000, is one of a group of new funds that has carefully structured itself to invest in an entrepreneurial economy with limited access to capital and markets.

Today small VC funds such as New York’s Milestone Venture Partners, which manages a pool of capital from mostly individual investors, are now among the most successful. MVP was formed in 1999 by Todd Pietri, a former investment banker, and Edwin Goodman. The two started with a $10 million pool; the fund closed in 2001 with $13.1 million.

Whereas all venture funds launched in 2001 have returned an average of 38 percent of paid-in capital (the money actually received by funds, as opposed to committed capital), MVP’s Milestone II has returned 160 percent, according to Pietri. Its internal rate of return of about 16 percent is far greater than the average of 5.5 percent for the upper quartile of funds launched during the same period, according to Cambridge Associates.

Even some venture capitalists who had been transformed into megafund managers are coming back to the idea of small, capital-efficient VC funds. New York’s Alan Patricof, who launched his first fund in 1969 — which evolved into Apax Partners, a $35 billion diversified equity pool — created Greycroft Ventures in 2008, a $75 million fund focused on early-stage businesses.

“The most attractive venture funds are the ones that have already adjusted to the market,” contends JoAnn Price, managing partner of Fairview Capital, a $2.8 billion fund-of-funds firm based in Hartford. Investors are drastically cutting down on the size of their investments and commitments.

“Endowments — investors of choice for venture capital — and pension funds are discovering they overallocated assets to venture capital in anticipation of faster distributions and overoptimistic returns,” says Price. Now that the value of their assets has plummeted and they need liquidity, they are not getting back into venture capital in a hurry. “Even venture capitalists with storied histories are not in a position to attract new investors,” she adds.

Although most gatekeepers and funds of funds continue to go after big-name VCs, Price’s firm has emerged as a champion of the smaller, innovative venture funds that often are ignored by the larger asset allocators. Price sees the future in partnerships such as Mundkur’s Artiman. The first Artiman fund was launched in 2000, perhaps the least propitious time in VC history to start. “The Internet bubble had already burst; the telecom bubble was about to,” recalls Mundkur. And after investing in two deals, the fund suspended investing. “The conditions just weren’t right,” he says.

Artiman began reinvesting in 2004 with $180 million in capital and started a second fund two years later, also with $180 million. In addition, it has a separate pool of capital that it uses for late-stage financings. At a time when some of the big funds are known more as asset gatherers than company builders, Artiman’s decision to keep the funds small is deliberate. Even in the early 1990s, when Mundkur was an entrepreneur — he was founder and president of Equator Technologies, a maker of programmable media processors that was sold to Sony Corp. in 1998 — the largest venture funds were in the $100 million-to-$150 million range, he notes. The key to smaller funds is that it takes only two or three big wins to be successful, Mundkur adds.

At a time when liquidity and exit strategies are issues that dominate venture capital, Artiman is focusing on building strong, stand-alone companies in what Mundkur calls white spaces, or large markets that go unnoticed by most venture capitalists because they fall outside of rigidly defined industry segments. White-space companies typically apply well-known technologies in nontraditional ways.

Take Artiman’s investment in Cellworks Group, a drug development company that is exploiting advances in proteomics, or protein-based analysis, to come up with new drugs at a fraction of the industry’s average cost. Proteomics isn’t new; what’s novel is applying it to drug development as a way to drastically cut costs.

Using this strategy, Mundkur is optimistic about the IPO market, even today. That’s because of the uniqueness of his firm’s portfolio companies, he says, and their potential to be independent stand-alones, for which the natural exit is an IPO.

Still, there are challenges to Artiman’s style of investing. Its emphasis on building sustainable companies in white spaces limits the number of deals it can do each year: never more than four or five. And in the tradition of old-style VC firms, Artiman doesn’t flip its portfolio companies, so its holding periods are longer than is typical. Says Mundkur, “While most venture investors tout four-to-five-year holding periods, we are at six to seven years.”

