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Camps face off on ‘transparency'

Following the disclosure of UTIMCO's private equity fund performance, the San José Mercury announced that it has filed a law suit in an attempt to force Calpers to do the same. Beth Healy of The Boston Globe wonders what the upshot will be.

As the debate intensifies over public disclosure of venture capital returns, two opposing camps are forming.

There are venture capitalists who want to slam the door on the matter entirely. And there are others who are willing to discuss the notion of better "transparency" in the venture business — including the possibility of creating a system under which venture returns could be fairly and accurately reported and compared.

There's a long way to go before any truce is reached. Tom Crotty, a general partner at Battery Ventures in Wellesley, is among the avant garde on the issue. He says he has "no problem" with aiming for better disclosure in the venture business.

But he is adamant that venture firms should never be forced to reveal information about the private companies in their portfolios: "That would be suicide," he says. If firms are to make their returns easier for investors to understand and compare, Crotty says, the industry will have to adopt a new, standardized approach to valuing portfolios and calculating returns.

"Right now, trying to compare returns between venture firms is like trying to compare a pineapple to a grape," Crotty said. "Unless there's some better standardization process, it's dangerous to get this information out there."

It's dangererous, VCs and their lawyers argue, because the numbers could easily be misinterpreted by people outside the business. Consultants, politicians, and reporters could spread word of bad numbers posted by a venture fund without the proper context to explain those figures, they say. Of course, rivals within the business also could use ugly numbers to embarrass a competitor.

The hypersensitivity rears its head mainly in the first year or two of a venture fund. In the best of times, these funds, which generally are 10-year investments, look like losers for a year or two. That's because investments are just beginning to be made, fees are being drawn by the venture firms, and there are no payoffs yet in the form of acquisitions or IPOs of portfolio companies. And in these gloomy times, young funds are looking more dreadful than usual.

A fund launched in 2000, for example, is likely to have made several investments at top dollar. As the market slumped, so did the private valuations of those companies (a complex calculation in itself) and there have been few so-called liquidity events to make money on those deals thus far. As a result, most funds launched over the past two years look dismal on paper right now; some are down as much as 33 percent.

Talk about uncomfortable timing. The venture capital industry is being pressured to open its doors just as it's grappling with the worst financial landscape in its history.

A showdown last month at the University of Texas blew the lid off the privacy discussion across the industry. Texas's attorney general ruled, in response to records requests by the Houston Chronicle newspaper and others, that the university's endowment had to make public its venture capital returns. It was the first time a public pension fund has been forced to break the confidentiality agreements that are standard with most venture contracts. The performance numbers were to be expected: strong results for older funds and mostly red ink for new funds.

After the Texas ordeal, VCs and lawyers in the nation's venture capital centers, including Boston, leaped into action. Charles River Ventures, Thomas H. Lee Co., and the law firm Hale and Dorr have written letters to the Massachusetts state pension fund, urging it to deny requests for information filed by two business people from out of state, according to Treasury officials and lawyers briefed on the letters. (The Globe recently submitted its own request for venture return information from the fund, the Pension Reserves Investment Trust.)

In California, another newspaper, the San Jose Mercury News, last week sued the nation's largest pension fund, the California Public Employees' Retirement System, or Calpers, for venture return data, saying, "California residents have the right to know how the pension fund's private investments are performing."

Brad Pacheco, a Calpers spokesman, said: "We're trying very hard to balance our fiduciary duty to our investors with our desire to participate in this asset class." Executives of some venture firms, including Charles River, have warned in public speeches that they would simply shut out public pension plans in the future, if those groups were unable to uphold their contractual promise of confidentiality.

"We hope to get a useful resolution in court," Pacheco said.

Threats to shut out the pension community from future funds may seem unimportant at a time when venture returns are poor. But participating in top venture funds has been hugely profitable for institutional investors over the long term.

Venture returns have averaged 20 percent a year over the past two decades, according to Venture Economics, a New York research group. Harvard University's endowment, which is private and not subject to the public records requests at issue in Texas and at the Massachusetts state pension plan, enjoyed huge venture gains in the late 1990s but suffered a loss in the sector of nearly 20 percent in fiscal 2002. The school has no intention of abandoning the sector because of the short-term pain.

One reason it may be easy to shut out pension plans in the future is that venture capital funds are shrinking back after several years of growing into $1 billion monstrosities. If the next round of funds are launched at half that size, or smaller, investors will be elbowing each other to get in, and public pension funds have never been any VC's favorite investor. Such funds are rife with politics and management changes that wealthy individuals and endowments don't bring to the table.

Venture Economics points out that VCs raised about 20 percent of the money for their funds from public pension plans in 2001. Private Equity Analyst, a Wellesley trade journal, found that public funds provided a whopping 41 percent of new buyout funds' cash last year. Another 10 percent of the buyout firms' money came from corporate pension plans.

Considering those numbers, says Dave Barry, a senior editor at Private Equity Analyst, "I just don't see public pension funds suddenly being out of the equation."

The threat remains. But at the same time, some key players in the venture community are putting their heads together to find ways to address an issue on which everyone seems to agree: Venture returns need to be clearer, even if it's just for the benefit of the current investors.

Josh Lerner, a professor who teaches venture capital courses at Harvard Business School, says demands for greater disclosure and transparency in the venture business are inevitable, given the industry's astronomical growth over the past 10 years.

"Since this train has left the station and the industry seems to be heading down the track, it really behooves everybody in the industry to sit down and say, `How can we better measure performance?"' Lerner says. That's coming from someone who knows how complicated venture returns are to express.

At the Boston law firm Testa, Hurwitz & Thibeault, which specializes in high-tech and venture capital clients, partner Tom Beaudoin said he and his clients are interested in improving the reporting of returns for fund investors, called limited partners, but not for the general public.

"We're working on how to improve on that information flow without having it corrupted by further disclosure to the public at large," Beaudoin said.

There's a national association of limited partners from big endowments and pension funds that is beginning to work on proposals to improve the way VC firms report their investment performance. Battery's Crotty says input and pressure from limited partners will be critical to the industry moving forward. Secrecy is a tradition of the business, he says, but it's not always a good trait.

"People with good performance frankly want to find a way to talk about it without looking like they're showboating," Crotty said. On the other hand, he said, "If you're a lousy fund and you're trying to hide bad performance, then shame on you."

Copyright © 2002 The Boston Globe

Beth Healy is a business reporter for The Boston Globe. Her Venture Capital column appears regularly. Beth can be reached by e-mail at bhealy@globe.com.