Azure Capital targets late-stage orphans

Mike Kwatinetz says a VC recovery is possible, sees opportunity in mature startups

Mike Kwatinetz knows about recession investing. In 2001, just after the bubble burst, he led Azure’s investment in Bill Me Later, which later became the target of the second-largest tech acquisition of 2008. The company sold to eBay for $1 billion in the worst exit environment in decades. Azure was the biggest shareholder and Kwatinetz had been on the board for 7 years.

The former Wall Street analyst says Azure is back at it again, and is taking advantage of a surge in Series-B down rounds, picking up some later-stage firms that could otherwise be orphaned. Below are his thoughts on where the venture industry is headed, what makes for smart investing in this environment, and how government policies have impacted the high-growth marketplace.

MB: What's happening to the VC industry? Give us your 30,000-foot view.

MK: Basically, it all starts with liquidity. If you look at the investors in venture, a certain portion of them try to manage their cash flow by recycling funds. They forecast how much liquidity they’re going to get each year, and when they make capital commitments, it’s based on their forecast of cash flow. The endowments in particular do this. When you go through nearly two years of no IPOs and a reduced M&A market, it means they’re not getting cash flow back and therefore they have to significantly cut their new commitments.

MB: The endowments are down about 30% and many are taking a more conservative investment approach, which means pulling back from alternative investments. Some people have guessed about half the VC firms will go away. Does that sound right?

MK: You know it’s so hard to say because when you do a VC fund, depending on how much money you raise, the goal is to have your fees fixed for about five years, and subsequent to that there’s a formula for how they trail off, so a fund that raised money in the last three years basically has at least two more years before their current revenue stream on that fund changes. So the question becomes: is the ability to raise capital going to be difficult for another two and a half years, or will it ease up as we see more liquidity in 2010 (assuming we do)?

There’s a backlog of close to 50 IPOs that are getting filed—again this assumes the public markets hold up—many of which are fairly large. So you may see a radical change if they go through and they raise the money and gain liquidity for these LPs, which could cause a change in how they behave. If it stays the way it is this year—well, this year is the worst fundraising environment in terms of total new committed dollars to venture since roughly 1993...

MB: What about your investment strategy? In 2001 you invested in Bill Me Later in the post-bubble down market, and that sold last year for $1 billion. About a year ago, you said Azure’s approach was to similarly take advantage of this economy.

MK: And we’ve been doing that. We don’t make many investments a year. We do four to six. This year—this may be one of the best investments we’ve done—we invested in BlogHer. There was a 14-month period from February of ‘08 until May of ‘09 that we didn’t do a new investment because we found there was a lag in the valuations in the private companies catching up with what had happened in the public markets. Things had gotten pretty fluffy in ‘07 in terms of where the valuations were moving. Then, starting in May, we found that we were able to invest again, in that we were finding deals that made sense from a valuation point of view as well as from the quality of the company. The first one we did was BlogHer. From May of ‘09 through April of ‘10 we’ll do probably five investments, which is our normal pace.

MB: You also mentioned you were looking for opportunities with later-stage companies whose current investors might not come back…

MK: Well, we look at a range. We’re essentially early-stage investors in terms of how much we want to own of a company, the governance and our relationship with the CEO, the board seats and the valuation, but we’re willing to invest at a later stage if it meets those requirements. The last data I saw, which was a couple months ago, said 85% of B rounds were down rounds. So now you say, “OK, you tend to be early stage, but you’re not getting paid to invest in an A Round, when there’s more risk. When you can invest in a B Round at a lower price per share, why would you do the A Round instead of the B Round?” So, we’ll shift our strategy. We’re very flexible in terms of how we deploy our capital, but it has to meet those early-stage requirements in terms of ownership, board governance, relationship with the CEO, etc. And we’re finding that right now we can find companies that are a little further along that meet those requirements.

MB: Last question: Government policy. Some are saying the regulations are so prohibitive that entrepreneurs aren’t even thinking IPO at the beginning.

MK: Well, entrepreneurs always think IPO (laughter). I’m exaggerating, but, you know, by nature, entrepreneurs are very optimistic. You wouldn’t be an entrepreneur and take the risk that they take if you didn’t have a very positive view of the world and how successful you could be.

On the other hand, in terms of government policy, I don’t think that everybody thought through the repercussions of enacting some of the things that have been enacted over the last eight or nine years, and what that would do to the IPO market. It’s multiple things, SOX being one of them. Putting Anderson out of business, which created more of a monopoly in the accounting industry, drove up audit prices. You create a monopoly, they raise prices, so that’s a problem as well. And the third thing is just the change in terms of research analysts. Something needed to be done to to guarantee the integrity of published research—I don’t have any problem with that—but the way it was done made it much more difficult for a new public company to have research coverage. And the problem you have is you wind up with orphan companies and that makes the prospect of going public less attractive.

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