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July 11, 2002
These days, investors and startup founders look at the venture capital business with the same suspicion as a solider who is asked to wear a macramé flack jacket.
Yes, it's hard to find a VC these days who's willing to speak about the industry – or even keep a stiff upper lip. But as the pace of deals has slowed and many of the startup investments over the past two years are washing out, Jerusalem Venture Partners founder Erel Margalit remains optimistic.
Margalit's firm raised its fourth general fund last fall, totaling US$400 million, from several investors including France Telecom SA, Infineon Technologies AG (NYSE/Frankfurt: IFX), Nortel Networks Corp. (NYSE/Toronto: NT), Reuters, Boeing, Columbia University, Massachusetts Institute of Technology (MIT), the government of Singapore, Jerusalem's Hebrew University, and Bank Leumi (see JVP Raises a $400M Fund). One of its big hits from years past was its investment in Chromatis Networks, which Lucent bought for $4.5 billion (see Lucent Catches Chromatis).
Months after JVP's fundraising triumph, however, the economy began to wear on its portfolio. In February, Israeli newspapers and private equity trade publications reported that JVP was asking its limited partners for an additional $15 million to $20 million so it could support existing portfolio companies.
So how is JVP faring at a time when limited partners are carping that VCs have paid themselves too handsomely for their meager returns? Light Reading had to find out, so we caught up with Margalit in late May at JVP's New York office near Madison Square Park.
Margalit had just returned from East Asia and, before that, Israel, where he spoke to an audience of VCs and politicians. And, though he'd been up late the night before, he dutifully hauled out a notebook as big as our overnight bags, stuffed with thoughts he has on just about every nook and cranny of the telecom industry.
Frankly, we were stunned and little frightened. Who in the heck takes time to make notes before a press interview?
Margalit, whose frequent flier miles alone could fund the colonization of Mars, is just that kind of student of the industry.
Read on for his views on:
A Cogent Discussion
Funds and Games
— Phil Harvey, Senior Editor, and R. Scott Raynovich, US Editor, Light Reading
http://www.lightreading.comLight Reading: So, what's going on in Asia?
Margalit: We went over there with a number of our portfolio companies to several countries. We started at a conference in Singapore – hosted by the Ministry of Technology and Trade – to give a presentation on Israeli technology. Some of our portfolio companies presented, and we had a lot of strategic partners from the region attend. There were a lot of people there just interested in investments generally and in learning about what's been happening in the U.S. market and in Europe and Israel.
Then we took the companies to Hong Kong, Taiwan, and to Japan. In Japan we've been very active with our companies for quite a while.
Speaking of Japan, I was there about a year and a half ago, and one of the most amazing things is just the broadband connectivity costs, and how Yahoo! Japan and Microsoft Corp. (Nasdaq: MSFT) have managed to bring them down. At the time, venture activity in Japan was not attractive, because a lot of companies were getting funded at a high valuation. Broadband connectivity and last-mile issues were still a big problem.
Now it has gone from the most expensive place in the world to one of the cheapest – with the enormous degree of online users coming out of the woodwork, you know, primarily with DSL. Because of the way the network is built there, DSL is a very comfortable and affordable strategy. Even Yahoo! Japan, supported by Softbank, is now saying it’s a telecom company! Japanese VCs and companies are also a lot more humble. With layoffs and unemployment, it’s now culturally acceptable to join a startup environment.
A lot of people are asking what's going to be really strong – 802.11 or 3G. I think that people in Japan are implementing wireless LANs in a big way in two kinds of situations. One is in enterprises. We're going to see a lot of mobile data applications and merging of devices. The other place [for wireless LANs] that's interesting is in public places like coffee shops and airports; major investments are going on there right now.
Light Reading: So are you saying that wireless data can help the telecom world out of its economic rut?
Margalit: In Japan, as broadband relates to the rest of the world, it's a pretty isolated phenomenon... even isolated from the rest of the Japanese economy. But I do think that that we're going to see it hit big-time there, and I think that will help.
