Investors tougher on big VC firms

By Sarah Lacy, Pg. 1

Kleiner Perkins Caufield & Byers won’t invest all of its 10th fund. Accel Partners will split its $1.4 billion fund into two sequential funds, charging management fees on only one-half at a time. Charles River Ventures now has four fewer general partners — leaving only one in its Sand Hill Road office.

But for Matthew Cherry, business is growing.

Mr. Cherry is president of Intelex Ltd., a due diligence firm, hired by private equity companies to dig up information pertinent to deals. The fastest growth area this year has been institutional investors looking to invest in venture firms.

About 70 percent of the venture firms Mr. Cherry is asked to investigate are ones he hasn’t heard of before. Such scrutiny isn’t a big surprise, since most in the industry expected a vast shakeout among firms started in the late 1990s or early 2000.
But a growing 30 percent are brand name firms. In the spotlight are rookie general partners.

“During the dot-com phase a lot of people got into the VC business without much of a track record,” Mr. Cherry says. “Over the past five years there’s been such a huge increase in money to private equity it has people a little nervous. These are people’s retirements and no one wants to be the [limited partner] who invested your retirement in an Enron or Global Crossing.”

About 40 percent of firms Intelex has been hired to investigate are on the West Coast. In fact, business here is growing so fast, the Greenwich, Conn., firm is thinking about opening an office on Menlo Park’s Sand Hill Road.

Despite a brisk pace for Mr. Cherry and his colleagues, much of the venture industry — partners and their institutional investors alike — held their breath during 2001, hoping for the IPOs and acquisitions to gain steam and the pace of new investments to pick up.

But even in 2002 after six quarters of contraction, new investments have decreased again moderately, according to numbers released by VentureWire the week of April 1. And like much of 2001, most of those dollars are going to follow-on investments in existing portfolio companies.

Many big firms have already started to wonder whether the megafunds of 1999 or 2000 can be profitability invested in this economy. Reports that some high-profile firms are reducing fund size or changing management fees have gotten the biggest headlines, but there have also been several reports of general partner numbers shrinking at big-name firms. In addition to the Charles River Ventures reductions, Battery Ventures declined to hire another partner at the last minute and Highland Capital Partners let go of well-known San Francisco partner Keith Benjamin, according to published reports. Those close to the situation have been mum on the details — an advantage the very private world of venture capital enjoys.

But these events didn’t happen in a vacuum, and, when looked at together, they indicate that some of the problems smaller firms saw in 2001 are now extending to the top. All this is happening when there are already concerns among institutional investors and some larger firms. Among them is the concern that older partners are leaving marquee firms, taking with them some of the firm’s historic perspective and long record of strong returns. And if some of these firms are giving back money because deal flow is down — a situation unthinkable several years ago — those who staffed up accordingly may need some thinning. Many industry watchers see such thinning as healthy, but for many new partners at these venerable firms it will mean more scrutiny and possibly some of that “triage” they applied to portfolio companies during the last 18 months.

“Venture firms are very Darwinian,” says Matt Ocko, general partner at Vantage Point Venture Partners, a Sand Hill Road firm, that is so far committed to keeping its $1.6 billion fund. “Two types of partners aren’t downsized: the old lions who rule the pride, and the producers — the people who’ve demonstrated capability to provide good returns. Anyone else is fair game.”

He says it’s a form of housecleaning just like the tech industry has undergone.

“There were three distinct sins over the last three and a half years,” he says. “Pride, or the blind staffing up of firms thinking `we cannot fail’; greed, or the VC who sits on 16 boards hoarding management fees; and naiveté, or reckless inexperience. At the end of 2000 and 2001, doing no deals was one of the smartest things you could do.”

Of the firms that did staff up during the boom, many hired people from the tech industry, with little-to-no investment experience. While some firms defend this talent pool, others question it.

“There will absolutely be downsizing,” says Steve Bird general partner at Focus Ventures. “The amount [of money] under management will continue to shrink, I think by 50 percent. The number of GPs won’t shrink by near that much, but there will be downsizing.”

Amid news of downsizings or firms going out of business altogether, it deserves noting that many are raising funds and growing. Advanced Technology Ventures, for one, closed an $800 million fund in the fourth quarter and has hired three partners since then, says Jos Henkens, ATV general partner.

“Firms grew so quickly, we used to joke about it,” he says. “Investment bankers, attorneys and accountants were investors in early stage companies overnight.”

ATV had its share of portfolio woes but like others resisted the billion-dollar allure during the boom times — and is now glad it did.

“We weren’t part of the billion club,” he says. “For a while that [club] was a real eye-catcher; now it’s almost a negative.”

Although VC recruiting is down, several firms in ATV’s position see now as a good time to find or lure top partner talent, says Jonathan Visbal, managing director of the Silicon Valley office of Spencer Stuart, a Chicago executive recruiting firm. But those firms are picky and many former partners looking for a new job don’t have the 10 years or more of investing experience his clients look for.

This is all against a backdrop of broad uncertainty cutting across the entire industry.

Venture firms are in a tough spot. At a time when their investors want experience, many of the big-name partners in VC firms are looking to retire, or take a less-active role in firms. In a relatively young industry, this will be the third generation of managers, Mr. Bird says.

Thirty years ago, the first generation were industry pioneers such as Reid Dennis of Institutional Venture Partners and Dick Kramlich of New Enterprise Associates. In the late ’80s, the transition to the second generation came during a smoother economic time, not the roller-coaster ride of the last few years, Mr. Bird says.

“But experience gained during this period is not indicative of what it’ll be like in the long term,” Mr. Bird says. “There’s a question whether this transition will happen as smoothly.”

The shakeout for big firms may not be over, but much of the handwringing is just that.

So far in investigator Mr. Cherry’s experience, his increase in business has led to only one deal-breaker between a limited partner and venture firm. In some situations, it has led to “key man” provisions in limited-partner contracts, stipulating the limited partner’s confidence may be in a certain lead partner, and if he or she leaves the limited partner has the right to take back its investment.

He’s been surprised at how welcoming partners at top-tier firms have been of the increased scrutiny.

“I thought they’d be more upset,” he says. “Their attitude has been, `We’re going to get through fine. A lot of little companies shouldn’t be here and it’ll knock them out.'”

SARAH LACY covers finance, venture capital, the economy and the arts for the Business Journal.