Style Shift
(Copyright (c) 2002, Institutional Investor)
May 2002

With promising early-stage investments scarcer than hens' teeth, some venture capital funds are turning to buyouts. Is that a good idea?--By Steven Brull

When there's a billion dollars at stake, asset managers are willing to be flexible. Consider Battery Ventures, which closed a $1 billion financing round in June 2000, near the height of the tech investing boom. Back then it announced that the fund would "seek out the finest start-up and early-stage investment opportunities around the world in fields including telecom and B2B e-commerce." Now, as promising early-stage deals have virtually disappeared, Battery has redefined its mission: In addition to early-stage deals, it is looking to diversify its portfolio with buyouts, which it view as less risky and less likely to require additional infusions of cash. "We want to find the hidden jewels and apply our skills," says Todd Dagres, a general partner at the Wellesley, Massachusetts-based firm who once spent his time on early-stage financings for hot high-tech start-ups like Akamai Technologies and Convergent Networks and currently focues on buyouts. "Early-stage investing will remain our bread and butter, but in this environment you have to be open and opportunistic."

Being open to new opportunities in a changed investment environment makes sense, but for VC funds - and their limited partners - it's also a difficult and potentially risky shift in style. The skill sets, clientele and investment objectives of buyout and venture capital funds differ in important ways. Venture capitalists nurture new companies; buyout professionals shape up older ones.

And changes in direction tend to make investors nervous. Real Desrockes, who oversees $4.4 billion in alternative investments for the California State Teachers' Retirement System pension fund, says: "In general, funds should stick to the strategies they initially proposed. If you want to go on a safari, you want to go with people who've been to Africa before."

Many market participants point to buyout firm Hicks, Muse, Tate & Furst as the poster child for failed diversification in private equity. The Dallas-based firm's $1 billion investment in a handful of telecommunications companies that eventually went bust racked up huge losses. Although this was a respected buyout firm straying into high-tech investing, some fear that the same thing could happen to a VC outfit entering an ill-conceived buyout deal.

That prospect, however, isn't scaring off many venture capitalists. Aided by broadly defined investment parameters, Battery is just one of a growing number of firms that focused on early-stage deals but have now gone on the prowl for buyouts. "It's the early edge of something we're going to be seeing," says Mark Jennings, co-head of Generation Partners. "Venture companies that raised $1 billion or more are looking for deals where they can put more money to work - and that means buyouts."

Generation is itself an offshoot of this investment overlap. With $325 million under management, the firm is a hybrid that, by design, invests in venture and late-stage deals, as well as buyouts, and has offices in New York and San Francisco. The number of such hybrids is growing, as are partnerships between venture and buyout funds.

But can venture capitalists thrive in buyout territory? There are reasons to be skeptical. VC operations tend to be smaller than buyout groups, with less money under management, smaller investments per deal and fewer people to analyze and oversee investments. The investment approach differs as well. "In an early-stage deal, you're trying to understand the technology risks, the financing risks, the market risks and the management risks," syas Jonathan Silver, a general partner at Core Capital Partners, a Washington, D.C., venture fund. "In a later-stage or buyout deal, you're trying to understand the risks of the transactional structure, the operational elements of a company and the operating efficiencies that are extant or available. It's the difference between launching or leveraging a company."

Indeed, many say venture capitalists often underestimate the differences between the two. Martin Gagen, who runs the U.S. operations of 3i Group, a leading international venture capital firm based in the U.K., notes that there is a major distinction in the way general partners relate to managements: "With a late-stage or buyout, you're acting as a full board member helping to create value. You afford them more respect about what they've done. At the early stage you're more of a sounder and creative thinker about how to build that company."

Predicts John Hawkins, co-head of Generation, who runs its San Francisco office, "Most of the [VC] firms will get mixed results." While related, the two fields are distinct enough to make the transfer of skills difficult. "It's like an osteopath tyring to do neurosurgery," Hawkins says.

What's more, venture capitalists may find themselves jumping from the frying pan into the fire. There are lots of leveraged buyout funds that have also been unable to deploy tens of billions of dollars in already raised capital. They are trawling for buyouts as well, making the market for available properties highly competitive, even though it is growing.

Still, there are powerful reasons for the VC funds to try. One is the pressure on the general partners at 39 firms with $1 billion or more that are struggling to invest funds. Limited partners are upset with oversize funds and unmerited management fees that typically run 1.5 to 3 percent of committed capital. Rather than return uninvested money, some of these funds will try to put the money to work elsewhere. "It's mandated by desperation and, to some extent, by frustration," says Eric Lomas, president of HT Capital Advisors, a privately held investment bank that also invests in private equity, of the shift in style. "There's no deal flow in relation to the money that's out there."

On that score the buyout market - while highly competitive - does offer some encouragement. Strategic buyers, such as Cisco Systems and Broadcom Corp., which used their high-priced stocks during the bubble to make acquisitions, have grown leery of doing deals now that their shares and cash reserves haves plummeted. Meanwhile, boards of financially healthy companies are ware of making acquisitions because of the Enron Corp. debacle. They fear that public markets may punish them for creating complex new entities. There is also growing pressure on conglomerates to reevaluate which divisions and businesses are central to their strategies. In time, that will bring many more buyouts to market as companies seek to shed noncore assets to reduce opacity in their financial statements.

