(Editor’s note: This is a truncated version of an interview that originally ran on VCExperts.com)
Dana Callow is the Managing Partner of Boston Millennia Partners. Prior to founding
Some have recently argued that the venture capital industry is undergoing a substantial reduction in size, in large part due to institutional capital reallocating funds to more conservative investments. Some have even argued that this is a necessary contraction in the industry. Will you share your thoughts on this subject?
Most institutional investors have reassessed their overall tolerance for risk. The poor performance of most asset classes last year and a loss in confidence of traditional correlation effects of multiple asset classes has changed investors’ thinking.
The venture industry has been inconsistent at best in its recent investment performance and therefore it is a casualty of the recent downturn. However, we believe there will be a reversion to the norm, and we will see the venture asset class outperform relatively significantly over the longer ten year term. Combined with a broader reduction in risk tolerance on the part of many investors, the result is a slow consolidation of our industry.
This trend will reverse as returns and increased liquidity and exits show up through M&A, limited IPOs and secondary restructuring. Many industry observers suggest that there has been too much money chasing too few good deals, but we believe that the weaker return issues are more centered around a limited pool of great CEOs and inadequate thinking on how and when to exit an investment.
It has always been easier to buy than to sell. What results is a healthy realignment of efforts toward the strategic sale on the part of the GPs. The industry consolidation is a necessary condition based on smaller or substantially reduced allocations to alternative assets coupled with liquidity problems in many of the larger institutional investors.
Nonetheless, there is still substantial capital available to those venture firms with a clear strategy, strong investment teams and a proven track record. A contraction in the number of firms is beneficial to both investors and entrepreneurs as it is a form of natural selection creating a more efficient marketplace.
While the economic conditions over the past year have created cause for concern for the venture capital industry, what are you seeing on the positive side in terms of innovation and advancements from companies in various sectors that excite you from an investor’s standpoint?
There remain substantial ongoing opportunities in many sectors for innovative companies [that] genuinely reduce costs and improve productivity for their customers. In difficult economic times, it is important for innovation to create economic growth and new opportunities.
In particular, the healthcare information and services sectors continue to offer many interesting investment opportunities due to (1) large dollars flowing through the segment and continued above average growth; (2) the need for immediate and substantial cost reduction; and (3) the critical need for better information to improve the productivity of healthcare providers, better accountability and improved quality of care.
In addition, because capital is very difficult to come by for most small companies, the ones receiving the capital are being subject to a higher level of scrutiny than when capital was easy to obtain, and hence the chance for these current companies to be successful may actually increase as a result.
Truly differentiated intellectual property is essential as there are so many underfunded opportunities at present that the corporate buyer has a multitude of companies to review and seeks only the best strategic combinations for their long-term growth.
You are to be commended for your prediction two years ago that the IPO market for most venture-based companies was all but over. What is your current outlook for the IPO market?
Challenging those that suggested the IPO market would become very active and a source of liquidity was not actually that difficult. Based on long term statistics, IPOs have had a relatively limited percentage of all exit values. High profile IPOs get attention, but by far the M&A route has been more robust.
Multiples on investors’ capital have proven more important than pure IRR numbers. Legislation such as Sarbanes-Oxley and new valuation rules – as well as the potentially damaging tax changes that may be forthcoming from Washington – do not alter our thinking and therefore future IPOs may be limited to larger buyout and private equity type companies restructuring their balance sheets.
An IPO market is needed at some minimum activity level to provide a “second buyer” and keep the M&A market from becoming a distress exit scenario. The exit is more than ever a process not an event that can require a year or more from first sale conversations to cash proceeds.
While the market may have opened a little bit with the A123 offering (of which we were a small part) and a handful of other IPOs, for the most part it remains closed to most venture backed companies, as there is little appetite on the part of institutional portfolio managers to buy and hold large positions in smaller companies.
What advice can you give to entrepreneurs seeking capital in this environment?
Come to any potential capital source with a well thought out business plan addressing key “got to have” features in the product or service offering, seeking a reasonable amount of capital for a highly capital-efficient model and participating in a sector characterized not only by high growth but most importantly by the prospect of a real and profitable exit within a reasonable period of time, perhaps 5 or 6 years.
We expect our entrepreneurs to be investors in their businesses, so align yourself with the investor with a capital gain focus, not operate as a current income centered employee.
Be prepared for a realistic valuation to be placed on the business and demonstrate a willingness and experience of working with professional investors. Further, put as much time into understanding your investor candidates as you do preparing your business plan as they will be your partner for several years and much of the success or failure of your company will be due to that partnering relationship.
Your firm seeks to make investments in the healthcare/life sciences industry. Although the healthcare/life science industry has been affected by the downturn in the economy, has it not seen as many negative effects as other industries?
The US healthcare sector, which arguably can be measured as large as the entire Chinese economy and growing equally fast, is comprised of many sub-sectors and each sub-sector has its own characteristics and requirements for success. We believe that there will be huge rewards offered to companies [that] can reduce costs while maintaining or increasing the quality of care.
Any time a company can improve interaction of the payer, patient and provider triangle there will be rewards. The lack of simple information technology at many of the nation’s healthcare providers is astounding to us, and we are aggressively pursuing improving information flow for many hospitals and physician groups around the country at our portfolio companies.
Areas where we are quite cautious include drug discovery and development, a sector [that] requires a large amount of capital, time and more detailed expertise than ever before. Our firm would rather service those research-intensive sectors than directly fund early stage molecules. Our company, Parexel, now public, is a case in point that “providing picks and shovels” can be as lucrative as doing the actual “mining.”
Innovation has been a hallmark of the healthcare device industry. New ideas that reduce costs directly or reduce the need for in-hospital care or provide better information for more timely decision making and thereby improve productivity and the quality of care can be the basis for a successful business.
Finally, large players in this sector have traditionally made many acquisitions of smaller companies thereby creating an exit for the venture backed company, and we expect that M&A activity to increase in the future.
(To read the entire interview, head to VCExperts.com)
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