February 12, 2003 Gap Between Venture Firms May Grow By Mark Boslet Dow Jones Newswires PALO ALTO, Calif. -- Top-name venture-capital firms should have little trouble rounding up money for their next funds, despite crumbling investment returns and a landscape of struggling start-ups, many investors and industry observers believe. However, venture firms' fund-raising success could come with an unintended consequence: a widening of the gap between rich and poor in a deeply stratified industry. This gulf, in turn, could widen another divide -- the one between the better returns more-established firms typically post and the weaker results of partnerships without the same resources. It is a chasm that could accelerate the consolidation in venture investing that many in the industry expect. The gap between the best-capitalized venture firms and those with the least amount of money long has been broad. The largest 20% of firms manage about 80% of the industry's capital. This clout often brings them more-experienced general partners with tighter bonds to corporate executives and attracts entrepreneurs with better business plans. Some observers see signs this gap could widen during the next couple of years as venture capitalists return to the nation's largest private-equity investors for more money. Many of these limited partners have seen the value of the current portfolios tumble and vow to place investments with what they believe are the safest firms, those with better track records and the longevity to prove they will be around 10 years from now when the next wave of funds matures. "The distinction is going to be between the older, established funds and the younger funds," said Mark Heesen, president of the National Venture Capital Association in Arlington, Va. Demand for the most-desired funds will exceed supply, while a lack of money will push many young funds toward extinction. "There is going to be a fight for the top funds," he said. There will be "those who want to get in who won't be able to get in," said Louis Morrell, vice president for investments at Wake Forest University in Winston-Salem, N.C. This long has been the case for the industry's elite firms -- a list that includes such names as Charles River Ventures of Waltham, Mass., Kleiner Perkins Caufield & Byers, Mayfield, Sequoia Capital and U.S. Venture Partners, all of Menlo Park, Calif. However, the imbalance could be greater this time as investors seem less willing to settle for second best. "The scrutiny [of firms] is much tougher than five years ago," Mr. Morrell said. Also, money is flowing into the venture-capital business at a slower pace, with large pension funds and endowments trimming the exposure of their portfolios to venture investing. This whittling will be somewhat offset by European investors, who are showing increased interest in American funds. Still, there will be less capital to go around. Mr. Heesen estimates the industry will raise $40 billion from 2003 to 2005, a substantial drop from the more than $200 billion raised from 1999 to 2001. At the same time, top-name funds are getting smaller. The typical big-name portfolio will collect between $350 million and $500 million during its next round of fund-raising, well shy of the $1 billion some partnerships raised during 1999 and 2000 at the height of the Internet bubble. Little room will be available for new investors. "We see a growing difference between the haves and the have-nots," said Eric Hirsch, chief investment officer at Hamilton Lane Advisors in Bala Cynwyd, Pa. Some limited partners say hundreds of firms hunted for money last year, but only slightly more than half were able to find it. A clearer picture of the fund-raising market will emerge during the coming months as several better-known firms are seeking money, industry insiders say. New Enterprise Associates of Menlo Park and Technology Crossover Ventures of Palo Alto are among those seeking money. New Enterprise couldn't be reached to comment; Technology Crossover declined to comment. Perhaps the most-scrutinized barometer of the funding environment will be 31-year-old Sequoia Capital, which several limited and general partners say is testing the fund-raising waters. Sequoia didn't respond to calls for comment. The partnership is planning a fund of $400 million to $425 million, people familiar with the matter say. Investors are eager to put in money, according to one industry insider who expects Sequoia won't have to offer concessions -- such as a more-lucrative split of earnings -- to entice capital. "There are a lot of people who would like to get into a top-tier group," said Mark Saul, general partner of Foundation Capital in Menlo Park. If the investors can't get into the top funds, he said, some of their money won't stay in the venture-capital business. This flight to firms with track records has obvious roots. Traditionally, there has been a large disparity between the best- and worst-performing funds. From 1972 to 2002, the average return for the top quarter of early-stage venture-capital funds was 19.6% while the performance for the bottom quarter was minus-11.4%, according to data tracked by Professor Josh Lerner of Harvard Business School in Boston. The top performers for the industry as a whole posted an 18.2% return while the laggards posted minus-3.4% returns. "I think the gap will absolutely widen," Hamilton Lane's Mr. Hirsch said. The money and resources of the established firms will snare the more-attractive venture deals. Not everyone agrees. Jon Feiber, general partner at Mohr Davidow Ventures in Palo Alto, contends there is no evidence that dollars won't trickle down to smaller, less-known organizations. Investors are "doing a lot more original research," said Don Wood, a general partner at Vanguard Ventures in Palo Alto. "They are looking at firms on a partner-by-partner basis." That could favor less-established firms with partners who have broken away from better-known firms, said Michael Greeley, who, for instance, left Polaris Ventures to join IDG Ventures in Boston. "You've got this pent-up supply [of money] looking for a place to go," he said. Investors "continue to look over the horizon for new funds." There is some indication that top-name funds aren't getting all the spoils. In mid-January, for instance, Leonard Green & Partners in Los Angeles closed a $1.85 billion buyout fund. Smaller firms also may turn to incentives such as reduced fees or a greater payout of potential profit to enhance their ability to attract reluctant money. Still, it may take more than a good deal to lure investors into riskier ventures. "There will always be a place for the specialist," said Graham Watson, a managing director at Deloitte & Touche LLP in Wilton, Conn. He said this might include a firm, for instance, that specializes in telecommunications equipment. But "as the money concentrates in the few, more-established funds, there will be pressure for these funds to become more diversified." That may be a difficult change to make for smaller firms with fewer partners. The idea is to decrease risk by being less wedded to early-stage or late-stage investing or to a particular industry. Today, "limited partners demand greater discipline," said Ronald Weissman, venture partner at Apax Partners, a London firm with a diversified, more-institutional approach. "Institutional isn't necessary a dirty word," he said. "What it means is replicable processes and less of a cowboy culture. That isn't a bad thing." Copyright © 2003 Dow Jones & Company, Inc. All Rights Reserved.