Lessons from the dotcom crash

As the denominator effect continues to impact limited partners' alternatives allocations, the fundraising market has taken a dip, both for venture capital and buyout firms.

Many placement agents and investor relations specialists are calling it the worst they have seen since the bursting of the tech bubble in the early 2000s. Furthermore, certain elements of the aftermath of the tech crash do seem to parallel the current climate – mega-fund investors are sitting on their hands, the pace of fundraising has slowed significantly, and some GPs are having to contemplate smaller successor funds.

Perhaps the tech crash, then, could provide useful lessons for firms that find themselves struggling to adjust to the new order?

SHRINK-WRAPPED
In the heady years at the height of the tech bubble, some of the brand-name venture capital firms were raising funds close to $1 billion. After the crash, those firms suddenly realised the volume and quality of deal flow just didn't justify the enormous pools of capital they had amassed. And they retrenched.

Sevin Rosen Funds raised $875 million in late 2000, but spent just $600 million of it. In 2002, Kleiner, Perkins, Caufield & Byers reduced its $800 million fund to around $650 million. Charles River Ventures raised a $1.2 billion fund in early 2001, and later cut that commitment to $450 million. Redpoint Ventures gave back about 40 percent of its $750 million fund in 2001, and Mohr Davidow Ventures reduced its $850 million fund to around $650 million. Though no-one is yet suggesting that venture or private equity firms are going to hand back capital, most industry observers agree that managers will be asking for less capital next time around.

“My guess is you'll see the same thing happen in private equity,”says Paul Kedrosky, a senior fellow at the Kauffman Foundation and a former venture partner at Ventures West. “You'll see an echelon of the industry drop off.”

After the tech crash, dramatic reductions in fund size were mirrored by dramatic reductions in fee income. Only a small percentage of venture firms actually closed their doors as a result, but many of them adapted to trimmed budgets by streamlining operations. Halving a $1 billion fund that generates a 2.5 percent annual management fee – as many of the top funds did in the late nineties – puts a $12.5 million dent in a firm's annual budget.

Raising a smaller than expected fund therefore forces a firm to revise its budget downward, even it if isn't in imminent danger of going out of business. And if fundraising goes on longer than expected, and fees from previous vehicles begin to step down before management fees from the new fund come in, a firm could find itself seriously pinching pennies.

Guy Hands, head of London-based private equity firm Terra Firma, went so far as to predict that dealmarkers' pay could drop by 75 percent in the coming years. His estimate was based on the assumption that private equity firms will own the assets they buy for an average of eight years instead of the pre-credit crunch average of four, and that they will take four years to invest their funds instead of two.

It's worth noting, however, that the big names in both the venture capital and private equity industries are somewhat buffered from a drop in fee income. Management fees often don't scale with fund size, meaning that the larger funds are generating enough fees to rival carry as a source of profit.

“The management fees that people get at the top end are driven by their status in the marketplace and not the actual costs of running the firm,”says Jonathan Axelrad, a partner in Goodwin Procter's private investment funds practice.

He notes that if management fee structures are correctly negotiated, a firm should have enough cash to run its business even if the next fund is smaller or slow to close.

“A properly negotiated partnership agreement provides for a management fee step down in the out years that is consistent with the fund manager's having enough money to continue to run the fund,”he says. “To the extent that a slowdown in new fundraising places cash flow stress on managers in certain segments of the market, it is possible that those managers may end up taking home less money or downsizing their firms. However, I don't see that process, by itself, creating a massive dislocation in the industry.”

Venture capital firms tend to run fairly streamlined operations, and so there wasn't much that could be cut during the tech crunch, Kedrosky says. For most firms the best way to cut costs was to cut personnel. A fund that's half the size of its predecessor clearly doesn't need as many partners to administer it.

“Many of the firms tried to operate off a much leaner structure that was very partner-centric and had far fewer associate-level people,”he says. “At the same time there was a push to get rid of what were deemed to be some of the poorer performing partners, but that was a much smaller component because partnership changes are so hard.”

LAY-OFF
The slump caused Battery Ventures to lay off nine employees, including two investing partners. New Enterprise Associates shed four of its 11 partners in 2003 after it raised a new fund. Mohr Davidow closed its Seattle office that year as well, just three years after it opened.

The great fear of a lot of the LPs is, ‘If I really put the boots to these guys, and all of a sudden this turns out to be the performing asset class of the next ten years, boy am I ever going to look stupid.’

Paul Kedrosky

Back office employees also suffered, says Mark Heesen, president of the National Venture Capital Association.

“At the top of the bubble you saw a number of these firms have in-house communications people, in-house legal staff, in-house recruiters,”he says. “You saw a winnowing out of “non-essential” personnel directly after the bubble.”

Ultimately it was easier to outsource those back office functions than to cut corners in areas directly related to investing, Heesen says.

“The other side of that coin is you did not see a sudden reduction in travel budgets or things like that, because right after the bubble what you started to see was a much bigger interest in India and China, and you saw people hopping on planes and going to those places,”he says. “Looking for deals, that's the fundamental part of what venture firms do, and so those types of activities did not ebb as a result of cutting back the management team.”

Not everyone slashed their staff after the tech crash though, Axelrad notes. He says he saw plenty of venture firms use less drastic means of keeping the lights on. “We saw firms slowing their investment pace, investing more conservatively, trying to extend their runways, and occasionally raising annex funds to provide stop-gaps between major fundraisings,”he says.

The effects of the current market are still playing out, and it remains to be seen just how much private equity firms will have to tighten their belts. Kedrosky echoes a view held by many, that private equity will prove more resilient than its critics predict.

“Private equity guys I'm sure are just like venture capitalists, in that they are remarkable survivors,”he says. “Even though we should probably see a fairly radical downsizing of the industry based on the absence of leverage and LP desire for capital, I think we'll all be surprised by how much less of a change there is in the size of the industry than would be rational at this point. They're sitting on a lot of cash and the great fear of a lot of the LPs is, ‘If I really put the boots to these guys, and all of a sudden this turns out to be the performing asset class of the next ten years, boy am I ever going to look stupid.’”