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Mid-Atlantic VCs Indicate Improving Investment Climate

Year-end data released by the Mid-Atlantic Venture Association illustrates an improving market for venture investment in the mid-Atlantic region. Coming off an active investment quarter in Q4 2004, VCs forecast an even stronger investment period in the first quarter of 2005.

VCs report spending more time looking at new deals and although deal flow appears to be healthy in region, they report mixed feelings about the quality of the opportunities seeking funding.

Evidence of positive feelings of market recovery again was illustrated this quarter, and even with valuations and term sheet competition continuing to increase, VCs are not shortening their average timeframe needed to close a new investment. Although 2004 saw many high-profile liquidity events, VCs predictions about exits opportunities within their own portfolio companies decreased this quarter.

"Both prior quarter investment results and forward-looking responses indicate VCs in the region are clearly positive about the prospects of future investment activity but VCs have not lost sight about the fundamentals needed to achieve positive returns," said Julia Spicer, Executive Director of MAVA, "Primarily, finding quality deals at an attractive valuation and achieving liquidity events for their portfolio companies is of paramount importance and is ultimately needed in the lifecycle of building a company."

The venture capital survey is part of MAVA's ongoing efforts to better assess the climate for private equity investing in the mid-Atlantic region. While the purpose of other private equity surveys is to track previous investment activity, the quarterly MAVA venture capital survey is intended to gauge investor attitudes, future activity and important investment trends. The Q4 2004 survey was conducted via email to 474 member VCs using WebSurveyor, and received a 12.3% response rate.

Survey's Major Findings

Investment Activity & Attitude about Market Recovery Continues to Increase According to Q4 2004 survey results, 72.4% of respondents were active investors with 44.8% closing 1-2 deals, 20.7% closing 3-5 deals, 5.2% closing 6-9 deals and 1.7% closing 10 or more deals. The forecast for investment activity in Q1 2005 calls for 89.7% of investors to be active, closing at least one deal in the current quarter.

Continuing the 10-quarter improvement trend, investors this quarter once again affirmed their positive feelings about market recovery with 43.1% saying we are "on the upswing, but uncertainty remains", 1.7% saying we are "still declining" and only 8.6% saying that the market is "flat but scrapping the bottom". VCs, however, do not believe we have achieved complete market recovery, with only 1.7% responding that the market is "fully on the upswing".

Condition of Public Markets Impacts Regional Entrepreneurs

Asked for their perspective on the most positive events for the industry in 2004, one VC responded, "A healthier public equity market and improving M&A environment has resulted in the return of capital to institutional investors, freeing up some capital for reinvestment into the venture space."

A concurring opinion was voiced by another VC respondent that said, "The stock market began to recover, leading to more M&A and IPO opportunities."

Regarding the biggest challenge facing the industry in 2005, one VC stated, "Uncertainty in the public markets with regard to interest rates, inflation and economic growth is affecting corporate investment."

Valuations and Term Sheet Competition Continue to Rise

Again this quarter, VCs indicated that valuations on term sheets continue to rise with 70.7% saying that "valuations are rising slightly". A decrease in the statement "valuations are too high" was noted this quarter, with 3.4% in Q4 2004, compared to 12.0% in Q3 2004.

Likewise, term sheet competition again increased in Q4 2004 with 20.7% routinely receiving competing term sheets and 60.3% occasionally receiving competing term sheets, as compared to 19.3% and 54.5% respectively in the previous year, Q4 2003.

The time to close a deal slowly increased over a one-year period as the 4-6 month timeframe shifted from 59.0% in Q4 2003 to 65.5% in Q4 2004; the 7-9 months timeframe grew from 2.6% in Q4 2003 to 10.3% in Q4 2004.

Deal Flow Ups & Downs

As competition for term sheets increases and valuations rise, the importance of quality deal flow becomes increasingly important to VCs. This quarter, VCs report an increase in time spent looking at new deals with 72.4% spending 40-100% of time, compared to 68.5% one year ago; 3.4% are spending less than 25% of time, as compared to 12.4% a year ago.

Also in one year's time, there is fluctuation in the average number of business plans that VCs received per month. Although there was an increase in 200+ plans received per month from 5.3% of funds in Q4 2003 to 10.3% in Q4 2004, the mid-range categories of 100-149 and 150-199 plans had decreased volume into funds while on of the lower volume categories, 50-99 saw an uptick from 36.8% in Q4 2004 to 48.3% in Q4 2004.

VCs were asked their opinion about the current state of deal flow in the mid-Atlantic region. Only 14% felt it was decreasing, while 35.1% felt it was increasing and 45.6% felt it was unchanging. When asked to assess the quality of the business plans received in the previous quarter, there were fluctuations in all categories measured, as compared to responses over a year ago. 36.2% indicated that both "quantity and quality had increased", 12.1% said that "quantity increased while quality decreased" and 13.8% said "quantity decreased while quality increased".

Exit Predictions Decrease; Overall Potential Still Positive

This quarter, VCs felt slightly less confident in the numbers of portfolio companies/investments that will experience a liquidity event, or exit, in the coming year. The category "less than 25% of their portfolio will exit" grew from 44% in Q3 2004 to 50% in Q4 2004 and those that felt "25-40% of their companies would exit" decreased from 46% in Q3 2004 to 41% in Q4 2004.

Of the companies that VCs do anticipate will experience an exit, the merger and acquisition (M&A) market appears to be a more viable route than Initial Public Offering (IPO). Nineteen percent (19.0%) of respondents this quarter felt there was "a large increase" in M&A activity, up from 6.0% the previous quarter. Those feeling that there was a "slight increase" in M&A activity measured a slight increase this quarter at 62.1% from 60.0% the previous quarter.

Respondents this quarter were less optimistic about their own portfolio companies' chances to exit via an IPO and responded accordingly with the decrease from 40.0% in Q3 2004 to 28.1% in Q4 2004. The respondents that noted they would have no portfolio companies exit in the coming year grew from 42.0% in Q3 2004 to 50.9% in Q4 2004. Commenting about the current health of the IPO market, one VC respondent said, "[The IPO market is] still uncertain. The bar is clearly higher. It will be the truly special portfolio company that can do an IPO."

Fundraising Timelines Stay on Track; Size of New Funds Larger

Consistent with previous quarters' survey results, VCs indicated that their timelines for raising new funds is on track, with 19.3% "currently fundraising" and 43.8% "anticipating beginning fundraising activity in 2005".

When asked about the size of the new fund, as compared to their current fund, 64.3% of respondents this quarter indicated that their new fund will be larger, increasing from 45.8% in Q3 2004. There was a noted decrease in the number of firms that expect to raise smaller funds (down from 10.4% in Q3 2004 to 3.6% in Q4 2004).

A VC respondent who was in the process of fundraising commented, "[It is a] good environment for emerging managers and good performers; it is a good market for the raise, but still not easy."

MAVA represents the collective interests and leverages the success of venture capitalists with investment interests in DC, Maryland and Virginia. Founded in 1986, MAVA provides a wide range of programs, information and forums designed to facilitate quality deal flow, encourage collaboration, and foster solid relationships with key service providers in order to promote private equity investment. For more information on MAVA visit http://www.mava.org