By Rebecca Kaufman and Lynn Scott

Published April 2008–Called a “must-read” by Mark Hessen, president of the National Venture Capital Association, during the NC Council for Entrepreneurial Development’s 2008 Venture Conference: One of the great ironies of the emerging company world is that venture capitalists themselves must raise money. The venture investor who just said no to your deal once sat across the table from another guy (a prospective limited partner), who said “no” to him. More than one fundraising CEO has smiled at that thought over the years.

So what does it take to raise a venture fund? This article explores that issue from a historical perspective, both nationally and with particular reference to those regional venture funds launched over the last three decades still active today in the life sciences sector. It also looks forward, to prospects for first time funds in view of current market conditions.

A little US history
The U.S. venture capital industry originated in the technology boom of the post WWII years. Many of the earliest funds were high-risk, high-return investment partnerships for wealthy individuals and families with such recognizable names as Whitney and Rockefeller.

The first modern venture fund was formed in 1946, when Gen. Georges Doriot, a Harvard Business School professor, co-founded American Research and Development Corp. (ARD). Doriot formed ARD as a public company on the premise that a “venture capital company” could raise money to fund new technologies by selling its own stock to public market investors.

More than half of ARD’s shares were owned by insurers and educational institutions, including MIT and the John Hancock Mutual Life Insurance Co. With $5 million in hand, ARD made a series of high-risk investments in emerging companies. Although it struggled for at least a decade, ARD ultimately delivered solid returns to investors, based largely on the success of two key technology deals. Doroit’s impact on the nascent venture capital industry wasn’t limited to ARD; in his continued role with HBS, he influenced the next generation of venture capitalists and entrepreneurs. As a result, he is widely regarded as the “father of venture capital.”

The passage of the Small Business Investment Act of 1958 further spurred the development of the venture capital industry. Concerned with the growing technological advancement of the Soviet Union, the federal government created the Small Business Investment Co. (SBIC) program within the U.S. Small Business Administration (SBA).

The legislation allowed SBA-licensed SBICs to borrow money from the federal government at favorable interest rates to leverage their private capital three-to-one and later, four-to-one, so $1 million became $4 million courtesy of the U.S. government. A number of non-SBIC funds also formed, not subject to certain restrictions (e.g., size) imposed by the SBIC program. Collectively, these funds were among the first professionally managed venture funds.

Unlike ARD, most of these funds were not public companies. Instead, they were private partnerships, which raised investment capital from wealthy individuals and their families, as well as public or private business entities controlling large sums of capital, such as banks and other financial institutions, insurance companies, pension funds and large corporations. These investors would typically allocate a small percentage of the capital under their control to relatively high-risk venture capital, as a way of diversifying their holdings.

Under the preferred structure, each investor would serve as a limited partner in the fund by committing a certain amount of capital. A fund would have anywhere from just a few to as many as 100 limited partners. The fund would then be invested by the professional fund manager, also known as the general partner.

Each fund had a given “lifetime” (typically 5-10 years) during which it was expected that all investments would be made and returns generated. Venture-style returns (historically, averaging 15-25 percent but sometimes far greater) were typically generated by public offerings or acquisitions, which would permit investors to liquidate their holdings. Funds that produced superior returns would find it relatively easy to raise their next fund from the same or new limited partners.

Sometimes, fundraising for the next fund would begin before profits from the first fund (or even committed capital) had been returned. In return for raising, investing and managing the funds, the general partner would collect a management fee (typically 2 percent) and, once the invested capital was returned to the limited partners, a share of the profits—together with the limited partners.

The funds were typically used to invest in new and rapidly growing private companies, in which the venture fund would take stock. In the late 1960’s and early 70’s, disproportionate number were located in Silicon Valley, where the success of Fairchild Semiconductor in consumer electronics and commercial computers post WWII spurred remarkable entrepreneurial efforts.

More than sixty semiconductor companies were formed in the area from 1961-1972, including Intel, National Semiconductor and Advanced Micro Devices, almost all by former Fairchild engineers and managers. The rapid growth coincided with the emergence of the local venture industry, including the launch of the now legendary Kleiner, Perkins, Caulfield and Byers in 1972 and the various other funds that would locate on Sand Hill Road, now synonymous with the venture industry. For a time, venture capital was all about technology investing.

