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Venture Capital
Trap door - Negative returns, cram-downs, incredible shrinking funds . . . No wonder vcs are trying to become buyout specialists--and that may be a major mistake.

By Tom Stein
November 15, 2002

Black is back in vogue in the fashion world this season (if you live in New York, you'd probably say it never left). In the private-equity world, venture capital isn't so lucky. The VC industry remains in a tailspin, with firms continuing to be forced to give money back to disgruntled investors--pension funds, endowments, and high-net worth individuals. In the second quarter, VCs returned a whopping $2.7 billion in pledged capital. They raised just $3.5 billion in the first six months of this year--nowhere near the spectacular $107 billion raised in 2000.

Buyout firms, however, are faring much better. Unlike VC firms, which purchase equity stakes in young, private companies, buyout firms use a combination of equity and debt to acquire older, more established companies experiencing hard times. In July, the buyout heavyweight Blackstone Group closed an eye-popping $6.4 billion fund--the most money ever raised by such an outfit. As a whole, the buyout industry raised a respectable $18.4 billion in the first two quarters of 2002, according to the research firms Venture Economics and National Venture Capital Association.

So buyouts are the new black, and VC firms are green with envy. Many VCs are sitting on piles of "dry powder," or uncommitted capital. Some estimates put the industry's total amount of unused cash at roughly $100 billion. VCs are anxious to put their money to work, but they are terrified of investing in startups now, when corporate America, which once fueled the technology expansion, has shut down its collective budget and is no longer experimenting with new technologies. As a result, some firms are switching gears, itching to get into the buyout business, which typically requires bigger up-front investments.

After a year or two of relative quiet, the technology buyout market is certainly starting to heat up. Though there are no hard numbers to support this, the anecdotal evidence is growing. Francisco Partners, a buyout firm that specializes in technology, says that after not doing a single deal in all of 2001, it has closed three deals in 2002, totaling about $1 billion. Francisco's biggest deal this year was an $800 million buyout in July of GE Global Exchange Services, formerly an e-commerce subsidiary of General Electric. Golden Gate Capital, another tech specialist, completed eight buyouts in the last 15 months, including the supply-chain software division of Peregrine Systems for an unspecified dollar amount, and the process-manufacturing software business of SCT in a transaction valued at $13.2 million.

Why the uptick? One reason may be that sellers who were waiting for the market to recover are growing increasingly desperate. They understand that valuations have been hammered down and are likely to remain that way for the foreseeable future. So they aren't nearly as eager anymore to stick it out and wait for their stock prices to recover.

Meanwhile, large publicly traded technology companies are under the gun to sell parts of their businesses to erase debt and clean up their balance sheets. Qwest Communications (NYSE: Q), for example, received a new lease on life in August, when it agreed to sell its yellow pages unit, QwestDex, for $7 billion to the buyout specialists Carlyle Group and Welsh, Carson, Anderson & Stow. Qwest shares catapulted 24 percent on the news. As the chances for a full-blown recovery become more and more distant, experts predict many established-yet-struggling tech companies (like telecom companies drowning in debt or companies in other sectors that have seen their revenue sources dry up) will be forced to sell noncore assets at attractive prices.

Tech buyouts make sense for yet another reason: roughly 150 tech companies that have more than $50 million each in the bank are trading below their net-cash values. For the most part, these are the same companies that VCs pushed to go public during the halcyon days of 1999 and 2000. Today, however, they don't want to be public anymore. Their stock prices are decimated; analysts don't bother covering them; and employee morale is lower than the mercury in a Siberian thermometer. These companies are facing issues that can best be resolved in a private context, where they don't have to report numbers or deal with the media. Since VCs are intimately involved with many of these companies, they are in a position to know which ones--if any--can benefit from going private.

