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an inside look at the venture industry
venture capital confidential
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Mr. Biddle: First time, but they had been following us for six years.

Mr. Wilcox: I would add only that institutional investors don't typically get involved with portfolio companies. There are special limited partners, however, who are typically successful former entrepreneurs. They have invested in the fund and they sometimes help generate deal flow. If they've got expertise in a particular area, they'll contribute it to the general partner on an as-needed basis.

Ms. Burkett: Otherwise, we only get to meet entrepreneurs at the annual meetings, at the cocktail hour, or at lunch. For most of us, that's a good way to keep in touch with how our fund and their portfolio companies are doing.

Mr. Burke: Given all the advice we give to entrepreneurs about “focus, focus, focus,” and “target the venture capitalists you want to approach,” should they also look at the limited partners of a fund? Do you think that should make a difference to the entrepreneur, or is all money green, so it doesn't make a difference?

Mr. Biddle: Well, the people who thought all money was green and took the highest price a couple of years ago are out of business. In the last three investments we made, there were multiple term sheets on the table. Ours had the lowest price and the entrepreneurs went with us. I think the reason is that we've stuck with our companies when we've had companies in trouble. We fight to the last dog. For the entrepreneurs, this is their one shot. We do deals all the time. If we lose a company, it averages out, but for the entrepreneurs, they get one shot. Today they want to go with the guys who have a 60% on-base percentage instead of a 20% on-base.

Mr. Burke: Do you think the entrepreneurs know who your LPs are?

Mr. Biddle: I don't think so.

Mr. Burke: Do you think it matters?

Mr. Biddle: I think today they don't, but a lot of hot money came into this business and is leaving the business. They came in at the peak and they're gone. Accenture just shut down their venture group -- $500 million, just gone. When we started our fund, we saw the industry crash in the 1980s. It was predictable. Groups like VRS are committed to the asset class. They understand the game. You have to be in it all the time. You don't go crazy, just nice and steady. Those are the people we wanted in our fund. We have capital. The majority of the funds in the region are not going to be able to raise another fund. Some of it is because they haven't done a good job, but some of it is that they have the wrong kind of limited partners.

Mr. Burke: What are you limited partners seeing on a macro level now? You see lots of pitches, you evaluate lots of funds, what are the general trends that you are seeing?

Mr. Wilcox: First-time funds are having a very difficult time raising money. You have to have a track record. If you've made money with a fund before, there's a good chance you'll go back to them.

Mr. Burke: But, as Jack was talking about, it's a 10-year partnership. They'll make investments for the first four, then they're going to start raising a fund again. In that case, you're going to be evaluating funds that may not have any returns yet. How do you evaluate that?

Mr. Wilcox: We typically don't. We generally won't invest with a firm if they're on their first or second fund, or if they don't have some exits under their belt that they can show us.

Mr. Burke: So you'll just wait?

Mr. Wilcox: Yes. We typically invest with the firms that have been around for a number of years. We do make exceptions, especially when the general partners are from other firms and have transferable track records, such as a number of exits that they can show. For people starting a first-time fund who don't have a number of exits under their belt, however, there isn't anything that we can look at, so the chances of them getting funded from Bessemer are very slim.

Ms. Burkett: There are first-time funds in the market right now that are getting funded mostly by their friends and family. Institutions just aren't looking at them now because the situation has cooled considerably.

          I would also say that the high profile funds, if they can, are staying out of the market at this time and working their portfolios so when they must come to market, they will come with some results, or at least some understanding of the direction in which their portfolio is going. As a result, you're definitely seeing a lack of urgency and a calmer market than there was even a year ago.

Mr. Burke: So Catharine, would that affect your judgment at all? If a VC comes to you that has raised one fund from friends, family, and individuals, and now they have some track record, would you think about it? Would it make a difference to you?

Ms. Burkett: It might make a difference. It might not tip me over the balance, but I might give them more of a hearing than I would have the prior time.

Mr. Biddle: You also have to understand the psychology of being a business. If an institution invests money in one of the high-profile VCs, such as New Enterprise Associates (NEA), and loses money, it's NEA's fault. If they invest in me and lose money, it's their fault. There's a strong institutional bias to back the IBMs and NEAs of the world.

Ms. Burkett: You don't get shot for that.

