Honey, I shrunk the fund

The Romans had their orgies and gladiator games; the Byzantines had their perfumed eunuchs; the Babylonians had the temples of Ishtar. More recently, the US venture capitalists had their superfluous billion-dollar funds.

Periods of great excess can't last forever – we all know what happened to the Romans, the Byzantines and the Babylonians. Rather than suffer a similar fate, many VCs have decided to proactively downsize their fundmanagement orgies and partially release their limited partners from what may have amounted to years of high management fees and scarce deal flow. In doing so, these firms have sacrificed easy fee income at the altar of franchise maintenance.

In seeking to understand the situation in which many venture capital firms today find themselves, it helps to remember the investor sentiment toward venture capital during the late 1990s and through the first half of 2000. Simply put, the soaring stock market for technology related companies created a mania for venture capital funds. Many otherwise cautious investing institutions suddenly became aware of the returns then being realized by limited partners with exposure to venture capital. Venture capital vintages as recent as 1996 were turning in average IRRs in the 90 per cent range. Certain venture funds were exiting deals that netted returns in excess of 1000 per cent. There was a feeling among investors that if they didn't get into a VC fund now, they risked suffering the indignity of not profiting from the technology that was transforming the world.

This kind of stampede mentality is usually present at the outermost expansion of a bubble. But at the time, who knew? If venture capitalists were aware that the IPO market was about to implode, and with it the tech and telecom markets, they certainly didn't act like it. The years 1999 and 2000 saw the formation of more than 20 US venture capital mega-funds, meaning funds that rounded up $1bn or more. This number does not even include the handful of crossover mega-funds that targeted growth-equity and buyout transactions in addition to pre-IPO technology deals. The managers of venture capital funds saw the opportunity to raise enormous funds, and took it. The venture capital funds raised during this period tended to be double the size of previous vehicles managed by their VC sponsors. Kleiner, Perkins, Caufield & Byers raised $550m in 1999, and the $1bn it raised the following year looks like an exercise in restraint compared with other firms. Spin-out group Lightspeed Venture Partners, which had raised $325m with Weiss, Peck & Greer, in 2000 raised $1bn. New Enterprise Associates raised $880m in 1999 and $2.2bn in 2000. Menlo Ventures raised a $500m fund in 1999 and a fresh $1.5bn for a new vehicle in 2000. But the firm that took the cake, statistically speaking, was Benchmark Capital, which, after managing a $150m fund for a couple of years, managed to draw $1bn in investor commitments in 1999. The following year, it found $750m for a debut European technology fund.

In raising these huge funds, and an unprecedented number of smaller vehicles, what the venture capitalists claimed, and what their backers believed, was that the number of quality venture capital investment opportunities was going to increase exponentially. Of course, what happened was the exact opposite. Just as most of the funds were holding final closes, the US public markets began their steady slide, with Internet, technology and telecom stocks leading the way. The approximately $95bn raised by venture capital funds in 2000 was quickly seen as far, far too much to invest effectively.

Doubts and changes of plan
In the wake of this market meltdown has been a slow series of reverse fundraisings. The reversal has unfolded in roughly three stages. The first saw a number of venture capital firms simply refuse new capital and wind down their funds entirely. Several months later, venture capital firms began ?right-sizing? their funds, releasing limited partners from portions of their commitments. The next stage may be unfolding now ? some firms that refuse to voluntarily reduce fund sizes are facing pressure, activism, and even lawsuits, from limited partners who want some or all of their money back.

The first admission that a billion-dollar fund might not be appropriate for early stage investing in a ravaged venture landscape came from the managers of Crosspoint Venture Partners. In November 2000, after barely a month of fund raising, Crosspoint had drawn capital commitments of $1bn. But the partners decided that nothing in the market matched their investment criteria, and told their would-be limited partners to hold on to their money.

The next month, Geocapital Partners sent a letter to investors informing them that the firm would not pursue its previously announced fund. The letter noted that, for the first time ever, more capital was committed to venture capital funds than to buyout funds. It read: ?Institutional investors have in aggregate made a bet: that the next few years will provide opportunity for more equity to be intelligently invested privately in embryonic technology companies than in the entire economy of positive cash flow businesses! We doubt it.?

Stage two began early this year, when a steady stream of venture capital firms began announcing that they would free their LPs of a percentage of their capital commitments, citing a poor investment climate. These capital give-backs have mostly come from top-shelf venture capital firms and have, on the surface at least, been quite amicable.

In January, Mohr, Davidow Ventures announced it would reduce its fund size 20 per cent to $650m. The funds that have followed Mohr Davidow's have been increasingly generous. In March, Kleiner Perkins announced a 25 per cent downsize. Days later, Redpoint Ventures announced its own 25 per cent reduction. In April, Accel Partners announced it would cut its $1.4bn fund in half. In May, Charles River Ventures, which had closed on $1.2 bn in early 2001, announced a 63 per cent fund-slashing. The trend has begun to expand to Europe, at least among US-based managers. In May, Benchmark announced it would right-size its European fund to $500m from $750m.

More pressure
Now stage three. Those firms that ignore gentle suggestions from their limited partners risk seeing gentlemen's disagreements escalate into less genteel disputes. The first sign of this came from the backers of Accel Partners, who in April told the firm they weren't at all satisfied with its original fund-reduction proposal. Yes, Accel had offered to cut its fund in half, but had endeavoured to hold the second half hostage until it was time for a new fund, essentially locking up LP capital for the next 20 years. After backroom manoeuverings by key limited partners, the GPs of Accel acquiesced and released $700m in commitments.

Other venture capital firms, all of them relatively new to the VC game, are facing revolts of a far more serious nature. Idealab is fighting a lawsuit brought against it by backers who claim the firm has been egregious in its use of management fees. Another new firm, 12 Entrepreneuring, run by Scient founder Eric Greenberg, collapsed in February after a group of high-profile investors demanded their money back amid accusations of lavish spending. In the case of San Vicente Group, the original management were thrown out after LPs accused them of fraud (the firm invested in junk bonds instead of tech companies).

Of course, most venture capital firms are guilty of nothing more than raising as much money as they could in a friendly market. Those GPs that decline to cut the size of their funds are well within their rights, but they may face a far less friendly market the next time they hit the fund raising trail. Existing LPs may resent having their capital tied up for so long, which may prevent certain firms from ever raising another fund. Then again, a venture capitalist with a fresh mega-fund under management may not ever need to raise another fund. The Babylonians should have been so lucky.

David Snow is the editor in chief of PrivateEquityCentral.net, a New York-based Web site providing news and information on the private equity industry.