Waiting for the Flood.

LOCAL VENTURE SPENDING IS WAY DOWN AS INVESTORS BIDE THEIR TIME WAITING FOR SIGNS OF A TURNAROUND

EVERYBODY'S seen the numbers: Venture capital investments in Los Angeles have fallen dramatically over the past year, just as they have in Silicon Valley.

Not for lack of funds, though. There's plenty of money at the ready, waiting for the VCs to draw down. When the right conditions return, it'll come back into play with a vengeance.

"There's going to be a flood, because there's so much money sitting on the sidelines," said Jay Turo, co-founder of Growthink Inc., a venture capital consulting firm in Venice.

VC activity has fallen to one-fifth of last year's level, but there are literally billions of committed dollars at the call of L.A.-based venture capital firms.

Redpoint Ventures might have the biggest pile of ready cash in Los Angeles, with $1 billion of the firm's latest fund yet to be deployed. That fund, launched in October 2000, will take about three years to invest, estimated partner Brad Jones. Redpoint's first fund, launched in October 1999, raised $600 million and was fully invested in one year.

Another local firm with plenty of cash is Rustic Canyon Group of Santa Monica. "We started out with $550 million in October 1999 and we haven't even invested half of it yet," said Managing Partner Tom Unterman.

What are VCs waiting for? In a word, Nasdaq.

For venture capitalists, the ultimate goal is a glorious IPO on the nation's stock market of choice for growth companies. But with the exception of health care, the IPO market is in the doldrums, leaving VCs without a reliable exit strategy for their investments. In the technology sector, where the IPOs came fast and furious in the late '90s and early 2000, some Nasdaq-listed companies are selling at 75 percent to 90 percent below their last-year highs.

"Unless there's a conviction that the IPO market in particular has returned, there's not going to be (a pick-up in deal-making)," said George Abe, venture partner with Palomar Ventures in Santa Monica.

In the meantime, the new watchword among VCs is patience.

"There was a phenomenon last year where you felt you had to work quickly to make a decision or someone else would," said Jones. The current climate is closer to the historical norm, "with the exception being the past couple of years," he said.

Volume plummets

The volume of venture capital activity has been in a quarter-over-quarter tailspin all year. But each quarter, the rate of decline has been less -- leading some to suspect that the worst may be over.

"We're expecting about a 15-to-20-percent drop in Q3, compared with Q2, much of that because VC activity is always slow in July and August," said Dave Lavinsky, president of Growthink, who expects the downward trend to reverse in the fourth quarter.

For now, venture capitalists are biding their time. The "right" deal still can get done, but investors are taking their time before plunging in. There's been a return to fundamental evaluations -- revenues, cash flows, real markets, strong management teams -- which went on hiatus during the go-go days.

"For our fund, while the quantity of deals is down dramatically, the quality's up. We think that has significance in that the true entrepreneur is left standing, not the opportunistic business person thinking they're an entrepreneur," said David Cremin, partner at Zone Ventures in Los Angeles.

One area that's gaining momentum is health care. In the second quarter of 2001, venture capital investments in health care rose to $1.6 billion nationwide, from $1 billion, in the first quarter, according to Growthink figures. Southern California mirrored that trend, with a 21 percent sequential increase.

"Health care is still 14 to 16 percent of the gross national product," said Eve Kurtin, managing director at Pacific Venture Group in Encino. Some VC firms are considering bringing in health care partners, or resuming health care investing after exiting the sector in the late 1990s, she said.

It's the exception, though Connectivity, which includes areas like telecommunications and wireless technologies, fell markedly from the first quarter, and e-content and commerce activity remained far lower than the like quarter a year earlier, Turo said.

Managing portfolios

In this climate, a lot of VCs are spending their time managing existing portfolio companies, finding and guiding management teams, and looking for exits from earlier investments. This makes it harder not only for entrepreneurs but venture capitalists trying to raise additional funding for companies already in their portfolios.

In this regard, many L.A. firms have been blessed by good timing. "In the last two years, when the frenzy was going on, L.A. firms were essentially shut out of many deals that were originating up north," Abe said. Now, when firms on Sand Hill Road in Silicon Valley need follow-on rounds, they're shopping for partners in Los Angeles. "We're the pretty girl at the ball. Last year we were the ugly duckling," he said.

With the outlook for venture capital investing so precarious, it's possible that some limited partners will withdraw commitments to VC firms. But the term of the limited partnerships -- 10 years is typical -- and heavy penalties for early termination make it unlikely to happen often.

U.S. Venture Investments, Second Quarter
Southern California companies
received a small fraction of
the total money invested.
                           Dollars         Percent     No. of
                     Invested (millions)  of Total $  Companies
Bay Area                  $3,239.0           30.1%       226
Central U.S.               1,924.0           17.9        184
Southeast                  1,582.4           14.7        135
Northeast                  1,347.9           12.5        130
New England                1,319.0           12.2        109
Southern California          884.1            8.2         85
Pacific Northwest            405.6            3.8         40
Other                         73.5            0.7         12
Totals                   $10,775.6           100%        921
                        Percent           Average
                     of Total cos.  Deal Size (millions)
Bay Area                 24.5%             $14.3
Central U.S.             20.0               10.5
Southeast                14.7               11.7
Northeast                14.1               10.4
New England              11.8               12.1
Southern California       9.2               10.4
Pacific Northwest         4.3               10.1
Other                     1.3                6.1
Totals                   100%              $11.7
Source: Growthink's Southern California Private Equity Funding Report