The long and winding close

Venture capital funds don't go out of business; they stop fund raising and quietly fade away.

Five years after the tech bubble burst, venture capital firms are coping with the havoc that event had on fund returns and the way they do business.

A number of venture capital partners have retired in the past two years. Overall, there are fewer executives in the venture capital business, dropping to 9,266 from a high of 10,000 professionals in 2001, according to the National Venture Capital Association, Washington. And while the number of firms has remained stable, industry insiders say it will take another five years for that statistic to be affected — the six- to eight-year investment period can keep a fading firm in business as it winds up the investments of the last fund.

This slow rate of adjustment leads to more pronounced downturns, as institutional investors struggle to invest with a shrinking number of seasoned venture capital firms that are raising smaller funds.

And that, in turn, can lead to more overheating of the venture capital market during the booms.

"This type of delayed exit has been part of the reason the (venture capital) market has been so sticky, why downturns take so long to work themselves out," said Josh Lerner, the Jacob H. Schiff professor of investment banking at the Harvard School of Business, Boston.

The venture capital firms with new funds are either raising much smaller funds or moving up to midmarket private equity and raising much larger funds. What is clear is that the number of years between funds raised is lengthening to close to six years on average from a low of two and a half, Mr. Lerner said.

Buyout and distressed debt funds are closing two times quicker than venture capital funds, according to London-based private equity research firm Private Equity Intelligence Ltd. For example, it would take close to two years for venture capital firms worldwide to close the $42 billion in venture capital funds they were raising in May 2005, compared with only a year to close the $119 billion in buyout and $5 billion distressed funds.

Many of those that are not fund raising are staying in business in hopes that one of their portfolio companies will be the next Google Inc. and save the fund returns. Of the 908 U.S. venture capital firms, most — 724 — are staying out of the market, according to data from Private Equity Intelligence, London. Since Jan. 1, 2005, 170 U.S. venture capital funds were raised. Most of the fund raising is by newer firms; of the 184 U.S. venture capital firms in the market, 78 are raising their first funds and 34 are raising their second fund.

This limits institutional investors' access to seasoned teams. Institutional investors don't want to invest in 20 small first-time funds by brand new venture capital firms, said Kathy Fields, a partner in the corporate, private equity and technology companies group of Boston law firm Goodwin Procter LLP. Investors would rather put their money with the somewhat larger funds of venture capital firms with track records because it's easier to manage a portfolio with fewer managers.

Venture capital firms that were new when the tech bubble burst appear to be having the hardest time. Indeed, very few — only 28 — of those 170 funds were sponsored by firms formed during the high times just before the tech crash.

Firms are not going out of business right away but are investing their last dollars, earning management fees while doing it and hoping for a big win, Mr. Lerner said.

"If you look in the venture capital space, there are a ton of firms that raised dot-com funds that clearly can't raise another fund," said Karey Barker, managing director of Cross Creek Capital LP, Salt Lake City, which just closed its first fund with $111 million. Cross Creek — a new venture capital subsidiary of small-cap equity manager Wasatch Advisors Inc. — has been making venture capital investments for a number of years using capital from clients' public equity accounts, she said.

Unless they beat the odds, firms that raised a first or second fund during the dot-com era lost much of their clients' capital, Ms. Barker said. Some of these funds were saved by one big winner — a portfolio company that prospered. Other established venture capital firms raised a new fund before returns showed that their tech bubble-era fund "was a big failure," she said.

While U.S. venture capital firms are loath to discuss their troubles in public, some firms have slipped away recently with a bang rather than a whimper.

A few firms are publicly calling it quits, including Mobius Venture Capital Inc., Palo Alto, Calif., which had raised a $1 billion fund in 2000. In July, Worldview Technology Partners Inc., Palo Alto, threw in the towel on a new fund after a number of senior executives left. Meanwhile, industry sources say Crescendo Venture Management LLP, Palo Alto, is a near-dormant venture capital firm. However, John Borchers, general partner of Crescendo, said the firm is still "actively investing the $650 million fund raised in 2000," but it does not plan to raise a new fund until next year. Mr. Borchers declined to give the target size of the new fund because the firm plans to be "in the market within the next 12 months."

"Partners are saying, ‘Let's hunker down. We have a pretty ugly portfolio.' If one of the portfolio companies does well they can live another day and raise another fund, but if not, they are out of luck," Mr. Lerner said.

An example of one firm that is hunkering down is ITU Ventures, a Los Angeles-based early stage venture capital firm. The limited and general partners in its third seed capital and early-stage venture capital fund, the $160 million ITU Ventures III, have agreed to stop the investment period, said Chad Brownstein, principal. This means the limited partners — including the $215.2 billion California Public Employees' Retirement System, Sacramento; the $25.9 billion Harvard Endowment, Cambridge, Mass.; and the $13.8 billion Los Angeles Fire and Police Pension System — will stop investing capital in the fund.

"ITU will continue to manage the existing investments," Mr. Brownstein said. Right now, the firm has 20 active portfolio companies, he said. However, he would not say whether the firm will raise another fund.

Not all venture capital firms that tighten their belts or go through management succession are about to go out of business. In 2003, OVP Venture Partners, a 23-year-old Kirkland, Wash.-based venture capital firm, stopped collecting management fees on its fifth fund, $150 million OVP Venture Partners V, until investors — including the $57 billion Oregon Public Employees Retirement Fund, Salem, and $66.9 billion Washington State Investment Board, Olympia — earned back the capital they had invested in the struggling fund. In May, the firm closed its largest fund, the $207 million OVP Venture Partners VII, with commitments from Oregon and Washington as well as new institutional investors.

"While a small number of venture capital firms are morphing into midmarket buyout firms and raising larger funds, most venture capital firms are getting smaller, Ms. Fields said.

"Early-stage firms with smaller fund sizes are not firms that can support large offices in five countries," Ms. Fields said.

"Everyone wants to invest in the funds in the top quartile," Ms. Fields said. In theory, this means 75% of venture capital firms won't get funded next time around, she added.