The Wall Street Journal

May 11, 2004

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 Complete coverage7
 

Venture Capitalists Scramble
To Keep Their Numbers Secret

Public University Discloses
Data After Court Fight,
Is Barred From New Funds
'Saddest Business Letter Ever'

By ANN GRIMES
Staff Reporter of THE WALL STREET JOURNAL
May 11, 2004; Page A1

OAKLAND, Calif. -- The University of California system is anticipating a bonanza, courtesy of Google Inc. Two venture-capital funds in which UC invested about five years ago each hold significant stakes in the Internet search-engine company, and when Google goes public, UC could end up with a return of more than $200 million.

But the 10-campus university system may have trouble cashing in on future Googles. When it tried to invest in several venture funds recently, it found venture capitalists with whom it had long relationships barring the door. Their complaint: Under a court ruling last year, the university, as a public institution, would have to disclose the performance of the funds. Many of those who operate the funds are so committed to privacy that they'd rather do without the university's money.

"After 22 years of being in business together, forces entirely beyond our control have impelled us to end our relationship," wrote Michael Moritz, a Sequoia Capital partner, in a letter last Aug. 27 to the University of California's treasurer, David Russ. Mr. Moritz was the sharp-eyed investor who spotted Google six years ago and led Sequoia to snap up an early 10% stake.

Mr. Russ is one of many public officials who are caught in an escalating fight over just what the venture-capital industry must make public about its investment performance. Venture funds drew some $18 billion last year from universities, pension funds, and other institutions and wealthy investors seeking a payoff from risky investments in fledgling companies. The financiers who run the funds say they can pick long-term winners better if they work out of public view.

But since the technology bubble burst a growing chorus of critics says the public has a right to know in detail where public institutions' money is being invested and how those investments are doing. They have successfully gone to court to pry open venture funds' results.

The battle over disclosure has already led several of the best-known venture-capital funds to bar public institutions from new investments. These venture capitalists are cutting back on the information they provide to investors out of fear that it could end up in the public domain. Some states are so worried that they're passing laws exempting venture-capital funds from public-disclosure laws. The latest to do so was Michigan on April 22.

At one point UC's Mr. Russ even faced the danger that he would lose some of the Google gold mine. The university has investments in two funds that own Google stakes. It invested $16 million in a 1998 Sequoia fund and committed $20 million to one started in 1999 by Kleiner, Perkins, Caufield & Byers. Last summer, responding to the adverse court ruling, Sequoia asked that UC unload its investments in Sequoia funds including the one that holds Google shares. However, it hasn't pressed that request, according to Mr. Russ. Sequoia declined to comment.

Close to the Vest

The clubby venture-capital business has a long tradition of keeping information close to the vest. Venture capitalists typically raise money from institutions and wealthy individuals for funds with names like Mayfield VIII and Redpoint Ventures II. Each fund might invest in several dozen start-ups, expecting that many will fail but a few will hit it big like Google.

Venture capitalists argue that it's only fair to judge results after the full life of the fund, typically 10 years. Interim results are likely to look bad because they reflect the fund's fees, the quick failure of some start-ups and the immaturity of others. As those early numbers are made public, institutions like the University of California may feel pressure to nit-pick every decision. That would make it hard to invest for the long term, venture capitalists complain. Besides, they say, people might figure out how badly some of their start-up companies are doing, which would discourage potential business partners of those companies.

The industry's critics counter that venture capitalists prefer to keep results under wraps so they can hide poor results, inflated valuations and excessive fees.

Until recently, the debate was moot. Venture capitalists kept the performance of their funds secret through confidentiality agreements in which investors promised not to give out the information. Then some people found a chink in that armor: public institutions that must respond to requests filed under the Freedom of Information Act, or FOIA. Of the $250 billion in venture capital under management, about 22% comes from public sources, according to Thomson Venture Economics, a leading tabulator of venture-capital data.

Disclosure advocates argue that any promise a state might make to keep investment results confidential is trumped by the higher principle of open information enshrined in public-records laws.

Pensioners, university students and newspapers have filed FOIA requests for venture-capital data in many states around the country. Among the results: The University of Texas' fund manager, under orders from the state attorney general, began disclosing venture-investment details in 2002. Also, last year the nation's largest public pension fund, the California Public Employees' Retirement System, or Calpers, began disclosing venture returns, and the Washington state pension fund now releases venture-capital-return data quarterly.

REVEALING RESULTS
Some University of California venture-capital investments

Fund/ Year it started Amount invested (in millions) Annualized return²
Sequoia Capital VII/ 1995 $13 174.50%
Institutional Venture Partners VII/ 1996 18 97
Kleiner Perkins VIII/ 1996 20 287
Redpoint Ventures I/ 1999 24 –31¹
Venture Strategy Partners II/1999 10.1 –34¹
Sequoia Capital X/ 2000 17.5 –31¹
¹The university says these returns are not meaningful because the funds are too young.

²Return as of Sept. 30, 2003 for Kleiner and Sequoia, as of March 31, 2003

Source: Cambridge Associates via University of California

Data released by UC show just how lucrative venture-capital investments can be. For the 10 years ended June 2003, the university earned an average annualized return of 41% from venture-capital funds. That was largely thanks to windfalls from funds that started life in the mid-1990s, just before the Internet boom. In the case of one Kleiner Perkins fund, UC put in $15 million starting in 1994 and earned $483 million as of March 31, 2003. The fund's remaining investments had an estimated value of $4.7 million on the date, giving UC a total return of 32.5 times its original investment. The UC system has assets of $58 billion under management.