Shadow over the industry

The combination of an extended slump in the public markets and new legislation limiting the willingness of pension funds to invest in anything high risk, including venture capital, cast a shadow over the industry in the 1970s. It was short-lived, and the situation improved in the late 1970s because of changes in legislation and capital gains tax rates. In the new, favorable climate for high-risk equity, the venture industry raised approximately $750 million in 1978.

At this point, funds had much greater participation from institutional investors, particularly public and corporate pension funds. In fact, by the 1980s, wealthy individuals and their families accounted for less than 10 percent of funds invested in venture capital. The shift was prompted in large part by increasing fund size. Larger funds typically required larger commitments from individual limited partners—often out of reach for even the wealthiest individuals.

The 1980s was a breakthrough decade for the venture capital industry. A favorable fundraising environment for venture capitalists was paired with an open public market. Capital under management grew from just over $4 billion in 1980 to more than $34 billion by the end of the decade, managed by an ever-increasing number of funds.

It also marked the arrival of a new sector for venture investment, biotechnology, based on the development of recombinant DNA technology in the mid-1970s and the formation of Genentech in 1976. As the venture industry grew, it continued to cluster geographically in technology-rich areas, including California and Massachusetts.

Against this backdrop, the Southeastern venture capital industry was born.

1982: emergence of the Southeastern VC Industry
Noro-Moseley Partners (“NMP”) (Atlanta, GA) is considered the Southeast’s oldest venture fund. In 1980, founding partner Charlie Moseley, a Georgia Tech graduate, was a Senior Vice President and Director of The Robinson-Humphrey Company, Inc. (“R-H”), a regional investment banking firm serving a technology-heavy client base. Moseley saw how important it was for R-H to be physically close to these companies, as were the Silicon Valley venture firms.

“I thought there was a need for venture capital in the Southeast to duplicate what R-H was doing in investment banking,” says Moseley.

When R-H was sold to American Express in 1982, the timing seemed right. Wally Holley, a founding partner with Interwest (San Francisco, CA) who had participated in some transactions with R-H, made some key introductions for Moseley, including a key limited partner, to help raise NMP I. In 1985, former King & Spalding partner Rusty French joined the fund, ultimately making many of its investments in the life sciences.

Moseley describes fundraising process as “much easier” when the team hit the road a second time in 1987. Yet, he describes one presentation that momentarily shook his faith. Moseley was in Chicago, giving a presentation to a group of prospective investors when he noticed that people in the audience kept leaving the room and coming back, looking worried. He was afraid that their level of distraction might reflect disinterest in the second fund. As it turned out, the date was October 19, 1987 or “Black Monday,” the largest one-day percentage decline in stock market history.

Intersouth Partners established

Intersouth Partners was established just a few years after NMP, in 1985. Founding partner Dennis Dougherty was at the time a partner with Touche Ross & Co. (now Deloitte & Touche), where he was responsible for the high growth business practice. Dougherty spent time traveling with clients seeking venture funding to funds located in California and Boston, where the investment opportunity was typically met with interest but premised on the relocation of the company.

Dougherty figured that if there were so many RTP-based companies in need of venture money, there would sufficient deal flow for a local venture fund. Together, Dougherty and his co-founder, Roy Rodwell, who also had a background in accounting and investment banking, reached out to Duke University.

At the time, Duke was the only endowment in the Southeast with experience investing in venture funds. Duke was attracted to the premise that a fund located in and focused on the region would spur economic growth, and committed an initial $500,000. Duke’s biggest concern was the Intersouth founding team’s lack of venture investing experience, but helped the team in that regard with a key introduction to Eugene Kleiner, founder of Kleiner Perkins, who joined Intersouth as a special limited partner. “We were really in the right place at the right time on that one,” observes Dougherty.

With Duke in for half a million, the Intersouth team still had a long way to go. The fundraising process took more than 15 months, during which Dougherty estimates the team took more than 300 meetings, primarily with high net worth individuals or angels but with some institutions in the mix. “We took money from anyone who breathed,”

Dougherty notes with a laugh. At the end of the process, Intersouth had 15-20 investors committed for a total of just over $6 million. “It seemed like forever,” Dougherty says now.