There are also scores of companies that went public during the boom, but that have become fallen angels in need of capital. "The markets are telling you that a number of companies that went public should be private, especially in the technology sector," says Generation's Jennings. Timothy Dibble, a founder and managing partner at Alta Communications, a $1 billion buyout fund in Boston, accentuates the positive: "Why not restructure all these public and private companies - in whole or in part - and take advantage of somebody else's start that's now worth 10 cents."

Some investors believe these kinds of buyouts of operating companies are less risky than seed investments. "If you buy an operating company, it's easier to manage by an order of magnitude," says HT Capital's Lomas. "It's a cakewalk to give guidance to a seasoned management team. In early-stage investments you have to season the management team."

Limited partners can take some consolation in the fact that these two markets - which together make up the asset category known as private equity - have overlapped before. In the early 1990s, when both markets collapsed, venture capital firms nursed their portfolio companies with later-stage investments and did buyouts. And when venture capitalists began cashing in big time during the late-1990s tech-stock boom, envious LBO firms took a stab at technology ventures. Granted, Hicks Muse, among others, probably wishes it hadn't. Now it's the VCs eyeing the buyout market.

Part of the recent shift is natural. It's late in the entrepreneurial cycle - a time when venture capitalists tend to do add-on financing rather than seeding new companies. "We're seeing a significant shift to later-stage transactions," says Neal Pomroy, a vice president who runs the private equity business at Mercer Management Consulting in New York. "These companies have earnings of a minimum scale and are closer to the growth capital stage than the stage of concept development. People like the risk parameters a lot better, and both ticket size and confidence go up." Late-stage investments have increased to 62 percent of financing rounds in 2001, compared with 51 percent in 1995, according to research from VentureOne.

Most of all, the trend is simply confusing to investors. "Some of the larger VC funds are beginning to look more like buyout funds," says Core Capital's Silver. "They don't intend a wholesale makeover, but they're increasingly taking on some of the financing and deal-structuring roles that buyout firms have. Any large VC fund that puts $35 million or $50 million into a deal looks a lot more like a buyout fund than a start-up deal."

Indeed, general partners at several buyout firms report facing competition from traditionally venture-oriented firms. None of these has yet closed a deal, however; in part, that's because chastened capital markets have been leery of lending the leveraged portion for some buyouts.

The venture capital firms are also staffing themselves for more buyout business. Example: Last November Battery hired Stephen Terry, an investment banking veteran who had worked most recently at Credit Suisse First Boston.

The new interest in buyouts follows a clutch of collaborations at the height of the internet bubble between VC and buyout-oriented companies. The game plan was to marry their start-up and buyout skills and focus on acquiring technology firms. In 1999, for example, Integral Capital Partners, an offshoot of VC firm Kleiner, Perkins, Caufield & Byers, co-founded buyout firm Silver Lake Partners and raised a $2.2 billion fund. In March 2000 the fund led a $2 billion buyout of the disk drive division of Seagate Technology. Since then Seagate has become the dominant supplier of disk drives for servers, is showing a profit and may go public.

But buyouts from a more traditional venture capital firm could cause problems for limited partners, who may find themselves with unanticipated exposure - and a more concentrated portfolio than they intended. Investors typically allocate their capital so as to balance high-risk high-reward venture funds against lower-risk buyout funds that use debt to increase the reward.

Even venture funds balance risks internally. Doing buyouts could upset that balance. "One thing that VC funds historically do is focus a great deal on risk management, and a key tool is diversification across a relatively wide array of companies, even if they're in one domain," says Core Capital's Silver. "But if you start putting significant chunks of capital into a smaller number of deals, you lose some capacity to manage risk across investments."

To some extent, limited partners have only themselves to blame. They have been pressuring venture capitalists to do something with their billions of dollars of uncommitted capital or to stop collecting fat fees on idle funds. That has left the more than three dozen "gigafunds", which have each raised more than $1 billion, with a dilemma: They can return capital to investors, trim management fees or diversify into new fields.

"At the current rate, it will take 25 years to spend all that capital," J. Stephan Dolezalek, a partner at Silicon Valley's VantagePoint Venture Partners, told a mid-March VentureOne conference in San Francisco. Dolezalek was kidding about its duration, but not about the seriousness of the problem.

The limited partners don't want to pay fees on uninvested capital. "You can sit around and get a 3 percent management fee on $1 billion - and that's $30 million a year," explains Ravi Chiruvolu, a general partner at Palo Alto, California-based Charter Venture Capital. "Partners can pay themselves $3 million each and enjoy healthy outings, trips to Napa and vacations. They can keep doing that for the next five years and then just retire."