In addition to staying small and targeting previously unexplored investment opportunities, today’s successful venture capital funds are organizing themselves around fund communities. In Virginia, Arthur Marks’s Valhalla Partners is part of VC 2.0, an informal group of about 30 venture firms that cap the size of their funds at $250 million. They invest primarily in technology founders — entrepreneurs who get their hands dirty — and they like to keep their investments small, to no more than $1.5 million. Although most of the venture capitalists in the group are experienced investors and seasoned entrepreneurs, they have shunned the kind of publicity that many of the 1990s Internet VCs craved. The group insists that venture investing should be a collaborative process, not the intensely competitive one that helped inflate valuations and create the destructive “me too” companies of the 1990s.

The group also believes that its most likely exits will come through sales of companies rather than IPOs, and it’s likely right. Among technology companies, Cisco Systems, Hewlett-Packard Co., Intel, Microsoft Corp. and, most recently, Google — which has purchased 55 companies in the past two years — continue to be active buyers.

Preparing a company to go public and comply with financial regulations can not only take up scarce cash, but may also distract a company’s management, points out Valhalla’s Marks. “We start with the assumption that all our portfolio investments will be acquired,” he says. As a result, from the very beginning, Valhalla works with its portfolio companies to identify potential partners.

In 2004 it invested in RealOps, a start-up with a software program that helps large companies manage their computer installations. Valhalla estimated that the company needed a $5 million initial investment to build a prototype and start marketing and a co-investing partner to fill out much needed areas of expertise. Valhalla didn’t find the right partner, so it decided to invest the entire $5 million itself. Once RealOps had the working prototype in place, Valhalla sank a further $8 million into the company to help it ramp up. RealOps was acquired by BMC Software in 2009 for $52.5 million.

Even in New York — where success among venture capitalists is often measured more by blog readership than by investment performance — small funds are regaining the limelight. In July, in the midst of a swooning stock market, Milestone Venture Partners scored big when Medidata Solutions, a clinical data company, went public. MVP’s total investment of $552,500 in Medidata yielded a 37 times return and a 1.6 times multiple of its entire fund.

“We were supposed to be fearful that Medidata was undercapitalized given that it was only raising $1 million when the dominant company in the market at the time, Phase Forward, had already raised a war chest of many tens of millions of dollars,” wrote MVP co-founder Pietri in the firm’s newsletter this summer. “But the reality is that the best applied technology companies need only a modest amount of equity capital to be very successful.”

MVP’s Goodman says institutional investors told him that the fund was much too small for them to invest in without representing a huge percentage of the assets. They argued that its initial investments in early-stage companies would get “crushed” or “washed out” in punitive follow-on rounds of financing. In other words, the companies would run out of cash, and MVP would be unable to support them.

But the firm stuck to its guns, often being in the lead group of investors in its companies, helping them build management teams and business strategy and thriftily providing follow-on financing. Since 2001, MVP has raised a $54 million fund and may soon launch Milestone IV.

Today, as institutional players pull back from the traditional VC space, angels like Mitch Kapor are picking up much of the slack in early-stage investing. Venture capital doesn’t have to be a capital-intensive or bureaucratic process, says Kapor. “What I do see is that many of the best new start-ups, including ones with world-shaking ambitions, don’t need venture capital to get started,” he explains. “Seed rounds of $500,000 to $750,000 funded by angel investors and small, specialized funds — which are basically grown-up angels — are getting first choice of the best entrepreneurs in consumer Internet opportunities.”

Kapor’s recent investments include Get Satisfaction, a crowd-sourced customer service; CubeTree, which provides software to create a social network within a company to encourage collaboration; and DropCam, a YouTube for netcams. Kapor notes that start-ups have become cheaper, require fewer people to run and take less time to market because today’s platforms offer a more advanced starting point. Entrepreneurs can get access to both capital and expertise from angels and seed funders. “There is a whole generation of successful entrepreneurs with capital who form the core investors in this new band,” he says.

This generation of investors is helping the venture capital industry fulfill its basic purpose — financing innovation and bringing it to market — which, despite its recent troubles, hasn’t changed.