Boston Business Journal - August 13, 2001 http://boston.bizjournals.com/boston/stories/2001/08/13/story8.html

From the August 10, 2001 print edition

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Rates of return down for Hub VC firms

Edward Mason   Journal Staff Greater Boston's venture capital firms have paid for their investments in high technology, as the values of their portfolios have diminished by the downturn in that reeling sector, according to a report by Venture Economics.
The Newark, N.J., research company said venture firms posted negative internal rates of return for the second consecutive quarter. The internal rates of return--a snapshot of the present value of a firm's investments--for those firms in the first quarter this year was down 6 percent on average, while firms in the technology-laden Route 128 corridor were down 12 percent. In the fourth quarter last year, Boston-area firms were down 8 percent, while those in the 128 loop were down 13 percent.
Jesse Reyes, a vice president at Venture Economics, said the decline in internal rates of return reflects the diminishing value of investments made in high-technology companies--and Boston-area venture firms' heavy stake in the sector.
"I think it's the technology focus that we're seeing in the numbers," Reyes said.
The decline in internal rates of return could be even greater, said Reyes, who believes that not all venture firms have written down their investments as much as they could or should.
"One-third of the industry took its lumps and moved on," Reyes said, while the rest either aren't sure what to do or are waiting before giving up on investments. "That's clear denial."
Nationally, the numbers are similar. Venture firms' internal rates of return were down 9 percent in the first quarter and down 6 percent at the end of 2000.
"The cycle has turned," said D. Brooks Zug, senior managing director at Boston's HarbourVest Partners LLC, which invests in venture capital funds.
Zug said that the falling returns have come as the result of tumbling stock prices, for instance, when a high-tech company that a venture firm holds stock in sees its share price falter. Also, venture firms' rates of return take a hit when a portfolio company seeks another round of financing and has its value decreased.
What should be gleaned from the back-to-back quarterly writedowns is unclear. Richard Frisbie, general partner at Wellesley-based Battery Ventures, said that internal rates of return are given too much attention.
"It's the tail wagging the dog," Frisbie said. The lower valuations, he said, shouldn't be confused with real losses.
"They don't really mean VCs are losing money," Frisbie said. "They're writing down (values) to a more reasonable level."
In effect, many venture firms are doing the sensible thing--revising the astronomical valuations of companies invested in during 1999 and 2000, Frisbie said.
"They were highly inflated to begin with, and they are beginning to come back to earth," Frisbie said.
Some industry observers, though, believe that the internal rate of return is a misleading indicator of what venture firms are up to. Their performances are often closely guarded secrets, ones that are easy to keep because, as private companies, venture firms don't have to adhere to the same financial disclosure requirements publicly traded companies do. In fact, Venture Economics won't release data for specific companies. This is done, officials with the company said, to preserve access to internal return figures.
Such leverage makes the reliability of internal rate of return data questionable, said Stephen Lisson, editor and publisher of the Austin, Texas-based Internet newsletter InsiderVC.com.
Moreover, Lisson said, it doesn't say how much cash and stock a venture capital firm has distributed to its investors. That, he argued, is the real number that should be watched.
"IRR doesn't mean return to investors," Lisson said. "You can't spend IRR. Only cash and stock."
Lisson pointed to Matrix Partners as an example. According to his research, Matrix's fourth fund had a smaller internal rate of return than the fifth one. Yet, so far, the fourth fund has returned more money to investors, Lisson said. Matrix Partners officials could not be reached for comment.
Another signal of the industry's health, Frisbie said, is whether firms can continue to raise money. And, in fact, venture firms have continued to raise and close new funds, albeit with some difficulty, even as the economy appears shaky and the Wall Street slump has limited initial public offerings of stock--a key exit strategy for venture capitalists.
Still, internal rates of return garner considerable attention, observers said, because they offer rare, insider glimpses at the venture capital industry's financial performance--general though it may be. Even to veteran industry watchers, such as Venture Economics' Reyes, the internal rate of return data may only hint at venture firms continuing to write down the value of their underperforming investments.
"We don't know how much foam is left in the glass," Reyes said.


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