What's Really Driving Banks' Profits
The high-tech, biotech, and Internet market boom has launched a golden era for bank venture-capital units. They're pulling in a good chunk of their parent's profits, often while relying on their traditionally tiny staff. Wells Fargo & Co., for example, got 16% of its fourth-quarter 1999 net income, or $721 million, from deals vetted by just 14 partners in its venture-capital unit. The bank has 92,000 employees overall. First Union Corp., with a total payroll of 70,000, garnered 13% of its fourth-quarter net income, or $228 million, from deals captured by the 16 people in its unit.
Venture capital is nothing new for big banks. Many have been active players in the business for decades. Citicorp, after all, put up the seed money for Essence magazine in 1970, while Chase Manhattan Corp. bankrolled Internet search engine Lycos in 1998. FleetBoston Financial's VC unit, BancBoston Ventures claims to be the oldest registered small-business investor in the country, with 41 years of experience, and Wells Fargo's unit has nearly 40 years under its belt.
WEATHERPROOF. Banks and regulators alike, though, know that the VC industry is getting more competitive. So-called angel investors are flush with cash, while hedge funds that once concentrated on initial public offerings are hungrily eyeing VC profits. Banks are reacting by trying to create their own new-business incubators. The rah-rah nature of the market and its importance to bank profits even prompted the Federal Reserve to tighten capital requirements and lay down ground rules on Mar. 17 that require banks to set aside capital equal to 50% of their VC investments, and limiting their duration to eight years. Nonetheless, banks are unlikely to be deterred--most are averaging returns on their investments near 40%, vs. 10% to 15% on traditional commercial lending.
To be sure, some missteps in the risky venture-capital business are almost inevitable. Although their approaches vary, the big banks contend that they are capable of weathering storms. If there are any victims, they say, they're likely to be the newcomers to the business. "If you're just starting to invest in early-stage venture deals, I pity you," said Jeffrey C. Walker, the senior managing partner of Chase Manhattan Corp.'s venture-capital unit, Chase Capital Partners.
As the biggest bank-owned unit, Chase argues that its worldwide presence protects it from a downturn in any one market. "We're the only firm that's truly global," says Walker. The bank currently has investments in 570 companies in 25 countries, is the leading investor in the Latin American Internet, and is the largest venture capitalist in India. Chase invested $2.3 billion last year in the unit and recorded $2.52 billion in venture-capital gains. Chase's Walker says that the units "presence and patience" are the keys to its ongoing success. Chase has been pounding the table for its VC shop, hoping investors will value the bank stock higher.
Chase certainly isn't alone in its VC emphasis. FleetBoston's venture-capital unit, BancBoston Ventures, together with BancBoston Capital, invested $1 billion in 1999, a $300 million jump from the year before. Like Chase, the bank has a heavy overseas presence, with nearly 30% of its investments outside the U.S. But finding exclusive deals is "the name of the game" says Frederick M. Fritz, president of FleetBoston's private equity units. The bank has investments in 500 companies today and often relies on the chief executives of those firms to sniff out venture-capital deals in their respective industries. BancBoston Ventures gets about 15% of its deals through the parent bank's corporate clients. Fritz concedes that there are a lot of dollars chasing hot sectors such as telecommunications and non-U.S. Web networks but says the competition hasn't cut into profits. "We're having the best quarter of our history," he says.
Some bank VC units are investing at a record pace, often without staffing up. For example, Wells Fargo's VC unit, has just 14 partners who evaluate deals. All the same, it invested $425 million last year. "We have a different investment focus," says John P. Whaley, chief financial officer of the division, explaining that the unit favors consolidation and management-led buyouts. A huge amount of capital has moved into private equity and VC investments in the past three or four years, Whaley concedes, increasing competition. But, for the time being, "a high tide is raising all boats, and it's a good time to be invested."
Bank venture-capital units can get a big lift if other divisions of the bank feed them deals. First Union Capital Partners culls new deals from First Union Securities Inc. and wrote $800 million in venture capital and leveraged deals last year. Credit Suisse First Boston is expecting to find deals for its newly launched $2.75 billion private equity fund from its 1,100 bankers, says Edward Johnson, a director of CSFB Private Equity. The unit, which has been in the business since 1979, compensates these bankers with a direct stake in the company.
In response to heightened competition, banks are finding innovative ways to back new startup businesses. "We're seeing a whole new play," says Sarah Diamond, managing director with KPMG's consulting practice. "What banks are doing is generating ideas and becoming incubators." J.P. Morgan & Co.'s LabMorgan, Chase Manhattan's Chase.com, and Citigroup's E-Citi were designed as e-finance petri dishes, intent on turning good ideas into good investments, whether they're generated within the bank or from an outside source. Then, the bank's venture-capital unit may invest in the business plan. "Banks are expanding their role in the marketplace," Diamond says.
The downside? Some may wind up with a portfolio of investments that aren't understood by some on the traditional side of the bank. Negative fallout is "more potential than reality" at this point, Diamond says. But, she says, the last time she saw a similar rush to invest in a popular sector was the mid-1990s boom in real estate investment trusts. The sector nearly went belly-up in 1998, after it was shunned by the capital markets and stock prices tumbled.
NO SUCKERS. Although most VC veterans agree that the increase in competition is leading some to make risky investments, picking those out against the backdrop of phenomenal market growth is nigh impossible. Besides, the level of disclosure varies widely. Chase Manhattan and Wells Fargo both have Web sites detailing individual venture-capital investments, for example, while BankOne Corp. and Bank of America Corp. don't break down the businesses' profits in their earnings statements, or detail transactions. "There's no one company out there that we can call the suckers," says Nam Ho, a 10-year venture-capital veteran and general partner of Altos Ventures, a Menlo Park (Calif.) VC firm. "There's a lot of deals that I've seen that looked crazy in the last few years--and they're all making a lot of money."
Normally, venture capital is a game of hits and misses. But the almost uninterrupted run of success in the business is now unnerving pros. "These days there are fewer...losses because of a good market, but in the end it will still go back to that cycle," warns Chase's Walker. Most of his competitors are hoping he's wrong.