March 28, 2006 Despite Portfolio Wallflowers, VCs Ready For New Party By Michelle Tsai NEW YORK (Dow Jones)—Venture capital is showing signs of expansion, but its return to health is still weighed down by nearly 2,000 portfolio companies from the dot-com days that have yet to find exit opportunities. Signs of improvement in the industry include slower rates of company and investor consolidation in 2005, according to the annual Venture Insight study from Dow Jones VentureOne and Ernst & Young LLP. In 2005, the pool of active venture firms in the U.S. declined by 5.6%, down from 7.5% the prior year. That represents a tapering off of a consolidation trend that has seen the number of VC firms shrink 49% since 2000, partly because many first-time VCs closed shop after failing to raise new capital. "There are probably still a few VC firms that will pop out of the industry as they fail to fund-raise in this new cycle, but it's starting to level out to where we'd expect it to be," said Steve Harmston, director of global research for VentureOne. VentureOne, along with VentureWire, is owned by Dow Jones & Co. (In addition to this newswire, Dow Jones publishes The Wall Street Journal and its international and online editions, Barron's and the Far Eastern Economic Review, Dow Jones Indexes, MarketWatch and the Ottaway group of community newspapers. Dow Jones is co-owner with Reuters Group of Factiva and with Hearst of SmartMoney. Dow Jones also provides news content to CNBC and radio stations in the U.S.) Top-tier venture-capital firms have led the new fund-raising cycle, including, in 2006, Polaris Venture Partners of Waltham, Mass., closing a $1 billion fund, Kleiner Perkins Caufield & Byers, of Menlo Park, Calif., announcing a $600 million fund, and New Enterprise Associates, also of Menlo Park, reportedly raising a $2.5 billion vehicle. Limited partners, particularly those that couldn't tap a premier fund, still have large allocations for venture capital. These days, however, LPs are picky. "If you have a good track record and you're competitive with your asset class, LPs would rather stick with people they know than dump that relationship and try somebody new," said Jim Feuille of Crosslink Capital, San Francisco, which closed a $250 million fund in the fall. So, the big question in 2006 is whether smaller venture firms can successfully raise new funds too, said VentureOne's Harmston. For Spark Capital, a first-time venture fund in Cambridge, Mass., the answer was yes, loud and clear. Co-founder Todd Dagres, who was previously a general partner at Battery Ventures, said his firm sought to raise $200 million, encountered four times that amount of interest from institutional investors, and closed with $260 million in the fall. Pointing to dot-com fallout conditions giving way to health in the industry, Dagres said, "The rat is working its way through the snake." While venture-capital firms are raising capital, they are also trying to revitalize portfolios. Venture-backed portfolio companies in the U.S. totaled 5,406 with $132 billion invested in them as of January. The number of companies declined by only 3% in the last year, and the capital investment represented saw an even smaller decrease of 1%. Compared to recent years, this was a small decline, as the number of U.S. companies has dropped by 11% since 2002. Most of the contraction in the U.S. occurred among companies in information technology, whose numbers dropped by 12% since 2002, and in products and services companies, which declined by 36% in this period. Health-care companies continued to find favor with VCs, growing by 14%. Despite being in a new fund cycle, venture-capital firms have plenty of reminders that they still have to clean house: 1,912 companies worldwide haven't raised capital since 2000 or 2001 and are still operating. Some of these companies drastically reduced their burn rates after raising large amounts of capital, while others don't need financing but haven't found buyers and can't go public. Of the hangers-on, 814 - about 43% - are profitable, while most of the remainder are shipping products. "Some of them may be in the process of raising money, but we'll definitely see a lot of write-offs by their venture investors and some companies going out of business," said Harmston. Secondary funds have begun to step in as VCs look to offload portfolio laggards. VCs certainly believe a revival, if not already present, could be just around the corner. The improved economy has steadily nudged company valuations upward, according to Warren Weiss, general partner of Foundation Capital, a Menlo Park, Calif.-based firm that just closed $525 million for its fifth fund. For Series B and C deals, "if there's real revenue traction in the company in the last 12 to 18 months, people are paying quite a bit," said Weiss. "There's a growing sense that this is a time when you can make some money," said Spark Capital's Dagres, "unlike the previous three to four years when people thought 'No matter what we do we're not going to make any money so there's no rush'." (This story originally appeared in VentureWire, a daily email newsletter that provides in-depth analysis on venture capital and high-tech start-ups. Dow Jones Newswires, publisher of VentureWire, runs select stories from the newsletter.) -By Michelle Tsai, Dow Jones Newswires; 201-938-4314; michelle.tsai@dowjones.com [ 03-28-06 1106ET ] Dow Jones News Service © 2006 Dow Jones & Company, Inc.