Mr. Wade: The majority of our general partners, specifically our venture managers, came back to market in 2000 or the beginning of 2001 and significantly decreased their investment pace. Most of them seem to be concentrating their efforts on their existing portfolios. As a result, most of the GPs we have exposure to aren't coming back, or we don't foresee them coming back, in the near term. Those we do see, as Catharine and George said, are the first-time funds, those with maybe some small, discernible track record working into their second fund. While we may take a meeting with them, it would be very difficult for us to get to the end.

Mr. Burke: So, the environment for funding these venture funds has changed. Lots of entrepreneurs think that the process is broken, for lack of a better word. It's very difficult, particularly for early stage companies, to get funded. How is this pressure that we've been talking about affecting that?

Mr. Biddle: There are two sets of issues. One is just raw economics. It's going to take twice as long and twice as much money for half the return to make an investment successful. As a result, the wealth that the company has to create to justify the investment is much higher than it was a couple of years ago. The economics have changed.

          The other issue, from my standpoint, is that these people on our panel are very high quality investors, and I'm going to go to all three of them in a year or two and ask them to invest in my next fund. Our numbers for the last few years aren't going to be terrific. I think they're going to be better than the vast majority of people that we compete against, but, as I said earlier, LPs have alternatives. They own bonds and real estate and office buildings. I would rather outperform their alternatives, and I think it's going to be very tough to do that in venture because there's still too much money in the business. I need to make investments that not only return, but are sensible, logical, and make sense to my limited partners. I'm not going to take any companies public in the next year or two, and you're crazy to sell a good company today, so the companies we sell are our bad companies. I'm not going to have a lot to point to in terms of results, so I need to do deals that make the economic hurdle. I also have to do deals that are sensible to limited partners so they can see that I'm a better investment than buying an office building. That's what they'll do with the money if I don't deliver.

Mr. Burke: You've got investments that are illiquid, they're tied up for years, and they've been tanking for the last couple of years. What are LPs doing investing in venture capital these days? What percentage of your total investments is private equity as an asset class? Is it going down? Going up?

Ms. Burkett: It's declining in value, that's for sure.

Mr. Wade: We got as high as 10% of the value of the fund in very early 2000, and we're fortunate enough, through some of our stronger general partners, to take a significant amount of money off the table. Now we're down to a little over 6% of the fund.

Mr. Burke: What has it been historically?

Mr. Wade: It's been somewhere between 5% and 10%. We typically don't like to get above 10%, but we did, essentially because of valuations. As Catharine said, our percentage has decreased because the value of our portfolio has dropped, but we're not going to change our direction as far as dropping out. We'd never make it trying to time the market and we don't expect to do it now. In some respects, now is a decent time, from our perspective, to ensure that you stay active.

Mr. Burke: So you're committed?

Mr. Wade: Yes.

Mr. Burke: George?

Mr. Wilcox: We're at about 10%. We manage about $35 billion, and about $3.5 billion of it is in private equity.

          You touched upon something in terms of vintage risk that's changed for us in the last 24 months. When we deploy capital in private equity, we look at diversification by sector. We invest in some firms that are generalists, some with an optical networking focus, some software. We want diversification across sectors, and we want diversification by geography, especially with regard to early stage funds which tend to have a very narrow geographic focus. We want diversification by stage. We don't want to just invest with early stage investors, so we place money with expansion and later stage funds also.

          Something that most investors hadn't really looked at was vintage risk. Typically, we would raise a fund every three or four years, a $600-$700 million dollar fund, then we'd be out of the market for three or four years, then we'll raise another one. There's inherent risk there. When you look at the numbers historically, the returns that you'll get out of a fund depend heavily upon its vintage year, so we've moved to a vintage model. We raise a fund every year, a smaller fund, and we're putting money out in the market every year. This way we get the vintage diversification that we think is critical.

          Yes, private equity valuations have come down, and funds have been marking down their portfolio companies. That will probably continue for another 12-18 months. The worst of it is probably behind us. The past 24 months have brought out a couple of phrases that we haven't heard around our shop in a long time. The first is, "Recessions catch what the auditors miss." The second is "Investing money is easy, getting it back isn't."

Mr. Biddle: A key point, though, is that venture, as an asset class, has beaten the public markets by 400 basis points. That's a lot over a decade, but it's not a huge difference.

