The Daily Interview: Venture Capital Gets Back to Basics

Venture capital investing, like so many other moving parts of the high-tech market's boom and bust, has been coming back to earth in recent months.

Don Phillips CEO, WestAM USA

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VC firms that provide financing to start-ups and expanding companies have pulled back their levels of financing dramatically. After years of throwing record levels of cash at flighty business plans of companies that seemingly came public overnight, the financiers are returning to a slower, more disciplined pace of funding.

According to trade association National Venture Capital Association, in the second quarter of 2001, a total of $10.6 million was invested in 982 companies. This is a marked decrease from the same period last year, when a hefty $27.2 million was invested in 1,873 companies.

That slower pace is a good thing according to Don Phillips, CIO of global money manager WestAM's private-equity group and CEO of its WestAM USA unit. Phillips has been involved with private-equity investing since the early 1980s, starting in 1983 with a seven-year stint at Ameritech in Chicago. During that time, the firm was among the first to invest in private equity, he says. After that, Phillips spent six years with real estate mogul Sam Zell, helping create what eventually became Equity Office Properties (EOP Quote).

Later, Phillips sold a private-equity company he founded to Westdeutsche Landesbank last year, a large German bank of which West AM is a unit. Phillips says the current trends he sees in private-equity investing mark a return to pre-1995 levels in terms of expected rates of return, time frames and the rigor with which potential investments are examined. But make no mistake, there are still opportunities to be had in this asset class, as long as investors are willing to have more realistic expectations.

TSC: What do you mean when you say venture capital investing is returning to the way it was handled prior to 1995?

Phillips: In the 1980s up through the early 1990s, the exit strategy for venture capital models was not necessarily the public marketplace. Companies were often acquired by larger companies for their strategic value or by other venture capital firms in a sort of Pac-Man strategy.

Post-1995, it seemed like the mindset was an expectation for returns of 50%. Plus, the time frame to invest and get money back was extremely shortened. It was like, start up a company and in 18 months take it public and create all this value. Between 1985 and 1995, the bulk of the money and the risk characteristics were very different than what they have looked like for the past five years. Prior to 1995, the expected return was somewhere between 18% to 22%, and it took five to seven years to get your money back.

TSC: How will the change in trends impact the market for private equity and venture capital investing?

Phillips: The more reasonable rate of return is just fundamentally sound. It's forcing us to bring discipline back into the process. Instead of going out and doing a deal because you're afraid somebody is going to come in and take it out from right under you, now firms take much more time and are more deliberate in the process. The former pace meant making more mistakes.

Fundamentally, [private-equity investing] is a very good asset class. We're still getting very high-quality deal flow, and that is teamed up with good, sound business plans. The funding is going to be slower, and the pricing will be much more sensible. [We'll] end up with the good, strong returns that the asset class has historically generated. The bubble we experienced was burst, and it's not going to return back to those levels. Eighteen percent to 22% is a very strong rate of return. If you are patient, you are going to be paid very handsomely.

TSC: So what sectors do you look at for opportunities? How do you get the 18% to 22% rate of return?

Phillips: It's not so much that we look at individual sectors as we look at a spectrum of risk. I weight my investment from venture capital on one side to structured finance buyouts on the other end.

For instance, the risk you take with venture capital is a product risk in that you're at an early stage of the product development. If someone comes to us and says I need money to design this keyboard, the question is does the product work? On the other hand, if we buy into an operating company that has been around for the last 50 years -- say they make shoes -- there is no risk to the fact that the product works. The risk is, did I pay too much to buy that company? Every dollar moves into different levels of risk, and the risk changes as you move up and down the spectrum. Maybe on one side the return is 15% to 20% and it may be higher somewhere else, but the expected rate of return on my portfolio [overall] is 18% to 22%.

TSC: So how is the capital invested?

Phillips: We are a fund of funds. We look for established partnerships in venture capital. We invest in general partnerships, as well as directly in the operating companies in their portfolios. For instance, if I invest in your fund and you invest in 20 portfolios, we will invest in a few of them, as well, at the company operating level. The third thing we do is distribution management, which involves deciding when to sell out of stock positions. Someone has to decide when to sell.

TSC: What do you think were the key mistakes of other venture capital firms, including the banks that rushed to get in on the boom in recent years?

Phillips: In the peak of the marketplace itself, a lot of the public companies that were out there had very little cash flow and zero earnings, but their balance sheets were high because of inflated stock prices. Banks started lending against the balance sheet, whereas they used to lend money against cash flow and earnings. You have to go back to the fundamentals.

If you're a bank, you lend against income statements and cash. Many of these companies did not have hard assets on those balance sheets. What they had was an inflated stock price. If you loan money against the balance sheet and the balance sheet drops dramatically because the price of the stock falls, then what is [the borrower's ability] to repay the debt? They learned a lesson about putting out loans against a balance sheet.