Milestone Group Quarterly: July 2003
Articles
Investment Viewpoint:
3i CEO Martin Gagen
How does an international venture capitalist see the market? Milestone Group’s Mark Zawacki and Jeffrey Walker sat down with Martin Gagen, CEO and President of 3i US and Asia Pacific and Peter Bollier, CFO of 3i US, one of the largest international private equity firms to explore current market issues.
Milestone: The press enjoys taking shots at the VC community through the recent disclosures of fund performances. Is this leading anywhere meaningful, or is it a passing form of sensationalism?
Martin: We believe the Limited Partners’ interest in performance is valid, but it is being exacerbated by the downturn. It is not going away. As 3i is a public company, we are driven by the requirement to disclose and are not intimidated by this. Individual company performance, which is proprietary, is the hard line for us. Limited partner pressure is increasing on firms and there are no ground rules. The "bright line" is still the same: we stop short at individual company disclosure, as this is inappropriate.
Milestone: What should we expect in 2003 for the venture capital business?
Martin: 2003 is not any easier than 2002, and in a funny way, it is more challenging. There is no indication it is more benign. Two reasons: 1) there are a slew of companies that need refinancing, and 2) many VC’s will be unable to raise more money to fund their portfolio. If there is no respite in the current economic conditions, there will be an increased rate of failure. The inability to raise more money will be the final nail in the coffin. But, the venture capital community knows this already. The whole market is sideways, and for certain firms, it will get worse. Those with money, those with more limited partners...the flagship firms will get stronger.
Peter: There is a likelihood of a long tail on the current condition of portfolio companies. To the extent that the current IPO window remains closed, 2003 is a lot like 2002.
Milestone: Public software valuations are still generally lower than private valuations. Do you expect private valuations to drop further? Or will this difference remain for now?
Martin: It is more probable that private company valuations will fall versus public companies rise. The challenge of building a software company is higher. The old methodology was that a small company had a reasonably low cost of market entry for a new technology and could sell to relatively large enterprises. This assumption is being severely challenged. Large corporate buyers are extremely cautious about the viability of small tech companies going out of business that supply mission-critical applications. The question remains: how do you build a software firm worth $100 million. Even public companies are struggling.
Peter: Private valuations are based on the expectation of how much capital it will take to build a company and for the shareholders to get liquidity. That expectation depresses valuations because investors must be compensated for this risk.
Milestone: What are the biggest challenges in your portfolio in the next twelve months?
Martin: The number one priority for the venture capital community is to drive and to find revenues. An example is the telecommunications venture coalition we formed with Mayfield and Worldview Technology Partners to facilitate a closer working relationship between IBM and our portfolio companies. Cash and financial controls are very much in vogue again. Disciplined spending is not just about cash burn, but about everything from customer acquisition to marketing programs.
Peter: Another area is corporate governance, which is important before a company is acquired or goes IPO. The strength of syndicates is more important. Companies with strong syndicates and strong balance sheets will remain the most promising, and this is why 3i is strong.
Martin: I should not be too negative, however, because the opportunity is very good for companies with a product that solves a pain point and that has a syndicate. There is a great opportunity to get management and get premises, which are cheaper. Further, the competition is in disarray for these good companies. The downturn is not all bad news. Too many companies were feeding from the same trough, so the challenge is finding those select good companies.
Looking anecdotally at 3i’s historic investment returns, many good vintage returns were started during a downturn. The mistake in the last 24 months is to stop and start in the venture business. You could end up with a hole in your future. This is not a black or white game, and this why we keep investing in a stable manner. 3i will not significantly decrease or increase its investing this year.
Milestone: That last comment should get you a few more business plans.
Martin: We should take the next two weeks on Holiday.
Milestone: As an international firm, what do you see in Europe that VC's here could benefit from applying?
Martin: Europe is very fragmented regardless of what anyone tells you. It is multi-jurisdictional, multi-lingual, multi-currency, multi-cultural, and quite hard to market. America, on the other hand, is comparatively easy. Companies that launch in Europe and do well find that launching in the US is relatively easy. One benefit of the US is the attitude to building a business. The market is much more accepting to tech startups and has the right mechanisms in place to do so. The US is a very good place to scale a business; whereas, in Europe, the scaling issues are so difficult. It is no longer an "either-or" proposition. Technology is a global business, yet is funded by regional venture players. This is an interesting disconnect. "Either-or" is the wrong question. The central question is: can you contain a tech company in one region? The answer is you cannot.
Milestone: How do you advise European tech companies right now in this economy about entering the U.S. market?
Martin: They need to be cautious in execution. There are too few opportunities for yet another competitor against local, hungry companies. To cross borders, your technology needs to be quite compelling. Further, European companies have tight budgets and are servicing - as they should be - their existing customers. The dilemma is that while the US is too big a market to ignore, financial constraints make it difficult to service the expansion.
Milestone: On the heels of many failed tech businesses, we are now seeing the closure of firms who served those businesses and most notably a prominent law firm, Brobeck. While we see some rationalization in venture capital, will we see a major VC closure?
Martin: Watch the changed behavior of the LPs, watch the tolerance of the LPs, and watch the ability of the VCs to remain in business. There is a lot of soul searching. If everyone lost money, how do you tell the difference? Even blue chip firms have problems. LPs behavior is the bell weather. LPs will force some out of business. And as you know, some are asking for their money back. Some older GPs are quietly walking out the back door because they see this coming.
Milestone: Are there any lasting changes to venture capital we should expect following the bubble?
Martin: What you will see is the emergence of some truly international VCs who act like corporations. 3i is clearly one, Carlyle is scaling although different from 3i, and Apax is an international brand. It is a reaction to the notion that you need some strength and structure to scale tech companies. This is not just about the downturn because you will see the emergence of a more ordered model with firms that have very good connections into large corporations. One reason IBM likes us is because we are a corporation. Many VC’s are not sympathetic to this. There will also be an emergence - like in the 70’s - of tiny partnerships that are just very smart guys. The guys I fear for are the ones in the middle. Why would an LP or an entrepreneur bother with them?
Milestone: If you had to invest $10 million in a competitor’s fund, which one?
Martin: If not one of the top tier venture firms with a clear focus on the US market then my answer would be - Lip-Bu Tan at Walden International has a very methodical view of the Chinese market. It’s not risk free but I’m a VC. It’s a ten-year bet.
Milestone: If you weren't a VC, what would you be doing?
Martin: Open a guitar shop in Santa Barbara, California with up-market, rare, vintage guitars on one side, and cheap combos on the other side.
Peter: One third with my family, one third volunteering, and one third doing deals.
About 3i
3i is a leading international venture capital company with U.S. offices in Menlo Park, CA and Waltham, MA. Operating since 1945, 3i has invested worldwide over $24 billion, including co-investment funds, with a total staff of 800 employees operating out of over 30 offices in 14 countries. 3i leverages this worldwide presence to add value to its portfolio companies and investment partners. In the United States, 3i concentrates on early and late stage technology investments in companies with the potential to be leaders in their markets. Outside the USA, 3i invests broadly in buyouts, growth capital and venture capital.
Since opening its US businesses in 1999, 3i has become one of the most active early and late stage VCs in the US. Recent investments in early stage companies include SiGe Semiconductors, Cometa Networks, Bitfone, Knowmadic, Sonim and OmniGuide. 3i has been equally active on the late stage, with recent investments in Skystream Networks, Placeware, AppShop, Top Layer and SCP. Visit 3i and its portfolio at www.3ius.com.
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