          Something like two-thirds of all the venture capital invested since Columbus has been invested in the last 36 months. In the venture business, what we're going to do as an industry is assume that you've invested in all of our funds since 1970 and we're going to show great numbers. That's really not the way it's worked. If you gave me $100 million in 1990 and I gave you back $300 million, then you gave me $1 billion and I gave you back $500 million, I can report a great IRR, but you lost your shirt.

          Right now we're in the situation where the absolute dollars are so big during these terrible vintage years, they'll be the worst ever. That's going to create a lot of pressure from the boards that oversee these institutional investors. Maybe they’ll say, “We want to do less private equity and buy Guatemala.” There's going to be pressure, I think, to shrink the pool. My competition is getting a lot tougher because we're going to be fighting for less money.

Ms. Burkett: We are looking at ways to diversify our private equity, including in the venture stage. One of the things we have in our early stage portfolio -- which I'm not really sure belongs, but has certainly helped us a lot in terms of our performance -- is venture lending and leasing kinds of opportunities. There are other ways to participate in the category and balance your returns in the process.

Mr. Burke: As LPs you have a unique view into venture funds. Most of these funds are private. They don't have to report results publicly, so you see what's behind the curtain in terms of the blood-letting that's been going on. When you look out over the next 18 months, is the blood-letting over? Have we seen the worst of these returns?

Mr. Wade: I think we've seen the worst, but it's definitely not over. I think there's another round, say, in the next two to three quarters. Companies that were over the hurdle in the last go-around aren't going to make it.

Ms. Burkett: We've seen some bad news. Some of the funds I've been looking at lately, in terms of their annual meetings, have one or two really good companies that are coming along. If those don't make it, the fund is not going to make it. We're at a critical juncture. We may not see the drastic number of write-offs, but some of the write-offs going forward could be key.

Mr. Wilcox: I think we'll still have write-downs in the next 18-24 months. There will still be companies that get shut down, but the worst is definitely behind us. It's not all doom and gloom for the entrepreneurs. There's a tremendous amount of money on the sidelines. We raised a $600 million dollar fund in 1999, 100% of it is committed, and only about 30% of it has been called, so it's probably time to start putting some money to work.

the audience: q&a

Q: I'm Walter Ludwig with a new company called Difference Engines. The sort of dramatic errors of the last three years on the part of VCs and entrepreneurs have created a reduced set of expectations for entrepreneurs as they seek venture capital. I'm wondering whether or not you have reduced your internal expectations for IRR in a similar fashion.

Mr. Biddle: A couple of years ago, everybody was saying that if you're not generating 100% IRR, you're not doing your job. You could do it on the back of an envelope. $100 billion was the commitment amount to a VC two years ago. With 100% IRR, the 1999 vintage startups would have to produce the entire gross national product in seven years. It's not likely to happen. You knew the numbers were going to come down.

          Before something like 1986, not one single institutional venture fund ever lost money. It might take eight years to get hold, but nobody ever lost money in this business. This is the first time that people are losing money. I'm an investor in venture funds personally, so I see the numbers. There are big franchise venture funds, big household names, that may return 20 or 30 cents on the dollar for some of these periods. It's that order of reduced returns.

          However, I think that the asset class has a competitive advantage -- the barriers to entry, the difficulty of raising the first fund, the fact that good funds tend to get the good deals -- it feeds on itself. I think that venture capital will continue to outperform the public markets forever, but that may not be saying a lot for a couple of years.

Ms. Burkett: A lot of venture funds are doing what we do to our boards, they are managing our expectations. They were telling us two, three years ago that these 100% returns weren't going to continue. Certainly, if they were rational people, they were telling us that. We, in turn, having been managed by them, are trying to manage our constituencies, too, “Be realistic about returns going forward.”

Mr. Biddle: I know one university that took the numbers the GPs provided and discounted them another 35%. What they're doing now is lowering their discount as the portfolio value drops. They're telling their board that it's flat, because they set the right expectations.

Q: My name is Cy Weinstock, I'm in the uncrackable encryption area. I find that when I talk to investors, their technical expertise seems to be limited, which affects their knowledge of the investment activity. While I've had people wanting to give me money, I didn't feel it would work out if they didn't understand the market and the expected return. I find that losing the money is tied in some part to the lack of technical expertise, which is tied to the business decisions.

Mr. Biddle: We have a very good relationship with some of the top experts in the field. Your stuff is going to go straight to them, and, if they tells us it's awesome, we're going to take a serious look at it. At our shop, our people are pretty technical and we have very good relationships with people who are extremely technical.

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