When the formerly hot online retailer eToys shut down its website and filed for bankruptcy last month, among the losers was Sequoia Capital, Menlo Park, Calif., the highly regarded venture capital firm that is eToys' second largest stockholder.
Sequoia never took profits after the company went public at $20 a share in May 1999, surging to a high of $86 a share during the height of the Internet frenzy in early 2000.
What happened with eToys' backers was typical of the times, according to Brooks Zug, senior managing director at HarbourVest Partners LLC, Boston, a fund of funds that invests in Sequoia funds. Because of lock-up rules and various regulations, many general partners weren't able to take their profits in some of their high-flying companies before the Internet bubble burst. "Many investors couldn't get out at the high valuations, because if they started to sell, it might have depressed the market for the stock," he said.
Mark Dempster, spokesman at Sequoia, did not return phone calls seeking comment. Mr. Zug said he didn't know how Sequoia might record the loss on its books, but added it probably won't show up for months because most private equity firms revalue their portfolios every six months, in June and January.
Why to diversify
"It wouldn't be surprising if lots of venture firms got caught with some companies that folded. But that's why they diversify their investments, as we do," Mr. Zug said.
Nevertheless, the tech wreck on the Nasdaq composite, which has fallen nearly 64% since its high of 5,048.62 on March 10, 2000, has been causing private equity managers at pension funds to worry about their venture allocations, although none has made any official cutbacks.
Sequoia was one of the early venture firms that did so well it closed its doors to most new investors. But college endowments, which moved into venture capital years before pension funds did, are among the firm's limited partners, according to Asset Alternatives' 2001 Directory of Alternative Investment Programs. Among them: the $14.3 billion endowment of Harvard University, Boston; the $2.7 billion endowment of the University of Chicago; the $3.6 billion endowment of Duke University, Durham, N.C.; the $3.9 billion endowment of Cornell University, Ithaca, N.Y.; the $5.1 billion endowment of the University of Michigan, Ann Arbor; and the $2 billion endowment of the University of Notre Dame, South Bend, Ind. Asset sizes are from Money Market Directory.
Pension funds got to invest in Sequoia by becoming investors in HarbourVest's U.S. fund of funds. Those investors include the $120 billion New York State Common Retirement Fund, Albany; the $90 billion New York State Teachers' Retirement System, Albany; the $56.7 billion State Teachers Retirement System of Ohio, Columbus; the $42 billion Oregon Public Employees Retirement Fund, Salem; and the $30 billion Pennsylvania State Employees' Retirement System, Harrisburg.
"Many pension funds were very surprised at how much their venture portfolios are correlated to the Nasdaq," observed Hal Strong, managing director at Russell Capital, a subsidiary of Frank Russell Co., Tacoma, Wash., which manages $3 billion in alternative assets. "It's been a real eye-opener for them. This market has shown them the asset class is not a diversifier."
Gary Robertson, vice president at Callan Associates, San Francisco, said institutional investors won't know how their venture investments performed until the third and fourth quarters, in general partners' reports to their investors.
"Everyone believes that funds raised in 1998 and 1999 will show up as bad vintage years, and that the median returns will be like cash at best, with upper quartile returns at 15%," Mr. Robertson said.
Early returns tracked by Venture Economics, Newark, N.J., show the beginning of the downturn. Returns on limited partners' investments in venture capital funds fell to 6.4% in the third quarter of 2000 (the most recent data available), compared with a return of 7.6% for the previous quarter. Returns for the first quarter of 2000 were 23.1%.
Jesse Reyes, vice president at Venture Economics, expects returns to get worse before they get better. "Returns for the fourth quarter will be negative, and we'll see a downturn in the first half of this year," he said.
HarbourVest's Mr. Zug concurred. He said the carnage will continue and results for 2000 will be much lower than those from a year before. "Every partnership will have companies that got hurt, because those high valuations weren't real. The smartest venture capitalists didn't record those values, but carried values that were much lower," he said. "Most experienced venture managers knew a correction was inevitable - it was a just question of when."