VCs wait for a new dawn

With the national economy in a deep recession and the Obama administration putting billions of dollars into recovery and bailout programs, venture capital firms are simultaneously cautious about new investments and guardedly optimistic about the future.

Venture capital investments in Washington, D.C., area companies fell from $1.27 billion in 2007 to $1.014 billion in 2008, reversing a four-year trend of steady if unspectacular growth, according to "The MoneyTree Report" by PricewaterhouseCoopers LLP and the National Venture Capital Association, based on data from Thomas Reuters.

Nationally, fourth-quarter 2008 venture capital investments declined 26 percent during the third quarter, representing the fewest dollars invested since the fourth quarter of 2005, the survey reported.

“At this point, venture capitalists are doing what everyone else is doing — assessing and reassessing their capital outlays and each and every investment carefully in order to make prudent decisions on what companies have the brightest outlook for the long term,” said Tracy Lefteroff, global managing partner of PricewaterhouseCoopers’ venture capital practice, in releasing the report.

John Hurley, senior executive in the Venture Pipeline Group at law firm DLA Piper US LLP, echoed that sentiment. Venture capitalists are being more cautious than normal in making investments, he said. “They have dry powder to invest, but they’re not necessarily going to pull the trigger very quickly.”

Also, they are probing deeper in researching potential investments, “basically [conducting] twice or triple the amount of scrutiny you would think about in the past,” Hurley added.

Going slow

“About 90 percent of VCs are playing defense now,” said Michael Coppa, a principal at the Merrill Advisory Group, a McLean, Va., consulting company for defense, government services and homeland security companies. “Very few are looking at new opportunities,” he said, adding that they are conserving their cash and trying to keep their existing portfolio companies as healthy as possible.

“In our case, that’s not necessarily true,” said Mark Levine, managing director of Core Capital Group, a venture capital firm that invests in information technology, software, data center and wireless technology.

“Our companies had a pretty robust and healthy fourth quarter,” Levine said. “It’s been a pretty steady performance by our portfolio.”

Levine said his fund is seeing some tremendous investment opportunities. “We like buying when prices are reasonable, [and] prices are reasonable today,” he said. “Actually our pipeline is quite full, we’re looking at quite a few deals.”

Industry experts say venture capitalists are not likely to invest in government services companies or in those that are focused solely on the government sector. Venture capitalists don’t generally invest in services companies because they are not scalable businesses, even if they have government contracts, Levine said. “We’re looking for businesses that can take equity and leverage them up and basically sell the same thing over and over again.”

Government contractors are niche companies with finite business opportunities, long sales cycles and pressures on profitability margins, Hurley said. “VCs have tended to shy away from those companies.”

Venture capitalists look for companies with technologies that have commercial aspects to them, said Julia Spicer, executive director of the Mid-Atlantic Venture Association, a trade organization that fosters private equity investing in the mid-Atlantic region.

Companies that can provide products and solutions in the commercial and government markets strike a chord with venture capital investors because “there’s a lot of things going on in the [Obama administration’s] stimulus package that has to do with technology, innovation,” she said.

As examples, Spicer cited Sourcefire Inc., a provider of enterprise threat management software; Triumfant Inc., an IT solutions provider; and Trust Digital, an enterprise mobility management provider, as companies that offer commercial and government solutions. All three are portfolio companies of Levine’s Core Capital Group.

“As VCs, when we look at technologies, we’re looking for the best, the best commercialized technologies in the world,” Levine said. “In many technologies, such as security technologies, the government is actually a leader.”

Better mousetrap

But introducing new technology into the government, especially the defense intelligence sectors, is a difficult process, said Mitchell Martin, also a principal at the Merrill Advisory Group. “The better mousetrap is not always the one the government purchases.”

In addition, winning government work requires a great deal of contracting infrastructure and expertise. “That adds substantial cost to these investments and makes them more risky,” he said.

There is a cultural issue involved, too, Martin added. “Many funds simply are not made up of people who are comfortable with government contracting.”

The venture capital model typically is focused on early stage enterprises, which are not usually found in the government services or products sector, Martin explained. “I haven’t seen a VC [solely] in the government space ever,” he added.

Venture capitalists often invest in companies that are market creators, said Joseph Kampf, co-founder, chairman and chief executive officer of CoVant, a private equity partnership. The government is an established market looking for new technologies for which there are many suppliers, he added. “That’s a risky model for a VC.”

“A VC has to find something where they can make a hit,” he said. “They could invest in a lot of things in the government marketplace and not have any hits. It’s entirely possible.”

For example, smaller providers of the innovative technology that the Homeland Security Department is seeking — optical scanning, facial recognition and radio frequency identification solutions, among others — will find an already crowded field of competition, Kampf said. “It’s not like they’re going into a new market or they have a product that is going to create a new market.”

There is always the possibility of a venture capital-funded company inventing the next great thing, Kampf added, “but it doesn’t happen often.”

President Obama’s actions to reverse the economy’s downward spiral are viewed as the source of some light at the end of the tunnel. “The government is still the biggest IT customer in the world,” Spicer said.

Venture capitalists view government IT providers as a continuing pipeline of business because of their strengths in software, telecommunications, homeland security and health care.

Levine cited process technologies, database efficiency, smart computing and energy savings for data centers as among the hot-button technologies the government will continue to seek and buy.

“We’re looking at hardware, software that delivers immediate cost savings,” he said. “We have quite a few [companies] in our portfolio that do that.”