Buy Focus
One VC firm starting to make a splash in buyouts is Oak Investment Partners. In early 2001, the firm raised $1.6 billion for venture investments. A portion of that money is still going toward VC deals, but the firm has dramatically expanded its focus to include buyouts. In May, Oak and other investors agreed to buy $45 million in preferred stock of the publicly traded wireless communications firm Wireless Facilities (Nasdaq: WFII). Oak was an early-stage venture investor in Wireless Facilities and has pumped millions into the company since its inception in the early '90s. In this latest round, much of Oak's money went toward retiring $33 million of debt associated with Wireless Facilities' line of credit. Oak quickly followed that deal with a $61 million private investment in the publicly held software company Divine (Nasdaq: DVIN) in June. Divine says it expects to be profitable by the fourth quarter and hopes to have more than $200 million in cash by year-end.

Not everyone is impressed with VCs trying to reinvent themselves. "A lot of VCs are now talking about playing the buyout game," says Jesse Rogers, managing director at the buyout firm Golden Gate Capital. "Some will do it right, but others will fail. They will likely have the same fate as the traditional leveraged buyout (LBO) firms that got burned when they moved into venture capital."

These thoughts are echoed by Diana Frazier, managing partner at FLAG Venture Management, a so-called fund of funds that invests in a wide spectrum of VC firms. "Some venture firms may get their heads handed to them if they attempt LBOs," she says. "Venture capital is all about people and relationships. Buyouts are about turning around companies that are already up and running, whereas venture is about investing in the beginning of an idea. I think there are very few people out there who have the skills to do both."

Indeed, several reputable LBO firms, including Forstmann Little, Hicks Muse Tate & Furst, and Kohlberg Kravis Roberts, recently learned this lesson the hard way. In April 2000, Hicks Muse invested $230 million in the broadband Internet provider ICG Communications. Today, ICG is bankrupt, and the investment is practically worthless. Other stunning losses include a $500 million infusion in Teligent, a wireless communications company that filed for bankruptcy in May 2001.

LBO firms traditionally had been known to steer clear of the tech sector because of its complicated products and quickly changing competitive landscape. But when the technology market went into overdrive in the late '90s, they entered the sector, as did the specialist firms like Francisco Partners. Today most traditional LBO firms won't go near any kind of technology deal, be it venture, buyout, or otherwise.

They have dropped out, leaving just specialists and a few mainstream firms with dedicated tech teams, like the Texas Pacific Group, to play the game. And now, of course, VC firms want in on the action.

"It's quite possible that VCs could partner and co-invest with us or any other LBO firm," says David Stanton, a cofounder of Francisco. "In some cases, they could even lend value and bring something specific to the table." Francisco, for example, has a strategic relationship with the VC firm Sequoia Capital. The two organizations share their network of contacts and technological expertise, though to date they have not done any deals together.

When VCs try to do an LBO deal on their own, soup to nuts, buyout firms look askance. "A venture firm is not really set up to do the two-tank scuba dive and the incredibly intense due diligence that buyouts demand," says Mark Jennings, managing partner at Generation Partners, a crossover venture capital/buyout firm. His firm, along with others, like Morgenthaler, typically manage to balance the two by having distinct buyout and VC teams. Morgenthaler, for instance, has an $850 million fund that both a VC team and a buyout team manage equally.

Firm Commitment
Mr. Jennings says his firm recently went toe-to-toe with an undisclosed VC outfit over the buyout of GE Disaster Recovery Services, formerly a division of General Electric. He says GEDRS originally selected the VC firm but called him back three weeks later to take over the deal. "I'm not exactly sure what happened," he says. "Maybe the VC firm couldn't line up a bank to help it secure the debt. I just know that the VCs dropped the ball, and the other party lost confidence. After GEDRS called us back, we wired them a check and closed the deal within a month."

Like the fashion world, private-equity players are keenly aware of the latest styles and trends. Nobody wants to be caught in yesterday's wardrobe. But VCs who stray too far from what they do best may soon find they're wearing nothing at all.

Write to Tom Stein.

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