FAIRNESS IS THE PRINCIPLE THAT MATTERS MOST TO ALL

Why VC Investors Shouldn't be too Concerned about a Softening IPO Market
June 19, 2000

It is no secret that the recent round of interest rate hikes combined with uncertainty over the direction of the U.S. economy have played havoc with the public equity markets and made conditions far less conducive to initial public offerings (IPOs). In fact, it wouldn't be an overstatement to say that the roaring IPO market of 1999, especially for Internet stocks, has become something of a distant memory.

For market commentators focusing on the venture capital industry, and for investors in certain venture capital related publicly listed companies, the slowdown in the IPO market has raised some red flags. In this article we would like to explain why a healthy IPO market is considered so important, but also why we believe that - excuse the pun - this concern is a bit of a red herring for many venture capital investors, including those in the meVC family of funds.

The connection between the IPO market and Venture Capital
As most VC investors are well aware, venture capital funds make their investments in private companies which, unlike publicly traded securities, are illiquid assets and therefore not as easy to value or dispose of. As a result, to realize a capital gain on - or "cash out" - of an investment the fund needs to devise an exit strategy. Depending on the success of each particular company, there are a number of ways to accomplish this, of which, an IPO is potentially the most lucrative. Other options include acquisition by another company, secondary buy-outs by other venture capital firms and, under a worse case scenario where a holding fails to meet expectations, liquidation.

In this context a white-hot IPO market such as that of 1999, is extremely beneficial for traditional funds nearing the end of their life, as well as the upstart incubator-type funds, which are relatively new on the private equity investment scene and tend to emphasize Internet companies.

At this point it would be useful to explore the differences between the more traditional VC funds and newer incubator-style private-equity funds.

• Traditional VC Funds - These funds generally have a life of about ten years. Fund holdings usually remain private for a number of years following the initial investment. During this time the venture capital firm becomes directly involved in the management of these companies, offering industry expertise and advice, and helping to patiently build value in the company before either taking it public or selling its stake. Only the most successful investments are taken public.
• Young Incubator-style funds - These funds are a relatively recent phenomenon spawned by the growth of the Internet and Internet companies. The most well-known include CMGI, a publicly listed incubator which specializes in investing in and bringing to market business-to-consumer (b-to-c) and business-to-business (b-to-b) Internet companies, and Internet Capital Group, a similar style incubator company that invests in b-to-b Internet companies. Unlike many more traditional venture capital funds, these types of companies have, until recently, taken their investments public at a far more rapid pace. Driving this increased speed has been the need to make a name for themselves with a notable success in an increasingly crowded field.

But a weaker IPO market will not affect all funds, and for many traditional and well-established funds a slowdown may even be beneficial.

Why some VCs will be more affected than others: What to watch out for
Venture capital funds most likely to feel some impact from a softening IPO market in the near-term include:

• Incubator companies reliant on a vibrant IPO market to generate a steady inflow of capital.
• New venture capitalists with no connections to established traditional venture capital firms, who may feel the need to "grandstand" investments - bring them to market early - in order to establish a short-term track record to attention. "Grandstanding" can have potentially negative effects on a company whose stock subsequently loses ground dramatically and therefore also negatively impact the fortunes of a newly established VC company
• Traditional VC funds nearing the end of their life - although many of these may have already taken the opportunity to "cash-out" while market conditions were favorable, so in our view they are likely to feel the least pain.

Keep your sights on the long-term: Why short-term fluctuations are not relevant to many more traditional VC Funds
In direct contrast to the above categories, a hot IPO market is not particularly relevant to a traditionally managed fund at the beginning of its life, or arguably even a middle-aged fund. *In fact, a strong inflow of funds into venture capital resulting from the attractive returns being generated by a strong IPO market may even hurt these funds in the short-term. , Reflecting the laws of supply and demand, if too much capital is chasing too few interesting opportunities, the cost of investing in these companies may be bid up. In these cases, a slow-down in the IPO market can actually be helpful in lowering expectations during the initial deal process.

Furthermore, while studies often stress the superior gains offered in the IPO market, venture capital investors shouldn't forget that there are other exit options. For example, if a fund holding has a strong product that compliments a product of another firm, a merger or acquisition can also prove to be lucrative. A well-managed fund that successfully nurtures its companies through the challenges of a start-up environment should have many more exit options, including IPOs for the most successful of its portfolio of companies even in a soft IPO market.

In conclusion
We have tried to show in this article that, as with any investment, be it in publicly traded stocks, mutual funds or bonds, not all private equity investments are created alike. Also, it is worthwhile noting that like these other types of investment vehicles, there will be years of extremely strong returns and years where returns are not as good. There will also be well run funds and not so well managed funds.

In this context, while there can be little argument that private equity investing is a very risky proposition, we believe that just because the IPO market has begun to weaken doesn't mean that all investors in private equity funds should be concerned. In our view, investors may even find that the lack of correlation between returns of certain private equity funds and the performance of the equities markets make private equity funds a more attractive proposition for the higher risk portion of their portfolio allocation. As a result, we believe that private equity exposure continues to be a good addition to a diversified investment portfolio.

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There are risks associated with funds whose investments are concentrated in a specific industry or sector. These funds are subject to a higher degree of market risk than funds whose investments are diversified and may not be suitable for all investors. In addition, technology securities tend to be relatively volatile as compared with other types of investments.Past performance does not guarantee future results