I think the U.S. is really going to lag behind on all the mobile applications. It's just way behind Japan and Europe – so, the importance of what's happening is that when somebody shows a model to carriers on how to make money, in a different manner, I think that's something that people will copy.
Light Reading: Who do you think some of the leading candidates are in that category?
Margalit: In how to make money in wireless? I don't know. I'm not a big expert on it – you know, I spoke more to the systems integrators and to the carriers. I think people were talking about music applications. Part of who you are there is the kind of music you have one your phone! There are also different ways an enterprise could manage itself better using wireless data.
Light Reading: Okay, enough about Asia. Tell us about your portfolio. What about your core and long-haul investments? A lot of VCs are trying to clean up their portfolios in that area.
Margalit: You know, I was thinking of a few things that we're seeing in the optical domain. [He hauls out his notebook.]
Starting in components, I think that what we're seeing is a very big need for technology platforms that enable a broader portfolio of products – like lasers and Semiconductor Optical Amplifiers that have smaller real estate, a smaller footprint. What's driving this is the need to have lower costs and smaller real estate and more functions aligned on your components. Like CyOptics Inc., which is coming out with a modulator and a laser on the same chip.
There's really a need for more startups in the industry. If you look at Bell Labs or Lucent Technologies Inc. or Agere Systems or JDS Uniphase Corp. or Nortel Networks Corp., they have a major problem of regrouping from the long-haul mindset of what a component is (and what the cost should be) to the metro mindset. You cannot look at the metro problem the same way. You have to look at more integrated components. You also need new materials and new techniques that the startups are leading with. And we're getting that – some of our startups are joint venturing with some of the larger players into that space and enabling them to come out with better products.
Light Reading: You're saying it's an inevitable direction, but there's nothing short-term that proves your case…
Margalit: Yeah, but that's great. That's the best time to make investments.
Light Reading: How do your limited partners feel when they hear that?
Margalit: We're talking to the carriers, and people are really moving. The guy we're talking to may not be the one signing the check, but he knows what the situation is and he's moving in his seat. [Component integration] is clearly a burning problem for systems vendors.
Margalit [flips page in notebook]: Going one step up to subsystems... I think that there's a whole void between the components companies and systems companies in integrating the lasers and the electronics. What you're seeing are companies like Kodeos Communications Inc., which has an all-purpose transponder that allows them to really bring a subsystem to the systems companies rather than just a teeny little component. And Xlight Photonics, which is the first tunable 10-Gbit/s transponder.
Now the question for a VC is whether these companies have the potential of being a big company. That's not clear. It's not clear – there's clearly a void, but it's not clear that there's room for large companies to emerge. But we're definitely seeing a need on some level.
Light Reading: Are you saying someone like JDSU would buy these companies if it fell behind in certain areas? Or would JDSU just buy their products?
Margalit: Either that or JDSU could have a strategy to work together with them.
Light Reading: Is that part of the joint venture you were talking about earlier?
Margalit: Well, the joint venture that I'm talking about is more with a company like Inplane Photonics Inc. or CyOptics. See, if you take the industry's main laser material, lithium niobate, that Agere is working with – it's a very inflexible material. Let's say Nortel was working with it. It's very hard for them to move to the metro with that material. So here indium phosphide is a new platform; it's much more adequate. So that's the kind of thing that the JDSUs of the world are cooperating with us on. I don't want to mention their name specifically…
Light Reading: You don't want to mention whose name?
Margalit: Companies like JDSU are doing this, but I really don't want to make a connection that JDSU is working with CyOptics or something like that.
Light Reading: So, what are you seeing with systems companies?
Margalit: In systems: The core IP routing market is too crowded. I think that this is one of the major issues for all the top VCs, and we’re known to invest in this area – whether because we backed Chromatis or others in the past – so we're being approached first.
