Managers get ‘no exit’ sign

The traditional exits for venture capital partners are few and far between this year.

Exit strategies — be they IPOs or M&A deals — provide the means for general and limited partners to make money in venture capital.

But this year, both the number of initial public offerings by venture-backed companies and the number of mergers and acquisitions of venture-backed firms are lower than comparable periods last year. Plus, distributions (cash returns to investors) are down.

The result is investors are making less money, while general partners are holding onto their portfolio companies longer.

Some specifics, according to Thomson Venture Economics and the National Venture Capital Association's quarterly survey:

• In the second quarter of this year, 10 venture-backed companies raised $714.1 million from U.S. initial public offerings; in the first quarter, 10 companies raised $720.7 million. By comparison, 29 venture-backed companies raised about $9 billion in the second quarter of 2004.

• At the same time, 75 were merged or sold during the second quarter vs. 79 in the first quarter and 89 a year earlier.

All and all, it's been a harrowing few years for venture capital fund managers and their investors, noted John Taylor, vice president of research at the NVCA, Arlington Va.

According to the data, the venture capital industry has been "upside down," returning less than was invested for a number of years, Mr. Taylor said. A company that sells for four times the total VC investment is break-even, Mr. Taylor said. "If you end up with 10 times (the total investment), chances are the venture investor did pretty well."

At the same time, institutional investors have been getting less money back from general partners. In the first quarter of 2005, total distributions to limited partners were $4.5 billion, according to NVCA/Thomson Venture Economics data. (Second quarter figures are not yet available.) The most dramatic drop in distributions was in 2001, when dollars returned to investors plummeted to $13 billion from $75 billion in 2000. So far, distributions have remained relatively constant, with $13.8 billion returned to limited partners last year.

"It's been several years since the industry distributed more than was invested. It has been since 1999 or earlier since that was last the case," Mr. Taylor said. "It raises the question of how successful the 1999 and 2000 vintage funds will be. A number will have a challenge returning 100 cents on the dollar back to the investors."

IPOs and mergers and acquisitions are tied more to the public markets than some people like to admit, said Bob Pavey, partner of venture capital firm Morgenthaler Ventures, Menlo Park, Calif.

"The returns venture capital generates to some extent are influenced by the public markets because … companies are sold by multiples that are driven by comparables to the stock market," Mr. Pavey said. "I think the important point is that the public markets are not there yet."

"In the past, when the markets were more vibrant, it took between three years and 10 years and now it's more like four years to infinity" for a venture capital fund to obtain an exit from portfolio companies, Mr. Pavey said.

Overall it's a challenging environment for venture capital fund managers, said Carl Eibl, managing director of Enterprise Partners, San Diego. Only a small percentage of companies in a venture manager's portfolio are ripe for sale, and those being sold hold leadership positions in their industries, Mr. Eibl said

"That dynamic will continue for quite some time," Mr. Eibl said. "Buyers (of venture-backed companies) are buying two things: enhanced capital and customers. If you don't have both, I think you will have be challenged."

Still, a number of industry watchers feel that the sector is beginning to rebound.

"I think you had a period of madness in 2000, followed by a nuclear winter (when the dot-coms crashed and there were no exits), followed by an even keel back to even levels of liquidity," said Clinton P. Harris, managing partner of Grove Street Advisors LLC., Wellesley, Mass. "Year to year, it's getting better." Grove Street is a consulting firm that advises private equity portfolios for a number of large institutional investors, including the $197.5 billion California Public Employees' Retirement System, Sacramento.

The public markets, especially Nasdaq, are used to value mergers and acquisitions as well as IPOs, he said. The Nasdaq is "way below the peak of 5000, but it's coming back reasonably nicely over the last three years," Mr. Harris said. Nasdaq closed at 2,136.08 on Aug. 18.

"I think the view of the industry today is liquidity is gradually getting better."

On the M&A side, corporations are coming back as buyers of venture-backed companies that had shut down their research and development departments after the technology bubble burst, Mr. Harris said. And if they're patient, venture capital managers can get a reasonable price and still return to investors 6% to 8% over the public markets, he said.

Tom Lynch, senior managing director of private equity consultant Wilshire Private Markets, Santa Monica, Calif., agrees venture capital is on an upswing, but added. "It's part of the cycle where realizations are still not at the level that promise great returns for venture capital investing."

In the future, venture-backed companies are more likely to be sold to strategic buyers like Cisco Systems Inc., Juniper Networks Inc. and Microsoft Corp., which are again starting to swallow up smaller start-up companies rather than invest in the still-lackluster public markets, Mr. Lynch said.

Corporations are buying companies rather than doing their own research to develop new products, Mr. Lynch explained. "And that is an attractive outcome for venture capital."