Although one of the morning panels at Wharton’s annual private equity conference in January was titled “Investment Opportunities in the Current Market,” panelists talked more about toughing it out in today’s weak economy than about new opportunities for investing, many of which are still down the road. 


Excess investment in the late 1990s and 2000 has left the industry with a hangover that will eventually lead to consolidation, suggested several of the panelists who also outlined how their firms are coping with the downturn.


Their comments reflect an economic climate that includes vastly scaled-down high-risk investments, fewer IPOs, greater reluctance to invest in start-ups as opposed to later-stage companies and a slowdown in M&A activity. Indeed, according to a study released last week by PricewaterhouseCoopers, Venture Economics and the National Venture Capital Association, venture capital nationally totaled $21 billion in 2002, compared to $41.3 billion in 2001 and $106.6 billion in 2000.


Two of the panelists are partners in Massachusetts venture capital firms where, says a report last month from the newsletter VentureWire, venture capital investments in start-ups fell by more than half, from $4.8 billion in 2001 to $2.3 billion in 2002. The number of deals dropped from 365 in 2001 to 237 in 2002.


“The amount of money raised in 1999 and 2000 was way in excess of what this industry can efficiently deploy,” said panelist Allan Ferguson, managing director of the U.S. East Coast office of 3i, the London venture investing firm which entered the U.S. market in 1999.


For 3i, opportunity these days lies in relieving weary investors who want to recoup something from earlier investments, he noted. “We’re trying to find later stage deals that were overpriced, [where] the investors in the deal are tired and [where] we can get a good price.”


Gerald Schaafsma, general partner at Anthem Capital Management, which focuses on Mid-Atlantic companies from offices in Philadelphia and Baltimore, is looking for companies with products that will be essential for business. “The fundamental question we ask is, ‘Is this a need-to-have or a nice-to-have for the customer?’ In 1998 and 1999 nice-to-have business plans could potentially fly. In today’s environment they absolutely won’t take off.”


According to Schaafsma, venture investors who got used to a quick turnaround in rich public offerings during the late 1990s now must wait much longer for their investments to pay off. The horizon is in a range of five to eight years. “The time-frame is elongated. We’re back to fundamental venture investing as it was practiced 10 or 15 years ago.”


He said the current market offers opportunities for investors to buy late-stage companies at lower, early-stage prices. Many late-stage companies were highly overpriced in the boom years because it was often considered a precursor to getting into a future initial public offering. “The round just before the IPO was to get institutional investors in the public and private space to prime the pump for the IPO,” he noted. Now, investors can move up the chain. “I can get b or c-round risk at a-round pricing,” he said. “In my mind it’s less risk, greater return and more value.”


At Boston Millennia Partners, the firm maintains a diversified portfolio with a third of its investments in communications, a third in information technology and another third in health care, according to partner Suresh Shanmugham. “The industry has gone through a phenomenal period of growth from the late 1990s through 2000. A lot of institutions have made a significant commitment to private equity.”


Stock market declines have put many investors’ portfolios out of alignment and they may need to cut their private-equity stakes, he added, noting, however, that the market is showing some signs of firming up. “The fact that people are talking about the economic issues indicates to me that we are near the bottom and the issues that need to be addressed are being addressed. But because of the excesses there will be dramatic changes in how the industry looks. Three or four years from now it will be driven by a lot fewer players.”


Ilan Carmi, a partner in Kodiak Venture Partners of Waltham, Mass., which invests in semiconductors, software and communications, suggested that in the current environment entrepreneurs need a good story and a strong management team. “Venture capitalists now face a changing landscape. On the one hand it is more difficult, but on the other hand there are more opportunities for the new, sharp funds with focused investments and a strong portfolio to shine in this environment.”


Christoph H. Westphal, general partner at Polaris Venture Partners, also in Waltham, Mass., said his firm invests about a third of its portfolio in medical companies and the rest in information technology. “Information technology has been under siege from March 2000 through today. The medical space had been spared the pain until about three to six months ago. Everything has gotten slower,” and investment decisions that took a few weeks to make in 1999 and 2000 now take two to six months.


The malaise in the IT area is confirmed by a report last month from Ernst & Young and VentureOne noting that technology companies received $11.7 billion in venture funding in 2002, a drop of 48% from 2001 and a 79% drop from 2000.  


The Government as Customer

The possibility of increased government spending linked to homeland security offers some potential upside for their businesses, the panelists said, but they were also cautious about relying too heavily on this particular source. According to Westphal, government spending on medical research has increased and start-up companies, shut out of the venture and public markets, are seeking these funds to help finance research. “If the government has $10 million in the form of a grant,” he said, “then a lot of smart folks are going to go where the money is.”