The biggest concern among potential investors in that first fund, apart from the team’s relative experience investing, was deal flow in the region, says Dougherty. “People thought there would be too much money chasing too few deals,” he says. Intersouth II followed in 1989, with the addition of partner Mitch Mumma, and met with similar resistance. Dougherty describes the viewpoint as “California bias,” recalling a meeting with an advisor to a California pension fund, in which the advisor expressed disbelief that anything could be invented first in North Carolina. The second fund, like the first, relied heavily on angels.

The year 1988 also marked the launch of the Wakefield Group (RTP, NC; Charlotte, NC), a venture fund that targets growth companies in a variety of sectors, including life sciences. Wakefield is unusual among the other SE funds, in that its entire $100 million in assets were provided by one investor, Charlotte billionaire C.D. Spangler, a retired businessman and former president of the University of North Carolina.

Early 90s marked by downturn

The early 90s were marked by a downturn in enthusiasm for the venture capital asset class, and institutional investors pulled back a bit. Total funds raised by the industry in 1991 hovered just over $2 billion. The slowing was only temporary, however, and by 1993, things picked back up, with the total closer to $4 billion.

In the Southeast, nearly 8 years after its founding, Intersouth raised a truly institutional fund, ISP III. By now, the team had a track record to point to that included several IPOs and other successful exists for its portfolio companies. Noro-Moseley continued to grow and launch follow-on funds. But as the technology and life sciences economy grew, the need for additional sources of venture funding in the region remained.

New to the scene was Alliance Technology Ventures (Atlanta, GA), formed in 1993. Founding partner Mike Henos had prior experience in venture capital as a general with Aspen Venture Partners (CA) and 3i Ventures (CA). Henos had also spent time as a consultant with Ernst & Young, specializing in venture financing of start-up medical technology companies. Alliance made key early investments in AtheroGenics and Inhibitex, spurring the growth of the Atlanta life sciences community.

In 1994, The Aurora Funds (RTP, NC) were established. Co-founder Jeff Clark had spent more than a decade working in development and external affairs for Duke University, with significant fundraising responsibility. Co-founder Scott Albert had been in the venture industry for nearly a decade, most recently as Chief Investment Officer of the North Carolina Technological Development Authority, Inc., and previously with Criterion Venture Partners (Houston, Texas) and Golder, Thoma and Cressey (Chicago, IL).

Clark felt there was still a significant funding need for early stage venture funding for life sciences and technology companies. He and Albert “jumped into the fray,” hitting the fundraising trail in earnest.

“I couldn’t have done it without Scott,” he notes, explaining that Albert’s experience in the industry was key to prospective limited partners. Together, they took more than 600 meetings over the next year, ultimately raising a first $6 million dollar fund from about 40 investors. The fundraising trail is “not for anybody with self-esteem issues,” observes Clark with a laugh.

A. M. Pappas & Associates (RTP, NC), which manages the venture capital funds known as Pappas Ventures, was formed in 1994– initially as an advisory merchant bank. Founder Art Pappas brought more than 20 years of operating experience in the pharmaceutical industry and in the international markets to the role, which included senior positions with Merrell Dow Pharmaceuticals, Abbott Laboratories and Glaxo. The company worked on a number of early projects, into which they invested and also had risk-sharing arrangements.

One such project included Quintiles Transnational Corporation where Pappas assisted the company in setting up its first CRO operation in East Asia in Singapore. In 1996, Pappas assisted Canadian pharmaceutical giant Biochem Pharma to establish a Montreal-based genomics venture capital fund and then became the investment manager for the fund, serving as its U.S. advisor. It would still be several years, however, before Pappas formed its own proprietary fund.

HIG Ventures, now one of the largest and most active regional funds, also began life in a slightly different form in this time period. In 1993, the first HIG fund was launched as a $73 million hybrid leverage buy-out (LBO)-venture fund, drawing on the backgrounds of its two founding partners. Even today, HIG remains fairly unique in the region as part of a larger, private equity firm.

After hovering in the low single digit billions for nearly a decade, investor interest grew dramatically in the period from 1995-1998, as new capital invested in venture funds grew from $10 billion to just over $30 billion.

In the Shadow of the Bubble: the late 1990s-2000
The turn of the century was marked by record stock prices and public market frenzy largely centered on the high-tech world. Venture money poured into the emerging company sector, including the life sciences, and the public markets promised lucrative exits.