For example, if a company needs $100 million, then they'll have a $100 million post-money valuation by delimitation. And if you're looking at that kind of valuation, and it needs to ramp up sales so that the company is worth $500 million or more, that’s tough. That's a key dilemma for VCs who need that type of turnaround.
Those companies that are around to raise money are primarily those that have been around a while and need to restart.
I think one key systems issue is whether there will be a metro Ethernet pure-play with companies like Atrica Inc. or whether there will be a more integrated box that works on Sonet like Native Networks Ltd. Our feeling is that with Native, you're utilizing an existing ring that you have, especially in Europe, where you're adding data services on a voice-oriented ring.
We invested in Chromatis. It's nice to see that the industry is coming back to that; because we always believed that there would be multiple elements coming together – ATM, IP, a crossconnect optical switch, a mux, Ethernet switch – without sacrificing any major functions. I think there may be still an opportunity there.
Light Reading: Where?
Margalit: What I just talked about. Somebody who can offer a reincarnation of Chromatis.
Light Reading: In the metro network? Something that can tie in Sonet and IP services?
Margalit: But with a super box. Someone that can do all of these things well. I don't know if it's because we're masochists or we really see an opportunity.
Light Reading: So you're saying Native is your play there?
Margalit: No, no. Native is much simpler. Native is adding IP to a Sonet ring.
Light Reading: So you're working on a new investment in this area?
Margalit: We're thinking about it.
Light Reading: In a multiservice metro God-box type of thing?
Margalit: Yeah. This area is not going to get a lot of investments. You need to have very good friends in other funds to move money in this market.
[Ed. note: Later, after the interview, it became clear that the company he was talking about was Mahi Networks Inc. (see Mahi Gets a Fresh $75M)]Margalit [back to the notebook]: Finally, with service providers, we do believe something good will come out of all this shakeup. When something is dying, it's hard to call it healthy. But in a long-term perspective it will be healthy. These companies have real assets, but the capital structure – the debt, versus equity versus this versus that – and the business structure – that of trying to be all things to all people – that's just not going to hold.
So with companies like Cogent Communications Inc., you want to think, in an industry that will finally get back to sanity, it has a chance at coming back and providing an alternative to incumbents in that area where they have been the weakest – data services.
Light Reading: Speaking of insanity and Cogent, most everyone we talk to doesn't get it at all – they have this huge amount of debt.
Margalit: I don't think so. Cogent has, like $100 million in the bank; they have a major arrangement with Cisco.
Light Reading: They have a bunch of vendor financing.
Margalit: But in a way that makes a lot of sense in terms of implementing the network. Cogent is addressing that last part of the last mile – connecting the buildings to the network. Once you're in the building, you get customers. The issue is getting into the building. We're seeing how difficult that is. But we're getting it done.
And they have the lowest operating cost of a network. Any network that we load onto our network – the amount of savings that we have because of the ingenuity of our network is unbelievable. A lot of the cost for carriers is just maintenance of, and overhead of, running the network. It's amazing how much cheaper running a pure data network over Ethernet really is. We need to build up the revenue and utilize – besides the end users in the buildings – we need to really utilize our network.
After buying PSINet Inc., we have probably the second-best peering agreement in the U.S. It's very healthy from a financial point of view. Cogent is going to be EBITDA positive in 2003. The devil's in the details. But it's a very healthy model.
A lot of people say, you did a reverse merger and you bought Allied Riser, and is it really worth it? We have a public stock, but we all hold preferred stock. That was just the vehicle to get ahold of some major assets. We're not building up so that the stock price can, all of a sudden, shoot up. We have a different strategy. When you have like 3 percent of the company on float, it's still like a private company. We're managing this company for 2003 and 2004. That's when we think it will have scale and profitability. We think that right now is the time to build out and gather assets and get revenues.
Light Reading: Which fund are you investing out of now?
Margalit: The $400 million fund we closed in September.
Light Reading: Are your limited partners griping about management fees?
