Getting in on the ground floor. That's the lure of investing in venture capital. Yet it's not easy for investors to ante up. Most VC funds are private partnerships that require either a net worth of at least $1 million or an annual income of $200,000. Even those who can meet such terms may not want to lock up their money for several years, as these funds demand.
So earlier this year, meVC Advisers, a San Francisco venture-capital firm, launched a publicly traded fund called meVC Draper Fisher Jurvetson Fund I, raising $330 million from thousands of individual investors. There are no big minimums or lengthy lockups, and buying the shares is as easy as a couple of clicks at an e-broker's site.
Thus far, meVC Draper shares haven't exactly wowed anyone. In fact, they're down 22% from their initial offering. But it takes a while to set up private equity deals--only 30% of the fund's IPO proceeds have been invested so far--and those investments can take several years to pay off.
NO REDEMPTIONS. This fund may be new, but it's really just a flashier version of a seasoned investment vehicle known as a business development company. Simply put, BDCs are publicly traded, closed-end funds that make private equity investments, which include venture capital. Soon, meVC will launch a family of VC funds.
All this might sound a little like Internet incubators CMGI, ICGE, and idealab!, which make VC investments. But there's a difference: Incubators are required to have controlling stakes of at least 60% in the companies they own. BDCs don't have that restriction, which makes them more diversified--and perhaps a little less risky.
Not all BDCs are venture-capital funds (table, page 136). Allied Capital, the largest and one of the oldest BDCs, mostly makes loans to private Old Economy companies, and it generates high current yield instead of long-term capital gains. Right now, Allied Capital's current yield is 10.2%, roughly equivalent to what you'd earn from a junk bond fund.
What's different here is that Allied Capital gets an equity kicker in its deals, in the form of warrants for shares. That allows it to earn some capital gains. But Allied Capital's own stock--an income-oriented issue in a growth-obsessed market--hasn't fared well for the past two years. Its long-term record, however, is excellent. The company says the shares' annual total return for the past 40 years has averaged 19%. That's price appreciation with dividends reinvested.
Midway between the income producers and the aggressive players are value investors, such as Equus II and Brantley Capital. They make private equity investments in established businesses that want to restructure or acquire other companies.
How does a BDC work? Like a normal corporation, a closed-end fund has a fixed number of shares outstanding; it doesn't redeem shares or add new ones, as a mutual fund does. Mutual funds can't invest easily in private companies whose shares aren't traded, because they must be able to sell shares easily to meet shareholder redemptions. A BDC manager doesn't have to contend with redemptions. Shareholders who want out must sell their BDC stock in the open market--where the price is usually different from the value of the underlying portfolio, or net asset value (NAV).
Shares of Allied Capital, for instance, almost always trade higher than its portfolio value, because its rich yield delivers cash up front. Shares of value players, such as Equus II and Brantley Capital, nearly always trade at deep discounts. For the venture-capital BDCs, the premiums and discounts fluctuate widely, depending on market speculation.
The NAV itself is a tricky number. BDCs value their private equity at original cost until there is a "significant event." That event could be an IPO, or perhaps a second round of financing for one of the portfolio companies--or an outright sale of a company. The BDC's managers decide what is a significant event and how to value the investments. Most BDCs report the value of their holdings quarterly.
"GOOD DEALS." Clearly, meVC Draper is getting a lot of attention these days. The fund's mission is to invest in early-stage technology companies with the idea of taking them public as soon as possible. Their holdings include stakes in FOLIOfn, which customizes stock portfolios online, and eYak, which specializes in Web-based videoconferencing. Fund manager John Grillos is a well-regarded industry veteran.
Better opportunities may lie in smaller, lesser-known venture players, such as Winfield Capital. Portfolio Co-Manager Scot Perlin, who is also a business professor at Columbia University, scored big with Internet darlings Commerce One and Cyberian Outpost. Even after the dot-com fallout this year, his $1.4 million investment in Commerce One is worth $31 million. Winfield's stock has also gone for a ride: After peaking at 56 in December, it's now at 12. But even at that price, its three-year appreciation is a heady 755.8%. M.H. Meyerson analyst Andrew Scott still thinks it's a bargain. "These guys are getting involved with some good deals," he says. "One of their companies, Vivid Semiconductor, is going to be a big hit when it goes public."
Another BDC, Harris & Harris Group, specializes in biotech. Manager Charles Harris has developed ties with major research centers such as Cold Spring Harbor Laboratory, where he is a trustee. His latest success is Alliance Pharmaceutical, which manufactures a blood substitute. Purchased privately at $2 a share, Alliance's stock now trades at 11 in the public market. Another portfolio company, Genomica, a genomics software designer, recently filed for an IPO. Harris & Harris trades at a high 80% premium to NAV, but many believe Harris' management skills and connections may be worth it.
The best buys in BDCs may be in the value players. Equus II, for instance, trades at 10 1/2, which Gruntal analyst Michael McGrath says is barely more than the value of its publicly traded holdings. In effect, the stock market assigns no value at all to the private equity positions, which constitute about 75% of the Equus II portfolio. Of course, those holdings include a window manufacturer, a glass recycler, and a turf-grass grower--hardly the kinds of companies that make investors salivate.
Value plays in private companies get no more respect these days than they do in the public market. So as the BDC concept expands, it's the aggressive venture-capital players that will likely grab all the attention.