Number of VC Firms Soars But Shakeout Expected.

THE number of venture capital firms operating in Los Angeles has exploded in recent years, but out-of-towners have a history of rushing in when times are good, only to pull up stakes at the first signs of an economic slowdown.

During the boom of the late 1980s, for example, a slew of New York and Japanese banks and law firms opened up offices in Los Angeles, only to close them down a few years later when the recession set in.

Is a similar scenario now unfolding with venture capital firms? Possibly so. The number of VC firms in Los Angeles exploded from 13 in 1999 to 47 today, according to a recent report by the Los Angeles Regional Technology Alliance.

Many were hired here by the critical mass of Internet-related businesses, both e-tailers and technology firms. But with a large and growing number of dot-coms biting the dust, a VC pullout could he around the corner.

Jess Reyes, an analyst with Venture Economics, a data firm in Newark, N.J., said he expects the number of venture firms in Los Angeles to decline by at least 5 percent before the end of the year.

"There will definitely be a shakeout in the number of venture firms that operate in Los Angeles," said Reyes. "Firms will have to shut down because of losses sustained from investments made in consumer-oriented online companies, where six out of 10 go bust within the first five years."

Unlike the 1980s, when Japanese banks fled Southern California due to pressure to reduce their overseas capital commitments, the decline of venture firms will be tied to poor investment choices, industry observers noted.

"The venture capital firms are somewhat different because they are pursuing high-risk investments with the expectation that most won't pay out," said Tom Lieser, senior economist with UCLA Anderson Business Forecast. "But with the investments that do bring a large return, firms hope that those investments will cover their losses."

Early casualty

One firm that has already shut down its local office (in Santa Monica) because of the slowing economy is Encore Venture Partners.

Encore, formed in 1999, raised $150 million and invested about $30 million in several fast-growing technology companies, only to close its office earlier this month and abandon its focus on technology.

"The firm decided to give up its technology focus after its primary limited partner, (Dallas-based homebuilder) D.R. Horton, said he wanted to limit future investments to residential real estate because of the stock market's turmoil," said Joe Reece, former partner in Encore's Santa Monica office and now a director in the merger and acquisitions group at Credit Suisse First Boston in Century City.

Encore still operates out of its Dallas office, where it monitors stakes already taken in technology companies. Among those companies are Westlake Village-based Nomadix, which develops and markets equipment for Internet service providers, and Media.net Communications, a Los Angeles-based tech company that offers broadband services to the entertainment industry.

Reece said that other individual investors were willing to continue backing Encore's operations locally, but Horton insisted on pulling out. "So there was no reason to sit around and run a business without capital," he said.

"We wanted to consolidate our business to better manage our portfolio," said Rick Beckwitt, managing general partner in the company's Dallas office. "We are still looking to invest in companies that have a proven track record and potential for revenue growth."

Putting down roots

Other venture firms that found a home in Los Angeles when times were good in the late '90s insist that, despite the slowing economy and limited opportunities, they are here to stay.

"We are an example of an out-of-town company that came to Los Angeles and has no plans to leave," said David Cremin, a partner with Zone Ventures. "There are fantastic opportunities in Southern California."

Zone was founded in 1998 as a Southern California affiliate of Silicon Valley-based venture capital firm Draper, Fisher, Jurvetson. The company specializes in early-stage investments of Internet, communications and wireless companies.

"The cream always rises to the top in these situations," said Cremin. "Those companies that can survive a shakeout will be noticed by firms with money to invest. We are still looking for investments."

Now, with few exceptions, venture firms that remain in Los Angeles are being far more selective about where they invest money.

"Venture capitalists these days want companies to have a feasible business model and an experienced management team in place before they invest millions of dollars of their clients' money," said Doug Achtemeier, vice president and senior portfolio manager at City National Investments. "Venture capitalists are less inclined to jump on an untested idea, which is a good thing. We had too much money chasing too many unsure ideas."

                             Active Investors
                     The top venture capital firms and
                     their amount invested in L.A. and
                     Orange County firms, in millions.
Levine Leichtman Partners        $91
Redpoint Ventures                 81
East West Venture Group           75
Idealab Capital Partners          54
Kline Hawkes & Co.                49
Mellon Ventures Inc.              42
TL Ventures                       27
DynaFund Ventures                 20
Trident Capital                   15
Allegis Capital/Media Technology
  Ventures                        10
Source: Business Journal Research