In the year 2000, riding a wave of blockbuster IPOs and spectacular returns, venture capital funds raised a record $105 billion. A decade later — the length of the typical cycle for a venture capital partnership — the results are in, and they’re ugly. In June and October, London-based alternative assets research firm Preqin privately circulated two reports covering some 100 venture funds launched in 2000. The funds’ median internal rate of return since inception was –0.3 percent, perhaps the poorest showing by a group of funds in venture capital history. Just 3.9 percent of them posted IRRs of 20 percent or more.
“We have seen the enemy, and it is us,” says Jonathan Flint, co-founder and general partner of Boston-based Polaris Venture Partners, one of the largest East Coast venture funds. Easy access to capital, overexpansion and bureaucratization , and the bear market of the early 2000s all contributed to the industry’s current sorry state, Flint explains. Then there are the zombie funds, whose portfolios bulge with living dead companies. Who’ll give them a proper burial?
Still, Flint believes venture capitalists have learned from their mistakes. Besides shrinking their partnerships and funds, they’re going back to what venture funds do best: financing and developing innovation. The new, nimbler venture capital fund is also part of an attempt to fight off the so-called superangels — investors who have raised modest funds to support emerging companies. As venture funds return to their roots, they may start looking like they did in the early days: small, hungry and entrepreneurial.
A healthier economy and a stronger stock market should also revive the venture business, says Joseph Cohen, former chairman and CEO of New York–based Cowen and Co., one of the banks that specialized in underwriting venture-backed companies in the 1980s and ’90s. Large acquisitions will inject new capital and restore investor interest in venture-backed companies, predicts Cohen, who is now chairman of New York family investment firm JM Cohen & Co. A recent example is French pharmaceuticals giant Sanofi-Aventis’s hostile $18.5 billion bid for Cambridge, Massachusetts–based Genzyme Corp.
Venture funds that launched in 2000 capitalized on their predecessors’ wild run during the 1990s. In 1997, for instance, top-decile funds earned an average 188.2 percent internal rate of return, while the IRR for the top quartile was 56.1 percent, according to Boston-based investment consulting firm Cambridge Associates. The venture industry also caught the updraft of a hot IPO market. Between 1993 and 1999 some 1,300 venture-backed companies went public, raising vast sums.
But most of the large 2000-vintage venture funds, especially those bigger than $500 million, had a tough time returning their initial capital net of management fees, expenses and carried interest. Among the notable underperformers: Sevin Rosen Funds of Dallas and Mayfield Fund and U.S. Venture Partners, both of Menlo Park, California — three illustrious shops that have financed some of the most successful companies of the past three decades.
Here’s what went wrong. Buoyed by the promise of ’90s-grade returns, investors offered venture funds truckloads of capital. All that cash was too much to manage, but the funds were in no mood to turn it down. Getting bigger would allow them to invest in bigger deals as well as fatten their fees. And instead of syndicating those deals, they could do all the financing themselves. Most important, size would attract new business and let them specialize.
“It became a classic case of buying high and then not having anywhere to go,” says Robert Raucci, a founding managing partner at New York investment firm Newlight Management, who used to invest in venture funds for institutional clients. Convinced they could quickly cash out, venture firms made hefty investments in companies when valuations were at their peak, Raucci adds. But then markets slumped and valuations dropped. “As exits — IPOs and M&As — became scarce, they had to pour even more capital into existing companies to keep them afloat,” Raucci says.
Venture funds still have plenty of reasons to worry. Regulations that inadvertently limit research coverage, especially for emerging companies; lower trading profits, thanks to online brokerages; a shift from long-term investing to short-term trading — all of these things work against them. “The markets in which venture capitalists and venture-backed companies thrived are simply not there,” Cohen says.