Margalit: We took unilateral actions before a lot of people forced different things. We did that before it became an issue.
Light Reading: Did you take an overall percentage cut, or did you space out the collection of fees over a longer period of time?
Margalit: It was a combination of the two. We have good investors, and we talked to them way ahead of all the things we're hearing now.
Light Reading: Will it be hard to fully invest a $400 million fund?
Light Reading: How much is left?
Margalit: There's more than $300 million left. But you need the discipline. We're seeing opportunities in Europe, the U.S., and we're passing on a few opportunities in Asia. We're spread geographically in different places, but the way we look at deals is by theme rather than geography. Then you take advantage of your international spread. This gives you an enormous deal flow. Once you announce that you're interested in a space to entrepreneurs, you get a lot of deals in that space.
Light Reading: Tell us about Israel. Have things really slowed down on the technology, investment, and business side because of the political unrest?
Margalit: I know it's really hard to see it here, but the businesses were never affected, at least not in the day-to-day work.
There is still a lot of startup activity. Israel still one of the most interesting technology producing countries in terms of innovation. The mood of the people is not so good, but they’re still seeking an optimistic horizon and a positive outcome. In terms of the high-tech community, things are beginning to move forward.
In Israel, you always have to look at short term and long term. In the long term, we feel, especially the younger generation, especially the entrepreneurs, that we're moving toward a settlement with the Palestinians. We feel like we're nearing the end of a very long journey. The fact that some people say there is no Palestinian state, or that there never will be, that... that's baloney. Everyone knows there's going to be a Palestinian state and everyone knows that that will be in the best interest of Israel.
On April 14th I was asked to give the keynote address at an Israeli Venture Association (IVA) venture capital association annual meeting in Tel Aviv, and I was asked to give the opening speech. Both Colin Powell and Ariel Sharon were there, and I was expected to give a speech about the role of the government and the venture industry. Instead, I took a different approach and discussed how businesspeople, and venture capitalists in particular, could support the peace process to the benefit of the economy, international trade, and all the people of the Middle East. I’m dedicated as an Israeli and as a businessperson to ensuring the success of all three.
For example, we've made some big changes in the taxes. Foreign investors now have zero capital gains taxes in Israel. That was JVP's battle.
Light Reading: What'd you say at the IVA meeting?
Margalit: Because the prime minister was there, I said that the real role of the government – I said we support you in going and fighting terrorism and suicide bombers. But we also want you to tell us and the rest of the people here: What's your strategic plan?
The peace process is like a startup that needs to be recapitalized. We've seen startups in difficult situations and you need to reinvigorate the process. We need to echo in a significant way, the Saudi initiative. And we need to move toward negotiations with whatever Palestinian leadership there is. Processes don't start and end with politicians. The business community in this role has the regional settlement on its agenda today. It's showing what the region could look like. The feedback I'm getting from the Arab world is very positive.
I recently had an op-ed piece published in a leading Arab newspaper, Asharkq Al-Awsat, published out of London, in support of the Saudi peace plan and the role that business leaders could play in the peace process. That was one of the rare instances that the paper published an op-ed by an Israeli written specifically for this paper.
Light Reading: Let's revisit that bit about capital gains taxes on foreign investments.
Margalit: Until last year capital gains taxes on VC investments were double what they were in the rest of the Western world. JVP helped to make the biggest changes in the capital gains taxes legislation by lobbying the ministry until they eliminated capital gains taxes until 2003. With the repeal, we’re seeking to increase the support of innovation in Israel and create a friendly investing environment for overseas investors.
Light Reading: Did that apply to your $400 million fund?
Margalit: It does. That's why we negotiated it.
Light Reading: Do people really use that "Submit Your Business Plan" button on JVP's homepage?
Margalit: The question is whether we actually look at them. We get bombarded by business plans. Especially now.
— Interviewed by Phil Harvey, Senior Editor, and R. Scott Raynovich, US Editor, Light Reading
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