After the technology correction many venture capital portfolios are in tatters. But investors should not throw in the towel just yet. Peter Kroeger of The Catalyst Group says there are ways investors can salvage value.

We have seen the stock value of high-tech investments fall to less than 20 per cent of their value a year ago. Such uncertainty prompts concerns about whether venture capitalists are feeling the pinch; when the IPO season might start again; and when, or if, trade sale valuations will improve. Currently there are no apparent routes for exits, which means funds are struggling to close. So how important are IPOs and trade sales to the venture capital investment cycle?

Most venture capital funds in the IT sector are billed as high-growth funds. Investors should expect to receive three times their money. For funds specialising in buy-outs, this can be a testing target. However, up to the end of 2000, most high-tech funds were returning multiples well in excess of that.

High-tech funds are by nature high risk and high return. Typically, over a three-year period, fund managers will make 12 to 20 investments, exiting five to seven years later. Growth varies enormously, but of these 20 investments, two will be outstanding performers returning greater than ten times the money invested, another ten to 14 will return between one and five times the money invested, while the remaining four to eight will fail completely.

The high-tech market will take several years to recover, and meanwhile we have to deal with the loss of value, and its effect on venture capital portfolios. If valuations remain at present levels and only rise slowly over the next few years, then for existing funds, investors' initial expectations are likely to be disappointed. Those feeling the squeeze could include:

Also for consideration is the speed at which corporate investors can work, compared with corporate venturers. Being parts of larger organisations with more complex decision making processes, corporate investors can be slower to commit to investments than VCs. Yet the ability to attract corporate money sends a strong signal to the company's customers and partners.

· funds in their late stage seeking exits for the remaining portfolio companies;
· funds in their mid-term that do not seem able to meet yield expectations from exits over the remaining five years;
· new funds that invested without exits in 2000-01 and which could now be looking at significant losses.

Fortunately for funds like these there is still time to repair the damage. In recent years many investments were made on market size and share predictions. In some cases these are no longer valid reasons. For example, ASPs were supposed to be the software solution delivery model of the future. Even though the idea failed monumentally in gaining widespread acceptance, some ASPs are still alive and growing, though their offer has changed.

Take vertical market software providers as another example. Most vertical markets have the capacity to support only two or three players adequately, leaving the rest to struggle. These markets rarely allow a single player to own more than 60 per cent, and with very few worth more than £20m each year, there is a natural ceiling of about £12m for software and associated services. Today, VCs would probably be more cautious about investing in a company with such a low natural ceiling.

Similarly, investments made in companies that aimed to develop technologies and enter markets might now be treated with scepticism. If those technologies and market presences can be bought or traded at a fraction of the 2000-01 cost, it makes greater economic sense to buy rather than build and provides a compelling reason for further consolidation. Many companies that overestimated market size have failed, mainly because they geared up overheads in expectation of customer demand that never materialised. The survivors' best chance to become high performers in the portfolio seems to be through consolidation. Together they are more likely to get the investors' original money back and return a profit. There is very little liquidity in the shares of companies with a revenue or market capitalisation of less than £100m, indicating that size is an important factor. This is the clue that VCs with portfolios at risk of underperforming are really looking for. In order to achieve a trade sale or an IPO, over the next five years, companies must be consistently profitable, growing and big enough to attract new owners.

So how do they achieve this? By merger or acquisition. For the VCs investing, this can provide an exit; however, if the investment is underwater, and time is still available, then they should stay in.

For VCs whose portfolio company is the acquirer, it represents an opportunity to accelerate growth and raise the chances of turning the company into a greater success, with better forward exit potential at a higher return. And this does help solve the problem of businesses that are run to suit the management team and not the shareholders - the lifestyle businesses.

Market conditions demand that fund managers now choose their investments and spend their time, very carefully. With the possible exception of 3i, which has a very large portfolio, most VCs have spread their risk by investing in different sectors of the high-tech industry. However, this means there are few candidates for intra-portfolio merger, which VCs find difficult anyway. Valuing the investment accurately enough to withstand any hint of criticism from different investors in each fund and their partners is hard work.

A catalyst is needed to bring fresh thinking and innovation. A careful and simultaneous evaluation of the companies of several VCs needs to be made. The catalyst should understand the technology, and have experience of running and integrating technology companies. It should understand the position that each company holds in its market; in adjacent markets; and where the merger will be cemented or create value. It should also have the ability to assess the negotiating VCs and management teams, take a judgement on whether the cultures will fit, and provide an independent and detached view of the personalities involved, maximising the chances of the deal occurring and successfully building the desired value.

VCs can help by carefully assessing their portfolios and injecting the funds needed for their better performing companies to grow rapidly. This assistance could include access via the VCs' networks to customers, management, money or advice. They can review the parts of the portfolio that are not performing so well but which are successful nonetheless. They need to take the necessary action to revitalise the company. And for those companies that are going to fail, accelerate the process gracefully or take some firm action such as changing the management and recapitalising. Looking to merge weak loss-making companies is seldom worth the effort.

Real Deals 30th May 2002