Turnaround Specialists to Make Their Case to Venture Firms’ LPs

IS TENDING TO AILING COMPANIES AWISE USE OF VCS’ TIME?

By Russ Garland

Turnaround specialists, saying that VCs are too slow to deal with marginal companies, are suggesting that venture firms let them take charge of a bunch.

VCs are cool to the suggestion. “I don’t think we need to have anyone on a wholesale basis telling us what to do with a company when they don’t know as much about it as the directors do,” said C. Richard Kramlich, a general partner at New Enterprise Associates, Reston, Va.

But dismissing the idea might not be easy. Two turnaround firms say they will take their case to limited partners who, facing big loses in their portfolios, might be ready to tell GPs to take some help.

“I think that a lot of these guys are in denial and still have hope,” said George W. Macintyre, chief marketing officer of Regent Pacific Management Corp. “The only way it’s going to work on a large scale is to get more pressure from the limited partners.”

Stressing the need for fast action, Gary J. Sbona, Regent Pacific’s chairman and CEO, described the venture capital industry as being “on fire.”

His 30-year-old San Francisco firm and the newly minted Charlespoint Group LLC, Boston, are leaders of the drive to persuade venture firms that they have a bigger problem than they think. Dot-com liquidator Sherwood Partners Inc., Los Angeles, also is looking for a piece of the action, but with a different approach. Others are bound to join the hunt for new business.

An Undercurrent of Concern

While venture firms assert that their own portfolios are largely problem free, there is an undercurrent of concern in the industry about the sheer number of venture-backed companies that might not survive the year. There is no IPO market, many acquisitions are fire sales, and attracting new investors is dicey unless a company is a strong performer.

Of the 2,536 IT companies initially financed in 1999 and 2000, 22.9 percent have already failed, versus 15.7 percent of those that were first backed from 1992 through 1998, according to VentureOne data. (See table below.) What’s also significant is the large number of 1999- and 2000-vintage information technology companies that are still private – 1540. That’s more than twice the number from the prior seven years. The IPO market will have to stage a recovery beyond anyone’s wildest dreams to make much of a dent in the inventory.

Mr. Sbona and John Dexheimer, a venture investor and technology advisor who is one of the founders of Charlespoint, contend that VCs would be better off leaving their problem children to professionals who are used to dealing with them. Regent Pacific’s Mr. Macintyre said, “I believe that many of these companies that are going to die a natural death could be saved, or at least they could be shut down in a way that does not wreak havoc on the industry as a whole.”

Of course VCs have already shut down many IT companies —559 from July 2001 through the middle of last month, according to VentureOne. Those companies had raised $13.9 billion in equity. The median raised was $13.5 million and the median time since their last round was 1.5 years. Seventy-three percent of these companies were shipping product when they failed.

Venture investors also say that many of their remaining companies have slashed spending and are concentrating on getting to positive cash flow with little or no new financing. And they appear to be more willing to consider merging companies or arranging an acquisition that will at least recoup some of their investment.

The issue is whether VCs are really adept at this sort of thing, and, perhaps more important, whether it is the best use of their time as opposed to investing in a new generation of startups.

Over the years, some venture firms have called on a handful of firms such as Regent Pacific to fix poorly performing technology companies, usually by bringing in a CEO and chief financial officer with turnaround experience. traditionally these have been one-shot deals. Venture firms on Regent Pacific’s list of clients includes NEA as well as Canaan Partners, Rowayton, Conn., Matrix Partners, Waltham, Mass., Oak Investment Partners, Westport, Conn., and Kleiner Perkins Caufield & Byers, Mayfield, Sequoia Capital and U.S. Venture Partners, all of Menlo Park.

But within the past two years, Mr. Sbona said, about 10 venture firms, which he declined to name, have hired his firm to review their portfolios. While this had led to some individual projects, Mr. Sbona said, only one firm has asked Regent Pacific to deal with a group of companies—eight in this particular case.

Mr. Kramlich said that while NEA has used Regent Pacific to handle specific companies, it has no plans to hire the firm or any other outsider to review its portfolio.

Mr. Dexheimer, who has worked with Regent Pacific in the past, is prowling the East Coast trying to persuade venture firms to entrust his Charlespoint Group with a portion of their portfolios. So far, he said, firms have been willing to listen to his pitch, but no one signed on. He is, however, talking to a corporation about its venture portfolio. He said he has turned down smaller projects to avoid being distracted from his main goal. Charlespoint’s payoff would chiefly be success fees or equity in surviving companies.

Sherwood Partners, which has garnered a lot of media attention for its liquidation work, claims to be developing a more holistic approach to working with venture-backed technology companies, said founder and President Martin D. Pichinson. He said he is expanding his firm from 25 to 40 employees, including a psychiatrist who specializes in corporate issues.

Sherwood is looking for referrals from VCs and would take a success fee in cash or equity from the company. The business is evolving, Mr. Pichinson said, but the key is that venture firms need him so that partners can spend their time more productively by letting Sherwood guide some of their toughest cases. “We’re building more time to get things done,” he said.

Within the last month, Mr. Pichinson said, venture firms have begun asking Sherwood to take a look at their portfolios.

Covington Associates LLC, a small M&A shop in Boston, has also found venture firms more open to seeking outside advice. Partner Benn Dunn said that recently a couple of firms have asked Covington to look at their portfolios “with the viewpoint of getting an outside opinion.”

Unlike Regent Pacific or Sherwood, which charge for such service, Covington did it without charge, and made recommendations on a number of companies. No business has resulted from this so far, Mr. Dunn said. One challenge is persuading co-investors to take action. “That’s a longer process for the VC to build a consensus,” he said.

Mr. Dexheimer acknowledged this hurdle but said that if simple persuasion fails, term-sheet provisions often have the potential for breaking deadlocks. “There are usually some clauses and ability to work the investor group and the company,” he said.

As 2002 fund reports start landing on limited partners’ desks this spring, Mr. Dexheimer said, general partners will find themselves under more pressure to seek outside help managing their portfolios.

The turnaround specialists have a message VCs might not want to hear, but it’s worth listening. It’s one thing to be slow at doing new deals because you think the timing or technology is wrong. It’s another to be avoiding them because you’re too busy.