VCs Wait for Liquidity

Communications venture funds are suffering just like all other areas of the telecom world. But after months of virtual inactivity, VCs are getting creative about what deals they're considering and what to do with busted companies.

The U.S. venture capital industry has seen negative annual returns for the second quarter in a row, according to recent data released by the National Venture Capital Association and Venture Economics, a Thomson Financial company. Within that broad swath of investments, however, the communications sector remains among the more volatile areas for VCs.

Table 1: Industry Returns of Venture Capital Funds

Industry	3 Mo.	1 Yr.	3 Yr.	5 Yr.
Communications	-7.00%	-38.3%	69.70%	43.40%
Computer Related	-0.60%	-12.10%	7.30%	0.60%
Internet Specific	-8.20%	-27.70%	35.70%	33.80%
Biotech/Pharmaceuticals	3.30%	12.40%	60.60%	42.50%
Medical/Health	3.70%	-6.30%	12.90%	12.60%
Results as of June 30, 2001 Source: Venture Economics/National Venture Capital Association * All industry returns represent performance of venture capital funds with 60% and above concentration in a particular industry.

The Venture Economics Private Equity Performance Index (PEPI), taken from a database that monitors 1,400 U.S. venture capital and buyout funds, shows that, on average, every dollar invested in the venture capital market lost about 18 cents in value over the year that ended June 30, 2001. Over three-year and five-year periods, however, the returns on venture capital investments were 54.5 percent and 40 percent, respectively.

Payouts to the investors in venture capital funds are also the lowest they've been in several quarters.

Table 3: Quarterly Venture Capital Distributions of Cash and Stock to Limited Partner Investors

Quarter	Amount (in millions of $)
Q1 1999	1,875
Q2 1999	2,700
Q3 1999	3,744
Q4 1999	10,648
Q1 2000	18,718
Q2 2000	10,882
Q3 2000	13,304
Q4 2000	6,836
Q1 2001	3,394
Q2 2001	2,102
Source: Venture Economics/National Venture Capital Association

Investment return results for the communications sector, which includes optical networking systems companies, revealed higher highs and lower lows for each period measured. For the one-year period ended June 30, 2001, venture capital funds with a concentration of 60 percent or higher in communications investments lost about 38 cents for each dollar invested. Over the three-year and five-year periods, the returns for communications-focused venture funds were 69.7 percent and 43.4 percent, respectively.

Why the dismal short-term returns? The answer is that there are fewer venture-backed companies being bought and hardly any going public through inital public offerings, the two ways venture investors realize liquidity on their equity investments.

Only four venture-backed companies completed IPOs in the third quarter of 2001, compared to 70 during the year-ago period, according to VentureOne. None of the four was in the optical networking market.

The M&A scene was a little better, but nothing to write home about. VentureOne data shows that about $4 billion was shelled out for 71 mergers and acquisition transactions involving venture-backed companies during the third quarter, compared to the $19 billion that was paid for 94 companies during the year-ago quarter.

Table 2: Largest M&As of Venture-Backed Companies in Q3 2001

Company Name	Industry Segment	Close Date	Post Money Valuation ($M)	Brief Description	Acquirer
Amber Networks	Communications	8/29/2001	$421.00	Provider of optical networking equipment	Nokia (NYSE:NOK)
StorageApps	Electronics	9/24/2001	$350.00	Provider of network storage appliances and software applications	Hewlett-Packard (NYSE:HWP)
Catamaran Communications	Semiconductors	7/31/2001	$250.00	Developer of high-speed communications chips	Infineon Technologies (NYSE:IFX)
Lara Networks	Semiconductors	7/3/2001	$200.00	Provider of high-performance network application processors	Cypress Semiconductor (NYSE:CY)
Versatile Optical Networks	Communications	7/31/2001	$167.10	Designer and manufacturer of optical and optoelectronic modules for core, metro, and access-level networks	Vitesse Semiconductor (Nasdaq:VTSS)
AuroraNetics	Semiconductors	8/23/2001	$150.00	Developer of optimized silicon solutions for Internet infrastructure	Cisco Systems (Nasdaq:CSCO)
Onex Communications	Semiconductors	9/24/2001	$89.00	Developer of ASICs for advanced communications equipment	TranSwitch (Nasdaq:TXCC)
Source: VentureOne

With expectations as low as investment returns, the time to make bets on cutting-edge optical networking technologies is now, in hopes of seeing a return during the market's recovery. "We're investing in risky technologies that will be brought to market between two and three years out," says Greg Blonder, a general partner with Morgenthaler Ventures. "The telecom market has probably skipped a generation [of technology]. Technologies that should have been in networks by now have been delayed."

Another takeaway from all the numbers: It's time to take advantage of the distressed, according to some VCs. With startups shutting down left and right, less expensive alternatives to mergers will become more commonplace.

Valuable intellectual property is being sold as startups enter bankruptcy proceedings; and all-stock reverse mergers, such as the one Cogent Communications Inc. is trying with Allied Riser, are providing a way for private companies to tap the public markets without as much investor scrutiny.

"There's a lot of talk of the M&A market coming back, but no direct evidence," says Blonder. "Investment bankers are making the rounds again -- that's some sign that things might be looking up -- but I don't see a lot of activity." - Phil Harvey, Senior Editor, Light Reading
http://www.lightreading.com