Business Week

JULY 18, 2002

VENTURE CAPITAL VCs Don't Want Your Money Anymore

With coffers bulging and scant prospects for the quick returns that characterized the boom years, they're returning clients' investments

Venture capitalists have a problem that most anyone would envy: too much money. During the boom times, VC funds, which finance startup companies, reaped staggering profits, and an embarrassment of riches from grateful investors.

What a difference a bear market makes. Now, most VC funds are underwater and quality investment pickings are slim. Foundations, pension funds, and endowments--the limited partners, or clients, of VC funds--are getting really edgy. What's more, nobody is in the mood to tie up money for the five years or more it takes typically for a high-risk venture to bear fruit.

NEGATIVE INFLUENCES. That has set in motion an unprecedented retreat by the VCs. They are shrinking their billion-dollar funds, giving back money and forfeiting management fees. It's not that they're cutting refund checks, but rather releasing investors from their contractual commitments to fork over more money for future investments. "It's the moral equivalent of a refund check," says Kirk Walden, national director of venture-capital research at PricewaterhouseCoopers.

Through June, the givebacks have totaled at least $3 billion. And that's a fraction of what's to come, observers say. In fact, VCs may end up returning about $50 billion to investors in the next year. That's roughly equal to what the global venture community laid out in investments in the four years through 1998, before the floodgates broke in 2000 and a record-breaking $105 billion was invested.

Why are the VCs handing back cash that they normally scramble to attract? "The issue here is the return that you can expect to get on the money two years from now," says Robert C. Roeper, managing director of Boston VC Venture Investment Management. "It might just be negative."

MANY UNHAPPY RETURNS. Judging by VCs' recent performance, he could be right. When first-quarter performance figures are published before the end of July, 2002, they're expected to show losses. Last year, VC funds posted a collective loss of 28% -- the first since 1970, when the numbers were first tracked. It's a blemish on an otherwise stellar record: The funds have earned 26.4% a year for the last decade and 18% a year since 1980.

Marquee names are leading the charge to hand back cash. Texas-based Austin Ventures Texas returned $670 million from a $1.5 billion fund in June. Charles River Ventures cut its latest $1.2 billion fund by more than 60% just weeks earlier. They followed a slew of venerable Silicon Valley firms -- Kleiner Perkins Caufield & Byers, Accel Partners, and Mohr, Davidow Ventures -- that had cut their billion-dollar funds by up to 32%. Cutbacks at those three firms alone took a total of $800 million out of the investment pool.

To be sure, the refunds aren't about altruism. A firm that gives back money now will likely have an easier time raising more of it when the going gets good again. Meantime, they're forfeiting future fees -- of about 2% a year on collected funds, plus a cut of any profits -- they would have earned had they called in the money, though they're still getting paid for idle funds they have in hand. "We're walking away from several million dollars to make a statement that this business has way too much money," says Ted R. Dintersmith, general partner of the 32-year-old Charles River Ventures, whose clients include Notre Dame University, Hewlett-Packard (HPQ ), and Memorial Sloan-Kettering Cancer Center. "It's the right thing to do, but it's a painful thing to do."

QUICK PROFITS? NOT ANYMORE. Even with the downsizing, there's still too much money in the pipeline. In the first quarter--the most recent data available--VCs invested $6 billion, equivalent to a more typical annual investment of $25 billion. But there's still an $80 billion overhang of uninvested capital from the 1999-2001 banner years. "There's enough money in the bank to last the industry for several more years," says Walden of PricewaterhouseCoopers.

The VCs' conundrum is the lack of exit strategies. Even when they find entrepreneurs worthy of funding, VCs are no longer able to unload their upstarts quickly and reap easy profits. The stock market is sour on both initial public offerings and mergers, and the outlook is worsening: According to Thomson Financial Venture Economics, VCs raised $1.96 billion through IPOs and mergers and acquisitions in the first quarter this year--a 40% drop from the final quarter of 2001.

The meteoric growth in assets during the bull market sowed the seeds of the VCs' current problems. Too much money chased a lot of bad business models. And those bad deals are still on the books. Dintersmith notes that few of the 300-odd private optical-networking companies that got financing have any hope of survival. "I don't think you're going to see 298 become successful," he says. "It's going to be a bloodbath."

SUCH A HANGOVER. Not so long ago, any entrepreneur with a half-baked idea could raise millions from VCs. Follow-on financing deals were a cinch. For a fast payoff, VCs pushed companies out assembly-line fashion to frenzied markets that bid up their shares. Investors couldn't pile in fast enough. "In the old days, you didn't worry too much about the fundamentals of the business. The arrogance was unbelievable," says Peter B. Yunich, managing partner of New York Metropolitan Venture Partners. "The VCs that raised a lot of money during the halcyon days, to put it bluntly, have not performed well."

As a result, VC funds are now raising less than their initial targets for the first time in memory. In June, for example, Murphree Venture Partners, a venture-capital firm based in Houston, closed its fifth fund at $28 million, well below its $100 million goal. Others are scuttling their plans altogether: Bank One Corp.'s private-equity arm shelved a $200 million fund of funds, citing a lack of interest among high-net-worth clients.

Although painful in the short term, the current shakeup will only help the market, say fund managers. "Our portfolio companies are going to have to use less cash to get to profitability," says Robert P. Badavas, who is chief operating officer of Atlas Venture in Waltham, Mass. "We're adding some conservatism back into the model." Atlas, which has $2.4 billion of committed capital, cut the size of its sixth fund, the Atlas Fund VI, by 12%, to $850 million, in June.

HALF MEASURES. New VC financing rounds are about half the size they were in boom times -- from $10 million to $15 million for each startup. More seasoned entrepreneurs and fewer twentysomethings are making the grade. "A year from now you'll see a stronger investing climate, and VCs will be more aggressive in competing for companies with a strong operational focus," Yunich says. "Innovation doesn't stop just because the Nasdaq is down."

Venture capitalists, who kept the champagne flowing during the tech bubble, are now nursing their own hangover. They'll continue to attract a trickle of money, even during tough times, because they're an important asset class to big pension funds and foundations. But to persuade investors to return in force, they'll have to keep sight of the lessons of the bust.

By Mara Der Hovanesian in New York

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