Returns on venture capital investments have been abysmal during the past few quarters, and optical networking VCs are investing at a much slower rate this year. But the money committed to venture capital funds by institutional investors hasn't changed all that much since last year, when investments were pouring into the telecom sector at a furious pace.

VCs generally agree there is still plenty of capital earmarked for funding optical startups. The catch is it's hard to convince investors to take new risks -- they're too busy bolstering their portfolio companies.

The venture capital industry recently saw its first negative return for any 12-month period since the early 1970s, according to data from Venture Economics, a Thomson Financial Company. In its database, which tracks the performances of more than 1,400 venture capital and buyout funds, Venture Economics found that returns for all venture capital investments posted a 21.1 percent loss for the six-month period ended March 31, 2001.

And according to VentureOne, a division of Reuters that monitors the venture industry, VC investments in the communications sector, which includes optical networking, fell to $2.4 billion for the first quarter of 2001 from $4.1 billion for the year-ago period -- a 42 percent drop.

VentureOne data also shows that the size of the average venture round in the communications sector has dropped to $14.6 million in the first quarter of 2001 from $17.15 million in the year-ago period, a 17 percent drop.

"The solicitation effort for many of these funds actually began in mid 2000," explains John Gabber, director of research for VentureOne. "And with the change in market conditions they'll put that money to work more slowly than they did during late 1999 and 2000."

"I think it's universally accepted in the VC community that 80 to 90 percent of the private optical communications companies are going to die," says Brian Kinard, a partner at Blueprint Ventures. "I think what everyone's doing is waiting and seeing who'll survive."

And while the rate of investing slows, VCs are paying more attention to the firms they've already funded, helping nurse the sick ones back to health (and shooting the ones with broken legs). "All of us are revisiting our [investment] strategies," says Erel Margalit, managing partner at Jerusalem Venture Partners. "Some of the companies need more effort to identify what it takes to get them to break through with carriers."

One thing VCs are doing is raising annex funds -- funds aimed at sustaining portfolio companies that haven't gone public or been acquired. Specifically, New Enterprise Associates (NEA) and Accel Partners raised funds this summer to keep their companies afloat. New Enterprise raised a $150 million annex fund in June, and Accel raised a $75 million annex fund in July.

Amidst their pragmatism, though, venture capitalists are still scanning technology breakthroughs, always looking for a fresh horse to bet on. Looking ahead, Margalit sees potential in 40-Gbit/s long-haul systems and in FEC (forward error correction) technology to improve the quality of data sent through existing networks. He also notes that some technologies that haven't been commercially successful in the U.S., such as broadband wireless equipment, are starting to make headway in China and in parts of Europe.

Then there's the "faster, better, cheaper" argument. "Regardless of the economy, anything coming to market right now will be obsolete very soon," says Michael Duran, a partner at Patricof & Co. Ventures Inc. He says there's an operative principle, equivalent to Moore's Law in optics, whereby so long as the Internet keeps growing, carriers will be forced to build networks with faster transmission speeds.

Blueprint's Kinard says he sees opportunities in optical shaping (solving the problems caused by chromatic dispersion in optical networks); optical monitoring (measuring a signal's characteristics without degrading it); and automated manufacturing process for optical components.

- Phil Harvey, Senior Editor, Light Reading
http://www.lightreading.com Light Reading's subscription research newsletter service, Optical Oracle, recently analyzed the VC funding crisis and the state of private-company valuations in a detailed report called "Valuation Deflation." The report includes the estimated valuations of 57 private companies. For the full details, go to www.opticaloracle.com



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