May 12, 2008

Grasping For Funds: As Economy Goes, So Goes Venture Capital

Scott Miller  /  Charleston Regional Business Journal

The weakening economy has trickled into the world of venture capital, the seed money that fuels fresh ideas in alternative energy, life sciences and other emerging technologies. Increasingly conservative venture capitalists have also shifted focus from high-risk startups to more established companies with recurring revenue streams, often eyeing renewable energy products rather than biopharmaceuticals watched closely by the U.S. Food and Drug Administration.

In the first quarter of 2008, venture capitalists invested $7.1 billion nationally, an 8.5% drop from the fourth quarter of 2007, according to the National Venture Capital Association and PricewaterhouseCoopers, a global advisory firm.

"Over the past year, I would say the average size of the investment has shrunk because people have some money tied up in real estate and other investments that aren't liquid," said Andrea Marshall, executive director of Charleston Angel Partners, a coalition of professionals who invest in young companies. "Somebody who invested $10,000 in a deal last year may only invest $5,000 this year," she said.

Risky business
Charleston Angel Partners, which currently has about 30 active investors, typically reviews two companies a month but only invests in two or three a year. To date, the member-driven company has invested in 10 companies. All 10 remain in business, but Marshall said venture capitalists expect 45% of these young companies to fail. "Inevitably we will have some failures, for sure," she said. "Ideally you like to have a portfolio where the returns offset the failures."

Those failures seem common in the high-risk world of biotechnology. In 2003, Pilot Therapeutics made noise when announcing plans to open on Daniel Island before quickly running into financial trouble. Similarly, CropTech Corp. filed for bankruptcy in 2003 before completing construction of its headquarters planned in Berkeley County.

Those problems aren't unique to South Carolina. Chlorogen Inc., a St. Louis-based biotech, shut down in September, ending a five-year run. California-based Large Scale Biology Corp. sold its assets in 2004. It was one of the first biotech companies, opening in 1987.

Limiting risk
Charleston Angel Partners continues to invest in young startups because high risk brings high reward, Marshall said. Plus, the organization typically joins a larger group of investors in a project. CAP may invest $200,000 to $400,000, for example, as part of a larger $1 million investment from other equity firms. "That's a level that the angels are comfortable with," Marshall said.

Other firms, particularly larger firms, however, have scaled back "seed" funding and backed more established companies with recurring revenues and possibly even profits. According to the NVCA report, seed funding decreased 17% in the first quarter of 2008.

"Over the last 10 years there's been a real decline in funding of seed and startup venture capital," said Harry Huntley, executive director of Invest SC, which essentially serves as the state's venture capital fund. "The risks are so much greater, that private equity firms are realizing they can make greater returns on companies that already have processes and maybe even have profits. There has been a shift on the stage of investing."

Invest SC stemmed from the S.C. Venture Capital Investment Act of 2004. The act allowed Invest SC to take out a $50 million line of credit, secured by state tax credits, from Deutsche Bank.

The corporation committed the money to the following four private equity firms:
* Nexus Medical Partners of Boston, $20 million.
* Noro-Moseley Partners of Atlanta, $10 million.
* Azalea Capital of Greenville, $10 million.
* Frontier Capital of Charlotte, N.C., $8 million.

The money just became available last summer, Huntley said. In April, Nexus was part of a $7.7 million investment that brought Myconostica Ltd., a medical company based in the United Kingdom, to Charleston. "They actually bring other investors in with them, particularly foreign investors with them," Huntley said. "They'll find other investors. It multiplies our investment. Our $20 million investment with Nexus will really become $70 million to $100 million once they bring in their other partners."

Each firm agrees to invest in companies located in South Carolina or planning to locate here, like Myconostica.

Chasing popular products
In addition, private equity firms tend to be shifting their focus from biopharmaceutical and other life sciences companies to fund advancements in alternative energy.

"The market is changing. We're seeing money move from the science arenas. It has been the darling of investment for many years now," said Karl Kelly, director of corporate operations at the Clemson University Restoration Institute in North Charleston and former director of SC Bio, a nonprofit agency dedicated to helping upstart biotech companies prosper. Kelly in February joined Clemson, where he is responsible for finding corporate partnerships to help fund and commercialize university research activities.

"Investors today are looking at the energy crisis and want to be part and parcel of a popular trend," he said. "Energy technology in liquid and renewable fuels will find adequate funding from both federal and private sources."

Clemson is ready to capitalize on that trend with research, not only to produce ethanol from switchgrass but to develop a commercial conversion process. Biopharmaceutical endeavors, meanwhile, now have a harder time finding venture capital because the FDA has such a close eye on them in the aftermath of illnesses from products like Vioxx, the Merck painkiller that has been found to boost the likelihood of heart attack or stroke in patients taking it.

While that may be the case, some private equity firms want to limit risk and are diversifying beyond biopharmaceuticals.

More money coming
All industries could receive funding, however, as more venture capital returns to the market. "We have seen that a downturn in the market has created a temporary decline in available funding for new venture opportunities. I anticipate that will extend at least through the next two quarters," Kelly said. The $50 million from Invest SC is just now getting to market, for example.

In addition, institutional investors like retirement funds and university endowments are starting to pursue venture capital investments, though riskier, because the returns can be greater than those found in the stock market, Huntley said. "A lot of institutional investors are putting money toward venture capital," he said. "The next step for us in South Carolina is to find a way to direct that capital to South Carolina."

According to the NVCA report, fundraising by private equity firms is up substantially, so they have the money to invest. In 2007, fundraising by firms like Nexus, Noro-Moseley, Azalea and Frontier increased 13% to $35.9 billion nationally. In the last five years, fundraising has nearly tripled.

"Venture capitalists still have large amounts of money in their coffers; therefore it's no surprise to see a solid level of investing continue," said Tracy Lefteroff of PricewaterhouseCoopers. "VCs have weathered numerous economic cycles and will continue to fund companies with innovative ideas and solid business models while they also stand behind their portfolio companies for the long term."