Ferguson expressed concern about companies that rely too heavily on government as a customer, particularly based on his firm’s experience in Europe where governments play a stronger role in the economy. “When the government is a customer, it really diminishes your returns,” he noted.


Carmi warned that the attention paid to new government spending on security may lead to another small investment bubble. “I think government is generating a lot of new demand, but at the same time with all the attention it is getting, everyone is rushing into that space and there is the potential for over-investment or a small bubble that will burst in two or three years.” Companies should view government as a way to build traction for a new technology, he suggested, but that technology should be able to stand on its own with customers in other fields. “If you are locked into the government vertical you are taking a risk.”


The Cost of Good Health

In looking at trends in biotech, health care and information technology, Westphal indicated that his time horizon for biotechs is out seven to 15 years. Entrepreneurs at the companies he is funding are top scientists who are also increasingly savvy about business. “They are interested in world class science,” but they are also highly aware of the importance of other economic forces, including patents and intellectual property protection, in building their firms.


According to Schaafsma, biotech investors should focus on diseases with very large populations. A product with the potential to reap $1 billion to $2 billion “leaves room for error. Even if your company gets 10%, that’s still a large market.”


Ferguson sees a convergence between biotech and computer technology evolving out of advances in the fields of genomics and chemistry: “There is too much information to efficiently process. Tools using computer technology to manage and improve the drug development cycle are very interesting right now.” There are also vast opportunities in developing technologies to improve costly efficiencies in the health-care delivery system. “Health care is still in the dark ages in using technology the way other industries use it to increase productivity.”


But Ferguson added that demand for these new technologies won’t exist until consumers begin to bring more pressure to contain health-care spending. That will happen as insurance companies and employers require workers to pay a greater share of health-care costs. “We are going to see more of those pressures. The computer technology is there; the software needs to be developed.”


According to Westphal, despite pressure to contain costs, there will always be strong demand for health care. “It’s about elasticity of demand. How much is your life worth? I’m willing to buy anything to make myself healthier.”


Blockbuster Potential

In the area of information technology, two panelists differed on the degree to which computer companies should rely on providing services. Shanmugham claimed that service is crucial in the field of electronic customer relationship management, adding that the provision of these services allows technology companies to remain in close contact with their customers and anticipate their needs. Finally, he noted, it is profitable: “If you can generate 30-40% gross margins on service, that is moderating risk.”


But according to Carmi, services are hard to scale up. “They can be a small component of penetrating your market, but you never want to be caught in a company in which services are the main revenue stream.” He also suggested that it is difficult for companies to provide services and products equally well. “If you have a service mentality it’s hard to convert to a product company.”


Looking ahead, the panelists pointed to several technologies with blockbuster potential and they forecast future developments that might seem surprising today. “Nanotechnology truly is the next big thing,” said Schaafsma. “The big question is when?” While there is a lot of hype in the market about nanotechnology now, the industry is still in the early stages and it will be 10 to 15 years before projects are commercialized.


Ferguson, agreeing that nanotechnology will be a major development, also predicted semiconductors will soon make a comeback. His company has recently made several small bets in this area and is working on a large semiconductor deal.


The Internet is far from dead, Schaafsma added, citing a survey of mid-Atlantic businesses that recently indicated strong interest in wireless Internet. Wireless, Carmi agreed, “is going to open up tremendous opportunities, combined with the Internet phenomenon which is by no means over … Computers are changing their shape. It’s not a wide box with a processor, a monitor and a keyboard anymore. We see significant architectural changes.”


Meanwhile, Shanmugham said PC spending is about to come out of its slump. “We will see the PC upgrade cycle start to take hold earlier than people speaking in the media are expecting,” he noted, adding that PC upgrades made in anticipation of Y2K problems are coming to the end of their useful life. “As a result, later this year and in ‘04 you will see software spending start to pick up.”


Carmi also expects signs of life in the PC area, but he said other industries, including telecommunications, are still foundering. “Until we get some significant structural changes, you’re not going to see the V-shaped recovery everyone is looking for.” Westphal was more upbeat: “We’re in the third year of a terrible downturn. It will turn around this year or next.”


Because venture capitalists raise money for long-term investing, it will take a long time to work out the industry’s problems, Schaafsma suggested. “You won’t see a sudden contraction. It takes time for assets under management to start peeling off. It will take a long time for the correction to work through. I anticipate that in the next five to 10 years this industry will go through a tough period.”