After last year's cratering of the Internet sector, venture capitalists and their investment banking partners are certainly in a more somber mood. Having returned 165% in 1999 and another 47% in 2000, VC portfolios began losing money in the second half of last year, according to

Venture Economics

, a venture capital research firm.

Jesse Reyes
Vice President
Venture Economics

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In the fourth quarter of 2000, VC portfolios lost 11% of their value, the worst quarter in VC history and possibly a trend that will continue into 2001. In addition, the amount of money being funded to VCs this year could decline about 50% from the $103 billion in venture capital invested in 2000, Venture Economics predicts.

Even so, that isn't likely to stop some overly aggressive VC firms from trying to slip a few IPO lightweights into the market, warns Jesse Reyes, a vice president with Venture Economics. Reyes doesn't think that all of the "hot" companies on the IPO circuit this year -- all-in-one personal digital appliances, wireless applications, optical networking and customer relationship management software outfits -- are going to make it.

He advises investors to continue to be cautious about IPOs, reminding them that 40% of such companies fail and that the pioneers of seductive new products are often outdone by later competitors.

TSC: How much of a damper is the current decline in venture capital investing having on the IPO market and, in turn, the returns in hedge funds and mutual funds with small asset bases, which typically tend to favor these types of investments?

Reyes:

Definitely in 2001, there have been fewer IPOs. Over the last couple of years there were a significant number of IPOs, a couple of hundred a year. In the first quarter of 2000 alone, there were 112 IPOs, of which 79 were venture backed. But in the first quarter of this year, there were only 32 IPOs, and only 11 of those were venture backed.

The VC record in the public market is pretty much in tatters right now since a majority of the companies that they took public were in the dot-com space. This year, venture capitalists have fewer investing opportunities, and their declining returns are going to put a damper on seed money from their pension funds, endowments and wealthy individual investors.

TSC: Can investors continue to have faith in the wisdom of venture capitalists and investment bankers, given how many publicly traded dot-com companies have gone out of business and lost so much of investors' money?

If you take the view that venture capitalists invest in only the best companies --

Microsoft

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,

Oracle

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,

Amazon.com

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,

Yahoo!

(YHOO)

,

Intel

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and

Federal Express

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to name a few -- then, you're in the camp that they are smart investors capable of delivering the 20%, 30%, 40% annual returns that they promise.

But even venture capitalists got seduced by the Internet, like everybody else did. So, it might not be a bad thing that these IPOs are dropping off. It may mean that VCs have returned to quality, rather than putting out companies before they're really ready to fly.

A lot of the companies that they took public in 1999 and 2000 probably would have failed anyway, because venture capitalists were taking them public when they were only two- to four-years-old, sometimes less than that. Start-up companies headed for failure typically fail in their first three to four years. In normal times, these companies probably would have failed anyway. They just would have failed in the private portfolios of venture capitalists, rather than in the public limelight.

TSC: How is it, then, that venture capitalists got seduced, when they are supposed to have the wisdom and the foresight to invest only in the best companies?

Reyes:

There's plenty of blame to go around. It's a little like gun dealers. They see themselves as blameless. If I look at who came in ahead in that game, it was the investment banks who got paid no matter what happened to these stocks. On the other hand, their research should have been telling them exactly what it should have been telling the VCs, which is too much of a good thing probably means that there's something bad around the corner.

Venture capitalists typically have been technology investors, and when they started looking at the Internet, a lot of them felt they were making technology investments. Beginning in the middle of 1999, a year before the rest of the world caught on, they began to realize that in many cases they were investing in retail companies, a space in which venture capitalists don't do too well. By the winter of 1999 when the first e-tailing Christmas season of mention hit, they figured out pretty quickly that their fears had been validated.

So they began cutting back dramatically on their e-tailing and moved further upstream into technology, software and routers. Like many people, they thought they were investing in something new. And it's not so much a matter of being mistaken in their investments, but in their timing.

This isn't the first time that venture capitalists have made mistakes. They invested heavily in hard disc and software manufacturers back in the early 1980s. In 1984, there were 25 different hard disc manufacturers and probably 40 software makers on the marketplace, all backed by venture capitalists. At the end of the day, those all consolidated dramatically, and a number of venture capitalists were left empty-handed because as a group, they had over invested.

They tried the same thing in the early 1990s with biotech, but a lot of those investments took too long to come to fruition. Every time you have one of these big technology booms, everyone gets excited, and the public and the financial community starts clamoring for more IPOs.

Believe me, if we find out tomorrow that there's some brand-new application, and it hits the street, they will get excited all over again.

TSC: So, should investors continue to be cautious about investing in an IPO stock or in a mutual fund loaded up on them?

Reyes:

They should always do their own research. If there's anything that anyone should have learned, it's that you can't believe everything that someone tells you. Just because a stock has a big VC or investment banking name behind it, that doesn't guarantee that it's the world's next greatest thing. There does tend to be a VC, IPO mania that develops.

TSC: What types of start-ups are garnering seed capital?

Reyes:

Surprisingly, there are still some Internet investments being made. The IT area continues to be the extremely interesting part of the VC industry. Even B2B isn't something that they are shying away from.

What's hot right now falls into five broad areas, some of which could be another mistake. They're putting a lot of stock into all-in-one appliances: your PDA linked up to your laptop to your phone and the software being able to run all that. A lot is also being said about wireless applications. Optical networking is another hot topic, as are workflow solutions and customer relationship management software.

The technology may be proven, but the business models and concepts are a little more complicated because we don't have global standards on these things. Right now, these will be the types of bets like the old Beta vs. VHS, or high definition TV. And who's going to win? There will be a winner somewhere along the line, but I think it's always too early to tell.

Apple Computer

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wasn't the first to come out with the mouse.

Xerox

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had it, along with the Windows application, but who the heck ever bought a Xerox operating system? Likewise, Apple got burned when it came out with the Newton, the precursor to the

Palm

(PALM)

Pilot.

If you jump in the boat with the first one coming out, yeah, you might get a Microsoft or a Federal Express. But you might also get a loser or a company whose pioneer timing isn't right, and who might be outshone by a homesteader, which is why it's very important to be diversified in your approach to any of these VC start-ups.