Venture Capitalists: More Caution, More Due Diligence, More DiversityPublished: January 30, 2002 in Knowledge@Wharton
It seems like only yesterday that venture capitalists were being treated like masters of the universe, financing companies that promised all kinds of sophisticated goods and services. But then the dot-com bubble burst, the NASDAQ tanked and the VCs were themselves caught with equity stakes in failing businesses.
As 2002 begins, venture capitalists attending the Eighth Annual Wharton Private Equity Conference were more sanguine, but no less enthusiastic, about the future. Venture money is out there, they said, but it will be staying more and more with entrepreneurs who have better grounding, better products and at least a modicum of a track record.
"What has changed is that the market is now giving us time to conduct the due diligence we need to," said Arun Gupta, a partner in Alexandria, Va.-based Columbia Capital, which manages $1.3 billion in venture capital. "Two years ago, we were being asked to find out everything we could in two or three weeks or lose out to someone else willing to put money down. Now we have a chance to look at all the dynamics. Things are a lot saner."
While the search for the next e-Bay or even the next Microsoft is still ongoing among venture capitalists, they are no longer blindly funding an idea that they know very little about, in hopes that it will become next month’s billion-dollar initial public offering. The slowdown, and increased due diligence, they said, will help all concerned.
"That the time horizon has lengthened is good for the entrepreneur as well," said Michael Hirshland, a general partner in Boston-based Polaris Ventures. "We are more interested in the total capital needed for the life of the company. We are more likely to invest for the long-term. We also have time to be more subtle. We can ask the entrepreneur what made the light bulb go off. You want passion from the entrepreneur, but you also want to know what kind of market he expects."
As Charles Beeler, a general partner at El Dorado Ventures in Menlo Park, Ca., put it: "We were seeing snapshots of companies; now we are getting moving pictures." El Dorado, he said, follows a company for at least four months before committing money to it. "It will make a difference in the long run. More companies will get better financing and more will make it."
Though venture capitalists have long sat on boards of companies in which they have invested, in the boom years of the late 1990s there was often no real time to investigate what was going on day to day. The next deal would happen and the VC would have to move on. Don’t count on that happening now, the venture capitalists say.
"We’re not going to be just advisors, but partners now," said Alfred F. Hurley Jr., a Merrill Lynch senior vice president. "That will also help everyone get a fairer price. They know we will be there not just for the moment, but for the next couple of rounds."
From Hot to Cold
Mitchell Blutt, a medical doctor who is an executive partner of J. P. Morgan Partners, LLC, and oversees its llfe sciences and health care infrastructure group, said in his keynote address that venture capital and private equity may have reached a new stage. He sees a consolidation in the field. The boutiques and small firms that have been in the forefront in the tech boom are bound, he said, to cede their pre-eminence to large firms like his.
"You are going to have to be highly diversified and think globally as well," said Blutt. "If you do this right, you are never going to be concentrated in one industry even if it is the industry to be in, because it will eventually fall out of favor."
For example, he said, it seems hot to be investing in biotechnology right now, but with the lag times in the product cycle, it would be unwise to get over-invested there. To be out of the Internet, too, because it is on the downtrend, would be foolish because judicious investment there will be good when it comes back in favor. J.P. Morgan, Blutt added, isn’t completely abandoning Latin American investments because of the troubling Argentinian money problems. "You want to have a presence there when things turn around …
"We believe the private equity model of the future is a globally integrated network fund," he said. "While there is a substantial recession in private equity, it is important to be diversified. That wasn’t the case in the late 1990s."
Meanwhile, some members of the venture capital world remain unmoved by talk of consolidation. They continue to revel in some of the picks they made in the 1990s that are still around. "In the past five years, it was easy to get an investment in and then find a quick exit," said Thanasis Delistathis, a principal in the Reston, Va.-based venture firm Draper Atlantic. "That was an unusual time. Now funds are being deployed inside the existing portfolio more and more. Companies we backed a few years ago that are still moving along are getting more attention."
Lawrence Mock, Jr., president of Mellon Ventures, Inc.,headquartered in Pittsburgh, Pa., said that his company did 53 new deals in 2000, but only 10 in 2001. That didn’t mean, he said, it was a fallow time. "We now have 40 investments in our portfolio and each one of them is getting more attention," said Mock. "It’s more realistic to have an exit strategy of five to seven years, rather than what seemed like 18 months in the late 1990s."
Delistathis agreed and said the bubble, while fun, was a strange time. "How can you build a great company in one or two years?" he asked. "Back before that dot-com bubble, venture capitalists wanted to see eight straight quarters of profits. Pre-1995, 80% of IPOs had profits. Was that a bad thing?"
These days, according to conference participants, no one is predicting that every investment they make will be the next new-new thing. Most were reluctant even to say which fields they thought were hot right now.
"We’re looking at wireless and bandwidth [areas]," said Fred Wilson, managing partner of Flatiron Partners in New York City. "An immense amount of capital went that way from 1998 to 2000, but it was much too early. It is not that these were bad ideas, but they were funded before there was a use for them. Now that more infrastructure is in place, it may be a time to look backward to look forward. But having said that, you wouldn’t rush to fund everything the way you might have before."
Delistathis was even more adamant about avoiding anything designated "hot." "We discovered in the bubble that it was good to invest early, but never too early," he said. "Frankly, we may not want to invest in revolutionary technologies. We want to have companies giving service to customers. For that, you have to have a market, which revolutionary technologies may not yet have."
But venture capitalists still want to encourage entrepreneurs to come their way. "The good news is that the cost of doing business is much cheaper," said James McNiel, a principal in Pequot Ventures. "You can get [equipment] for ten cents on the dollar and good management professionals are certainly coming on for a lot less. If you have really done your homework, this could be a great time to be an entrepreneur seeking venture capital."