Online Brokers Breaking Into Venture Cap Plays

Online brokerages do whatever it takes to be players. They buy blue-blood trust companies. They give away trips to Hawaii. Heck, they'll sponsor the Super Bowl halftime show if they have to.

Now they're turning that energy and focus to a less visible but potentially more lucrative area: venture capital.

It may be hard to imagine an industry built on the discount fringe of the market as a source of funding and counsel for nascent companies, but three of the sector's bigger players are aggressively pursuing venture investments, action that may even foreshadow pre-IPO opportunities for individual investors. Sometimes they even find new partners or outright acquisitions.

TD Waterhouse(TWE Quote) recently unveiled plans to launch a $100 million fund to invest in online financial services companies. E*Trade(EGRP Quote), which has a similar $100 million e-commerce fund that's three-fifths invested, plans to launch a larger fund during the second quarter.

Wit Capital (WITC Quote), a brokerage-investment bank hybrid, has a $40 million fund and plans to close a second $200 million fund (the Wit Dawntreader II fund) in the next month.

Venture Cap's Next Frontier Three big electronic brokers have moved into the venture capital arena. Will they bring individual investors along for the ride?

As overall venture capital investments more than doubled to $48.3 billion in 1999, according to Venture Economics/National Venture Capital Association, the online financial services sector attracted $346.7 million in investments, six times more than came its way in 1998.

Private-equity funds, long the province of the highest of high-net-worth investors, are still a few steps away from the average investor's hands, but the interest in them from online brokerages could mean they're getting closer.

Wit is working on a way to use the Internet to bring these funds to accredited investors, company president Ronald Readmond says. Meantime, the brokerages' venture cap investments buy them access to hot new technologies, services and, perhaps, access to IPOs. It's not all that different from the kind of tech seed money scattered around by Microsoft (MSFT Quote) and Intel (INTC Quote).

But soliciting investors for venture capital investing could raise suitability issues and liability if investors aren't financially suited to the investments they are making, says Kord Lagemann, a New York securities lawyer. "If you are in venture capital, the rewards could be tremendous but so could the risk because you are talking about a highly speculative entity," he says.

Strong performance, however, can shore up these online brokerages' balance sheets, industry players say. E*Trade, for instance, bought into Critical Path(CPTH Quote) years before its March 1999 IPO and its 13% stake is now worth $585 million.

"It's a great opportunity to make additional money," says Alex Lynch, an e-commerce specialist and partner at law firm Brobeck Phleger & Harrison. "Look at the returns on some of their investments."

For E*Trade, investing early in companies has meant turning a $100 million investment or so into around $700 million in assets. During its most recent quarter, the company recorded $16.8 million in unrealized after-tax gains, or 7 cents a share, from these investments. Typically, analysts strip those numbers out of earnings, but the assets strengthen the balance sheets of online brokers, who are primarily dependent on volatile commission revenue.

Those gains come in handy to fund online brokers' expansion plans without tapping public markets, E*Trade executive vice president of corporate development and strategic investments, Tom Bevilacqua says. And though E*Trade is issuing a $650 million convertible bond Friday, without its venture cap gains, he says, "it's quite conceivable the company would have had to raise even more money."

It's not clear who'll join the fray next. "It would make all the sense in the world to me for Schwab (SCH Quote) to do something similar," Chase H&Q analyst Greg Smith says.

A Charles Schwab spokeswoman, however, says that the company isn't considering that at this time. Ameritrade (AMTD Quote) co-chief executive Tom Lewis says the firm might look at launching a fund down the road, but currently is concentrating on its core brokerage business.

Venture investing could be more palatable to other e-brokers if there was a chance it could boost their share of stock distribution in IPOs.

Online investors have found that IPOs, once only available to the best retail accounts, are a lucrative endeavor in a bull market. The problem is finding the deals because only a small percentage of shares are available to online investors.

Wit Capital co-manages and distributes deals; E*Trade distributes deals it gets from E*Offering, of which it owns 28%, and other tech investment banks; and DLJdirect (DIR Quote) distributes and co-manages some IPOs from the pipeline of parent company, Donaldson Lufkin & Jenrette (DLJ Quote).

TD Waterhouse Chief Executive Officer Stephen McDonald says he hopes that's what happens. "That is a vehicle that can be used to assist companies in completing IPOs and we would certainly hope that would be the case," he says. "We'll be looking for opportunities to pursue IPOs and get that product to our retail customers."