The cup runneth over: Firms adapt to venture capital glut

It's good to be a venture capitalist these days, right? When public market investors gobble up technology and communications IPOs and send their stock prices into nosebleed territory, the big winners are the early-stage private investors that paid for ownership stakes at garage-sale prices.

For the most part, that's still the case, but increasingly venture capitalists are having to share the wealth with other VC firms, corporate venture outfits and venture funds backed by investment banks. The newcomers are helping fuel an oversupply in monies available to start-ups, the size of which are unprecedented. For 2000, that means VC firms must adapt their investment strategies and look outside the U.S. for big returns.

If 1998 was a watershed year for private equity deals involving communications start-ups, 1999 was a dam-breaker. Research firms still are crunching data on deals consummated in the fourth quarter. But by the end of third quarter 1999, the total amount of money raised by communications and networking companies already had jumped 55% from 1998's total to $4.5 billion, said a spokeswoman at VentureOne. Median amounts raised by start-ups and the number of financing rounds completed also were up sharply (see figure).

During third quarter 1999, two telecom firms raised rounds in excess of $100 million. European-focused local multipoint distribution service access company Formus Communications amassed $115.8 million, and ClearSource, a hybrid fiber/coax network builder in the Southwest, raised $126 million.

If the sizes of the largest fourth-quarter deals were any indication, investments continued apace through the end of 1999. In December 1999, venture investors and corporate partners infused $100 million into 2-year-old Vstream, a maker of Web-conferencing technology. The company's previous rounds of financing, totaling $11.5 million, paled in comparison.

The blockbuster deal, though, belonged to Colo.com, a co-location services firm serving ISPs, competitive local exchange carriers (CLECs) and other network services providers. Led by former U.S. Sprint CEO Charles Skibo, Colo.com raised $200 million in its third venture round.

The swell of dollars available to communications firms is growing even bigger as corporate participation surges. In third quarter 1999, corporations and their venture outfits invested about $2.1 billion in venture-stage companies, compared with $1.1 billion for all of 1998, according to data from Venture Economics and the National Venture Capital Associa tion.

Investment banks also have become venture-stage interlopers, figuring they can bring access and contacts to greenhorn outfits and put them on the fast track to an IPO. Early this month, Goldman, Sachs & Co. took the venture capital plunge. It announced a $285 million fund with Japanese carrier Kyocera to invest in Japanese IT, Internet communications and computer businesses.

W. James Peet, managing director of Lehman Brothers private equity investment group, is raising a new communications fund focused on service providers. One potential area of specialization for the fund brings successful application service provider and ISP business models overseas.

Competition is not a favorite subject among venture capitalists, but they do acknowledge that it appears as if a limitless amount of capital is chasing a finite number of deals. Although sound business plans abound, venture capitalists say start-up-savvy telecom executives are rare.

"The supply-demand bottleneck is all on the management side. The talent to execute seems to be the scarce commodity," said William J. Elsner, managing member of Telecom Partners, which recently closed on a $500 million fund - its third.

"Management is always what scares me about doing a deal - can I get the right management to execute on the vision?" said Sean Dalton, general partner at Highland Capital Partners. Highland recently announced its fifth fund, which also totaled $500 million.

But finding talent is less of a problem than it used to be, as more seasoned telecom executives jump ship and join the start-up ranks, Dalton said. For example, last month Dalton helped snag Michael Pisterzi, former chief operating officer of Alcatel America, to run Highland investment AccessLan, a carrier equipment vendor.

For other VCs, the key is to find highly differentiated businesses that have first-mover advantage. "We're going up the food chain on the services side to applications services - that's where differentiation exists," said Roland Van der Meer, general partner of ComVentures. As an example, he cited a recent investment in Demand Video, an overbuilder of video-on-demand networks.

Although some interesting models are still to be sought in basic transport services, Van der Meer is concentrating on areas such as virtual private networks, voice over IP and bandwidth exchanges. The company's ComVentures IV fund closed on a $350 million deal in December 1999.

But like most of his brethren, Van der Meer expects to find the most generous investment returns overseas in 2000. Currently, ComVentures is funding an unannounced next generation IP carrier in Europe.

"In Europe, the competition is not nearly as severe as it is in the U.S.," said Ben Coughlin, principal with Spectrum Equity Investors.

Spectrum already has had success overseas. Last year's $12 million investment in Jazztel PLC, a Spanish services provider, was worth more than $2 billion as of mid-January.

Spectrum also has invested in many CLECs in Canada. Asia and Latin America are other likely venture investment hotbeds for 2000, according to many VCs.

But the good times won't last forever, which is why VC firms are corralling capital and handing it out in large bites to promising businesses that have proven management teams at the helm.

"We think this is a five-year upheaval, and we are in the middle of it," Van der Meer said. "That's why we're investing pretty aggressively."

"Veteran investors know it will be cyclical. Still, it's a great time to be in the company formation business," Elsner said.