A lot of money also poured into venture capital, driven by record returns, with the average one-year return close to 150 percent in 1999, according to Venture Economics. Both the overall number of funds and fund size had grown dramatically. In the period from 1999 to 2001, a record $200 billion went into venture capital, more than $100 billion of it in 2000 alone, a dramatic increase over the period just ten years before.

A record 40 percent of all venture funds completing successful fundraising in 2000 were first time funds.

Reflecting that national trend, the number and size of funds based in the region also grew. Among the new funds was the first proprietary Pappas fund. Launched in 1998, the new fund leveraged the team’s advisory experience and its role with the Montreal fund.

The Pappas fund was unique among the regional groups because many of its limited partners were strategic investors, including large pharmaceutical companies and contract research organizations. Institutional investors responded positively to the presence of the strategic investors, and the first fund was raised fairly quickly.

The fund was also positioned as a national fund, deploying about a third of its capital in California and a third in the Northeast. “We began with a national mandate,” explains founder Art Pappas, “which was unique in the region at the time.” That national focus meant that Pappas had access to different deal flow and syndication relationships.

Unlike many of the other funds based in the region, which served both the life sciences and technology sectors, Pappas invested exclusively in the life sciences.

HIG’s hybrid 1993 LBO-venture fund was a success, prompting limited partners to push to put more money to work. Uncertain they could manage a large amount effectively, the founding HIG team decided in 2000 to split off the venture fund as a separate vehicle. The first dedicated venture fund totaled $255 million and included several life sciences investments.

New funds launched
Other funds launched in this time frame include Atlanta-based Cordova Technology Partners (1997), a first time fund under the existing Cordova Ventures umbrella, and a number of NC-based funds including Eno River Capital (1998) and Research Triangle Ventures (2000).

Funds were also launched in new locations, including Tall Oaks Capital (Charlottesville, VA) in 2000. Members of the founding team had worked in operational roles with companies and investors across of variety of industries, and each had considered the possibility of forming a fund on their own.

“There wasn’t a base of what I would call organized capital in our area that was really focused on early stage investment opportunities, so collectively we agreed as a group to combine our interests and form an investment fund,” says co-founder Kathy Carr.

The group was approached by Village Ventures, at that time establishing a business model in which early stage venture funds would affiliate to provide for collaboration, co-investment and administrative cost sharing. “The added value of a nationwide network of resources helped confirm the value of the VVI model for us,” says Carr. “That affiliation and our respective networks helped organize Fund I.”

Follow-on funds continued to grow in size, reflecting the national trend. Alliance’s second fund, raised in 1998, was much larger than its first at $75 million. Intersouth VI closed at $175 million. In 2000, NMP announced the closing of NMP V, a $320 million venture capital fund, the largest ever in the Southeast.

The Bubble Bursts: 2001

While the venture industry had experienced ups and down in its relatively short lifetime, The internet bubble, and its ultimate burst, had a dramatic impact on the venture capital industry.

Looking back, many characterize the exuberance of the late 1990s and early 2000 as unsustainable, with too much money pouring into the industry and too few quality deals to support it. Returns were uniformly poor, and capital dried up. Many venture capitalists simply held off raising money while they struggled to manage losses across their existing portfolio companies. The industry hit bottom in 2002, when venture capitalists raised just under $4.0 billion. Compared to the $100 billion raised in 2000, just two years prior, it was a virtual wasteland.

In the post-bubble world, the prospects for a first time fund were pretty dismal. For the founders of the fund now known as Hatteras Ventures (RTP, NC), it was born of necessity. Co-founders Clay Thorp and John Crumpler, both experienced entrepreneurs, had recently launched the RTP-arm of Atlanta based Catalysta Partners, a technology consulting company.

They realized quickly that a venture fund would be an excellent companion piece. They positioned what was then known as Catalysta Ventures as a “company formation fund,” which would form and provide early management for the companies in which it would then invest, on the premise that a properly formed company, managed by experienced entrepreneurs from the outset, would have a much better prospect of attracting follow-on investment.

Together, Thorp and Crumpler raised close to $2 million for Catalysta Ventures when it closed in September 2001. Investors included high net worth individuals, a bank and the North Carolina Biotech Center. A companion fund, known as Catalysta-Cooper, represented the investment from a hedge fund limited partner who was prevented, by charter, from investing in anything other than healthcare.

