Cullen: In your paper, Boom and Bust in the Venture Capital Industry and the Impact on Innovation, you explore the implications of the recent collapse in venture activity on innovation. Given recent cuts in corporate support for R&D, do you feel this is cause for concern to the innovation process? Or do you feel private equity investment will pick up the slack?
Lerner: This is an excellent question. It is clear that corporations over the past two decades, and particularly in recent years, have been seeking to transform their central research facilities from "ivory towers" into places where the research is much more relevant to the corporation. Certainly, it is legitimate to worry that long-run but nonetheless critically important research once performed by organizations such as IBM and Bell Labs will be trimmed, and that no one will take the slack.
After all, it is unlikely that a venture-backed firm, which is typically expected to go public within five to seven years of its initial financing, will be able to pursue research that will not have a payoff for fifteen, twenty, or even more years in the future. (But it's not impossible—after all, venture capital has played a key role in the financing of the biotechnology industry.)
Thus, this is a real worry without a clear solution. There are, however, a few possible ways to address concern. First, publicly traded corporations could be clearer in describing and reporting on their long-run research projects, which may translate into a greater appreciation of such projects by investors. Second, venture capitalists and limited partners might explore the possibility of longer-lived funds: today, the typical venture fund is expected to liquidate its holdings at the end of ten to twelve years. If a fund was mandated from the outset to have a twenty-year life, for instance, the venture capitalists might be more comfortable in investing in truly early-stage technologies.
| My belief is that while many private equity investors may find such disclosures unappealing, greater transparency in the private equity industry is inevitable. |
| —Josh Lerner |
Q: What is the role of the buyout firm in the VC investing cycle, given the activity they and restructuring firms have had in keeping ventures afloat in the current downturn? How do they factor in your survey of VC investing and innovation?
A: Buyout groups in fact exacerbated much of the volatility in the venture capital cycle. During the late 1990s, many buyout groups began abandoning the basic industries in which they had traditionally invested and instead undertook Internet and telecommunications investments that normally would have been the exclusive territory of venture investors. Many of these forays into unfamiliar territory were made in none-too-sound companies at excessively high valuations. Not surprisingly, most ended badly. Today, most buyout groups have returned "back to basics," and are eschewing technology investments.
Some later-stage investment groups today are attempting to buy troubled technology firms, whether privately held units or (more typically) dysfunctional publicly traded entities. These investments may keep some companies with promising technology afloat when they would otherwise be liquidated.
Q: In your paper you mention the slowness with which investors are notified of the performance of venture capital funds. What could be done to make this information more readily available to investors?
A: The lack of transparency in private equity is a major issue that is likely to attract considerable attention in the years to come. The attention paid to this issue has grown dramatically since several large public institutions (for instance, the California Public Employees Retirement System and the University of Texas Investment Management Company) have released onto the Internet the returns from the funds in which they invested.
My belief is that while many private equity investors may find such disclosures unappealing, greater transparency in the private equity industry is inevitable. Nonetheless, much work remains to be done to insure that such disclosures are done in a way that maximizes the valuable information provided to the limited partners while limiting the disclosure of strategic information critical to the companies in the private equity investors' portfolios.
Q: What impact has the Sarbanes-Oxley Act had on how VC firms participate on the boards of their portfolio companies? Do you feel that this could influence the effectiveness of the VC investment process?
A: Sarbanes-Oxley is a complex piece of legislation, but it appears inevitable that the legislation will negatively affect the willingness of venture investors to remain on the boards of firms once they go public. (Of course, most firms are privately held at the time of the initial venture investment.) I think that it remains to be seen how severe the impact on the innovation process will be.
Q: It has been argued that prior to the early '90s, most venture capital investors were key stakeholders who had a commitment to the company and the products it was developing and had a very long-term outlook on returns, whereas today most VC investors have a more short-term view of IRR. What are your thoughts on this? And if you feel this is true, is this cause for concern?
A: Certainly, this would have been a fair critique of the industry in the late 1990s, when a "get rich quick" mentality pervaded many venture capital organizations. Today, though, reality has returned once again: venture capitalists realize that if they are going to be able to eventually take the firms in their portfolios public or sell them at an attractive valuation to corporate acquirers, they need to focus on creating sound and sustainable companies. 