Venture Capital Firms Swarming to Late-Stage Investments

Much of the new scrutiny and caution in the venture capital market can be traced to the technology boom and subsequent bust of the tech sector in the late 90s. Tech companies remain a popular choice among venture capital firms, but the VCs are not nearly so quick to write those big checks without doing serious due diligence first.

"The risk/reward is not as good as it used to be," says Tench Coxe, managing director of Sutter Hill Ventures, a venture capital firm based on Sand Hill Road in Menlo Park, ground zero of the Internet bubble. "Every tech segment has a leader" and that scares off potential investors, Coxe said.

Despite last year's big market gains, total VC investment in 2003 was $18.2 billion, down 15% from 2002. That's a smaller decrease than the slide of the previous two years, but still a significant drop, according to the MoneyTree survey, published by PricewaterhouseCoopers, Thomson and the National Venture Capital Association.

"Big institutional investors did not get great returns on their venture investments for several years," said Kathleen Smith, who manages Renaissance Capital's (IPOSX - Cramer's Take - Stockpickr)IPO Plus fund. "It will take another year or so until it really reverses."

Put simply, venture funds that made investments near the peak of the Internet bubble got caught and suffered horrendous losses, said Lawrence Aragon, a longtime IPO watcher and editor of Private Equity Week.

For example, the Accel VIII fund, which made its initial investments in 2000, lost 26.8% by March 2003, while the InterWest PartnersVII fund of 1999 and InterWest VIII of 2000 lost 28.9% and 32.4%, respectively, according to documents detailing investments made by the University of California.

Contrast that with funds that caught the crest of the IPO wave. One Kleiner Perkins fund from 1996 returned a phenomenal 286.6%, according to the university, while the average return for similar funds in that period was a still-enviable 87%, according to Venture Economics. (More current data won't be available until next month.)

A Slice of VC Life Software, biotech get big piece of pie

Source: PricewaterhouseCoopers

While it seems likely that funds that made most of their investments in 1999 and 2000 will do poorly, there's no way to predict how funds collecting money now will do. "There's a five-to-10-year horizon for most funds," notes Aragon.

Given recent results, it's not surprising that venture capitalists and their investors have lost their appetite for long-shot investment, and are looking for companies with a track record.

Despite this year's correction, that strategy seems to be working, and that in turn creates opportunities for other investors because higher-quality IPOs are able to better withstand the market's gyrations.

This year's crop of 27 IPOs is easily outperforming the market as a whole, appreciating an average return of 13% as of Tuesday's close. The S&P 500, by contrast, is down fractionally year to date.

"The market is still very picky," said Smith. "Investors are looking for more mature companies now."

According to Renaissance's research site -- ipohome.com -- just 26% of the 479 companies that went public in 199 were profitable before the IPOs. Last year, that ratio was nearly reversed: 70% were profitable, and so far this year 55% were profitable.

Venture Worm Has Turned

Picky or not, the venture environment has improved enormously in the last 15 months. It wasn't long ago that some VCs actually returned money to their investors, saying they couldn't find a profitable place to invest. That doesn't seem to be a problem now. According to IPO Vital Signs, 22 companies already have gone public this year, and another 58 have registered their intention to go public.

Currently, software and biotech start-ups are getting the largest slices of the venture pie. Last year, software attracted $3.6 billion in venture funding, or 20% of the total invested by the VCs in 2003, while biotech was just behind at $3.4 billion, according to the MoneyTree survey.