“We thought about raising more,” says Thorp, “but realized that we really just wanted to get started with the work of the fund, forming and managing young companies.” As for the focus on high net worth individuals, Thorpe comments that the team really never considered going to a broader audience, like the endowment community, noting the team’s relative lack of venture experience. “We really just went to the people we knew professionally, with the thought that they would understand the value we brought to a company formation-focused fund.”

Turning a Corner: 2003-2007

Some positive developments in the public markets began to turn things around in 2003, and investors once again became less risk-sensitive. More than $10 billion in new capital flowed into venture funds, exceeding 2002s record low but still far shy of the 1999-2001 bubble. The Southeast did very well, with Aurora closing its largest fund to date in 2003 at $85 million, exceeding its original $75 million target, and with Intersouth’s Fund VI breaking the $200 million barrier to close at $205 million.

HIG launched a second dedicated venture fund in 2004 totaling $300 million. Shortly thereafter, partner Aaron Davidson was recruited from Ventures West to oversee HIG’s expanding life sciences portfolio, bringing additional focus and expertise to the sector.

The third Pappas fund was raised in 2004 and proved more challenging to raise than the previous two.

The fund had begun to shift its focus away from strategic investors to more institutional investors and found it slower going than they had expected.

“By the time you reach a third or fourth fund,” says Art Pappas, “limited partners begin to look critically at the continuation of your institutional investor base and they focus sharply on organizational dynamics and succession planning. Some of our institutional limited partners also began to change their relative commitment to the venture asset class.”

Pappas found itself on the receiving end of a shift in investment strategy by a couple of limited partners — who dropped out at the last minute, taking everyone including Pappas by surprise. Pappas points out that… “at the end of the day we had a very strong experienced team, and going through this transition has made us an even stronger venture capital firm, introducing new top quality institutional investors while continuing to expand participation of unique key strategic investors in our limited partner base.”

Hatteras II, also raised in 2004, was fairly unique as it was actually a $35M investment in HBM BioCapital, to which Hatteras then served as an investment advisor. HVP II included $30 million from the Golden LEAF Foundation, established by the state of NC to manage half of the state’s portion of the national tobacco settlement. New to the Hatteras II team was Ken Lee, former co-head of the International Life Science Practice at Ernst & Young.

Smaller funds form in post-bubble world
Other, smaller funds were also formed in this post-bubble world. Golden Pine Ventures (RTP, NC), a seed and early stage fund launched in 2004. Founding partner Chris Meldrum was the former Director of Corporate Alliances for Paradigm Genetics.

He had also worked in academic technology transfer, and in both settings, had seen technologies in need of management and funding at the very earliest stages. His father, Peter Meldrum, had launched a similar small fund 20 years before, which included an investment that would ultimately become Myriad Genetics, which the senior Meldrum later joined and currently serves as CEO. It made sense to try something similar in North Carolina, says Chris, so after talking about it for several months, he hit the fundraising trail.

Although the total was not announced, the fund closed after approximately 3 months with commitments primarily from high net worth individuals. The senior Meldrum joined the fund as Chairman. Chris Meldrum was joined in the management of the fund by Ian Mehr, who brought experience in business development with Qualyst, Paradigm Genetics and LabCorp. Much like Catalysta Ventures/Hatteras I, the Golden Pine fund is focused on company formation and early stage management.

As a result, it has made investments more slowly than a typical early stage fund. Enthusiastic about the undertaking, Meldrum is quick to point out that raising and managing a small fund of this type is “really hard work.”

Georgia also became home to a smaller, seed stage fund in 2004. Georgia Venture Partners was launched with the dual goal of creating fundable companies and supporting development of the life sciences industry in Georgia. Limited partners included Emory University, the University of Georgia and the Georgia Institute of Technology Initial investments are between $100,000 and $500,000, with a total investment in a single company of $1 million.

GVP’s general partners also served as advisors to the State of Georgia Bioscience Seed Fund, established in 2000 by the Georgia State Legislature as a separate source of capital for companies that have already attracted investors.

For a small fund, GVP was unique in the depth of industry experience of its general partners, John Richard and Tom Callaway. Richard had significant prior, executive level experience in the biotechnology industry, while Callaway brought experience in business development and management recruiting.