Instead, a number are simply giving money back. In a bombshell announcement in late March, Kleiner Perkins, one of the nation's most successful and influential VC firms, said it told limited partners they were being released from 25 percent of their capital commitment to its $630 million 10th fund. Jsut a few days later Menlo Park, California-based Redpoint Ventures followed suit, saying it would reduce by 25 percent the size of its $1.25 billion second fund. Meanwhile, in January, Menlo Park's Mohr, Davidow Ventures cut the size of its latest fund by 23 percent and in March Waltham, Massachusetts-based Charles River Ventures made a similar move.

Slicing management fees is another alternative. Palo Alto's ComVentures, which has $550 million under management, decided late last year to trim its fee from 2.5 percent to 2.0 percent. Of course, lower fees mean costs have to be taken out elsewhere. Blueprint Ventures of San Francisco and the West Coast office of Charles River Ventures have said they are laying off partners.

These are tough decisions for venture capitalists, but not responding could have more dire consequences. In February Millennium Partners of New York, angry with what it views as unwarranted management fees, launched a proxy battle and federal lawsuit alleging excessive management fees on a $311 million fund run by San Francisco's MeVC, an affiliate of Redwood City, California-based Draper Fisher Jurvetson.

Among these alternatives, broadening the scope of investments remains a favorite. And it's always possible that the buyout market can accomodate all the deal makers. "This is the best environment in 20 years," says Generation's Hawkins. One reason is that there are many more companies or business units on the market. Generation bought GE Capital IT Solution's Disaster Recovery Services unit in February for under $100 million, which Jennings deems an attractive price for a profitable, growing company. The Canadian outfit rushes computers, servers and other hardware to a site following a disaster, like an earthquake, hurricane or terrorist attack.

Generation's partners claim the two disciplines can coexist - if done properly. An earlier fund of Jennings' brought elevator music icon Muzak in 1992. Utilizing Hawkins' technical expertise, Muzak improved its delivery by using direct broadcast satellites and was able to expand from seven music channels to 60. When the company was sold to Abry Partners in 1999, a $15 million investment was converted to $75 million in cash, plus a residual interest in the still-growing company.

Generation tries to use its technological and start-up know-how in buyouts like Muzak. "From that perspective, it really helps us," says Jennings. "In today's environment technology is affecting every business. And the only way to be aware of it is to be in it - to understand emerging trends of technologies."

The reverse is also true. Hawkins was able to tap the knowledge of the human resources executives at Generation's portfolio firms to improve the Web site of Hotjobs.com, in which it had a $10 million venture investment. And some of his investments have helped steer Generation clear of trouble. "We didn't invest in one e-tailer because we had done a buyout of United Retail Group," says Jennings. URG operates a national outlet chain offering clothing for plus-size women. "We could never get comfortable that the distribution channel would work."

Even these strong capabilities don't prevent miscues, however. In 1998 Generation bought a controlling interest in High End Systems, which make lighting systems used at concerts and theaters. Late last year Generation was forced to write down half of its investment as some of the company's manufacturing and other problems short-circuited promising sales growth.

The fact that even experienced buyout firms like Generation can run into unanticipated problems heightens investors' worries about less experienced venture capitalists. "I would be concerned as an LP if all of a sudden a venture firm changed its strategy," says Todd Wagner, who as a limited partner has invested $30 million with Generation. The internet entrepreneur - who cashed out nearly $1 billion less than a year after the firm he co-founded, Broadcast.com, was sold to Yahoo! for $5.7 billion in stock in July 1999 - sees parallels to his former trade. "This all reminds me of the dotcoms. When start-ups had one business model and could no longer raise money, suddenly they were in a different business. That's almost always doomed to fail. It's like when the investors come in and ask, 'What do you want me to be?'"

To avoid this syndrome a number of VC firms have partnered with buyout practitioners. "Partnering is pretty important," says Dagres of Battery Ventures, which in June 2000 joined forces with New York-based private equity firm Blackstone Group to invest in the London International Financial Futures and Options Exchange; Euronext acquired the exchange last October, tripling Battery's initial investment of $35 million.

In addition to the collaboration of Kleiner Perkins' Integral Capital and Silver Lake Partners, Accel Partners and Kohlberg Kravis Roberts & Co. formed Accel-KKR in 2000 to carve out internet businesses from traditional offline firms. Other notable partnerships include the 1999 alliance between Francisco Partners, which has traditionally focused on late-stage and buyout deals, and venture firm Sequoia Capital, both of which are based in Menlo Park.

But is an alliance sufficient? Leveraging skills requires that teams be in near constant communication and have a presence on both coasts to realize synergies, say the partners at Generation. "John and I speak on the phone five times a day, and we were best men at each other's wedding," Jennings, who works out of New York, says of his San Francisco-based partner, Hawkins. "You also need trust to transfer knowledge between the venture and buyout worlds. The challenge for others is to get people together enough for cross-fertilization."

Venture capitalists moving into buyouts insist that they aren't naive about the risks. "We haven't just sat down to make buyout-type investments because it's the only way we can spend our billion dollars," says Battery's Dagres. "Battery is different because it has 42 people. But most VC firms that are our peers don't have the resources that we do. If you have a fund with a billion dollars and seven tall guys, it's tough to do early-stage and add value to a buyout."

Some would say impossible.