Atlanta is also home to Arcapita Ventures, launched in 2004 as a $200 million venture capital fund targeting growth and expansion stage companies. The average early stage life sciences company isn’t a good fit for this fund type, but Arcapita has invested and will consider investing in early stage deals including medical device companies. Arcapita is led by industry veteran John Huntz, formerly of Fuqua Ventures.

Like HIG Ventures, the Arcapita venture fund is part of a larger company, which in Arcapita’s case includes corporate, real estate, asset-based, and venture capital investment businesses.

For the next several years, dollars raised by the venture industry continued to increase, going from $19 billion in 2004 to just over $34 billion in 2007. Hatteras announced the close of a third fund (HVP III) in 2007, an $83 million seed and early stage fund, with general partners including Bob Ingram, former CEO of GlaxoWellcome and vice chairman pharmaceuticals for GlaxoSmithKline, and Doug Reed, M.D., a 13-year venture capital veteran.

Average funds size continued to grow, averaging $175.6 million by 2006 according to the National Venture Capital Association (NVCA). In the Southeast, the historical leaders continued to have fundraising success. Intersouth VII, which is presently investing, is a $275 million fund closed in 2007. The seventh fund reportedly took fewer than three months to raise, and actually exceeded the original goal of $250 million.

NMP, however, has paired back from its record-breaking $320 million Fund V, announcing a $107 million first close on NMP VI in June 2007, targeting a $200 total that NMP has estimated will close later this year. A number of the original team members have since retired and will not play a role in the new fund.

What Lies Ahead: 2008 and Beyond
One thing that seems clear is that despite overall economic uncertainty, venture capitalists are continuing to raise significant amounts of money. According to Thompson Hine and NVCA, 235 venture capital firms raised $34.7 billion in 2007. The dollar figure raised some eyebrows, given that it’s the highest level of investment seen since 2001.

Yet, it’s going into fewer and much larger funds than ever before. Industry veterans predict further consolidation, as funds formed during the internet bubble reach the end of their 7-10 year life cycle. Some that struggled have now pulled through, but others who failed or simply never attempted to raise follow-on funds will shut down completely. A number of Southeastern funds raised in the late 1990s fall into this category, not so politely referred to as the “living dead.”

As new funds emerge, and others fall away, the Southeastern venture capital landscape will continue to evolve. Will new funds continue to emerge in our midst? While a number of new funds have been raised in recent years, the odds are stacked against it, as the ratio of follow-on to new funds was approximately 3 to 1 in 2007.

More fundamentally, the path established by NMP, Intersouth and others– raising a first time $5-6 million fund and growing over time to a follow-on $200-300 million fund, is tough going. “If you want to sign up,” says Jeff Clark, “you’ve got to be willing to go a full year with no salary, then, if you’re successful, live off of 2 percent management fee on $2-6 million.”

Clay Thorpe characterizes the model as “unsustainable.” Apart from the economics of small funds, observes Clark, venture capital is really a mentoring business. It’s very difficult, he says, to become a venture capitalist de novo. He does see some opportunity, however, for a group of seasoned entrepreneurs to make the transition to first time venture capitalists.

Assuming one can raise a very small fund, and survive the “Oodles of Noodles” phase, successful transition to a truly institutional fund is the next hurdle. Here, solid, early exits from the first fund or two are generally necessary.

Historically, many of those exists will be IPOs and those opportunities will depend heavily on the overall condition of the public markets– something that is very difficult to predict or control. Put another way, it’s not enough to be good, you’ve also got to be lucky.

On a positive note, venture capital veteran Dennis Dougherty observes that the statistics prove that first time venture funds actually do very well. The partners tend to be hungrier, he says. Plus, today’s first time funds don’t have to overcome the “California bias,” as the region is increasingly known as a source of technology and fundable companies.

“Regional funds have actually come into vogue in recent years,” Dougherty observes. For a region like the Southeast, that has to be good news.

Rebecca (“Becky”) Kaufman is Chairman of the Marketing Committee of Southeast Bio (SEBIO). Both Becky and Lynn Scott are partners in the Atlanta-based law firm of King & Spalding.

 

Southeast Venture Conference, February 29 – March 1, 2012 at the Ritz Carlton in Tysons Corner, VA – Where Smart Money Meets Smart People.
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