UC's more recent funds mostly show negative returns so far, partly due to the collapse of the Internet bubble. But the university predicts that performance will turn upward in the next few years as some of the venture-capital-backed start-ups mature and either go public or are sold.

At the University of California, Mr. Russ, the treasurer, faced a dilemma when FOIA requests began to roll in two years ago. If he responded to them, he believed he would be cut off from the best venture investments. Premier funds such as those run by Kleiner Perkins and Sequoia are generally oversubscribed and coveted spots go only to a chosen few institutions.

Although university officials initially answered some FOIA requests, Mr. Russ was hesitant -- and the university regents stood beside him. The university had signed confidentiality agreements with venture-capital firms, and it feared it would face retaliation if it broke them. "We couldn't give on this without a fight," says Christopher Patti, UC's general counsel.

In 2003 the case went to court. A coalition of university employees, the San Jose Mercury News and other allies filed suit in Alameda County Superior Court seeking data from UC on individual funds.

The coalition's lawyer, Karl Olson, says public institutions should invest their money only in funds that are willing to be open about their performance. "If the attitude of the outfit is, 'We'll let you into our new fund, but only if we don't have to comply with the law,' I don't think a public pension fund should be doing business with them,'' he says.

'Trade Secret'

Venture capitalists said data on their interim returns were a "trade secret." They also were worried that if information on the overall performance of their funds was made public, details on the performance of individual start-up companies in the funds might eventually leak out, too.

In July, Judge James Richman ordered UC to release its records. "... [T]he public interest in disclosure [of return data] clearly outweighs the claimed need to keep them secret," the judge wrote. UC asked Judge Richman to reconsider. It pointed out that just before his ruling Sequoia Capital had responded to the University of Michigan's disclosure of data by booting UM out of a new Sequoia fund.

Then, shortly before the judge offered his reconsidered ruling, Sequoia sent the letter severing relations with UC. "It is not in the interests of Sequoia Capital's other clients that we be hounded, badgered, and stalked by entities wishing to either profit from or publicize our private and confidential information," wrote Mr. Moritz, the Sequoia partner. He called it "the saddest business letter ever dispatched on Sequoia Capital stationery." Through a spokesman, Mr. Moritz declined to comment.

In his second decision, Judge Richman again ruled against UC. Two appeals to a state appellate court and the state supreme court failed. In mid-October, UC released records of its venture holdings.

Since then, Mr. Russ says, calls by his office to some of the leading firms go unreturned. As venture capitalists reduce the size of their funds, public institutions are often the first to be left out. Charles River Ventures, a leading venture-capital firm, has rejected new investments from public institutions, as reported by Private Equity Week. The University of Michigan and the state pension funds of Massachusetts, Pennsylvania and Virginia are among those who have gotten the snub from venture capitalists.

The UC did get an invitation to join a new $400 million fund managed by Kleiner Perkins, perhaps the nation's best-known venture-capital firm, people close to the situation say. But since March 2003, the university has been receiving less information about its existing Kleiner funds, according to public documents. Worries about information flow and confidentiality terms have prevented UC from investing in the new Kleiner fund, these people say. Kleiner declined to comment.

While many venture capitalists, especially at less prestigious firms, are willing to accede to the demands for public disclosure, several firms besides Kleiner are cutting back on financial information. "It's unbelievable what they have done," says Anthony Romanello, director of investor services for Thomson Venture Economics. For example, some funds that used to describe in detail which companies they were investing in and how each of those companies was faring now sometimes just give a bottom-line figure once a quarter or once a year. In general, that amount of disclosure is legal: Venture-capital funds are only lightly regulated.

The lack of information is a "serious concern" to Joseph Dear, executive director of Washington state's investment board. "Clearly one of the duties of the board and its staff is to conduct oversight of its managers and if we have insufficient information to do that, we can't perform our fiduciary functions," Mr. Dear says.

Some public institutions have decided they can't invest in funds they know so little about. Calpers, for instance, recently declined to reinvest in a $1.1 billion fund at New Enterprise Associates because the firm insisted on reserving the right to cut off information if Calpers were forced to disclose too much, people familiar with the situation say.

Other public institutions, including the University of Michigan, have successfully pushed state legislators to partially exempt venture capital from open-record laws. Massachusetts is considering the idea.

At UC, Mr. Russ is trying to work out a modus vivendi with Sequoia. The university's records show that it is no longer getting certain information on the performance of Sequoia funds and several others. Previously the university got that information from Cambridge Associates LLC, a consulting company, which analyzes venture-capital returns based on raw data provided by the funds. While the funds are still providing that data to Cambridge Associates, new nondisclosure agreements are restricting Cambridge from sending its analyses to UC, according to a Cambridge official.

University officials say this cutoff of information is part of the funds' strategy to keep their data confidential. "We're in a standoff on disclosure," says Mr. Russ. But he adds that UC is getting the information it needs through "ongoing dialogue" with funds.

Mr. Russ is also scrambling to find a place to put the roughly $300 million a year he earmarked for venture investments. Sequoia had been ready to take $8 million from UC for its latest fund. Instead, it booted UC while making room for private universities that can keep data confidential, such as Harvard, Duke and Stanford.

Among Mr. Russ's remaining options, he says, are "funds of funds" that invest in multiple venture funds. It might be possible to skirt FOIA challenges if the fund of funds doesn't pass on to investors the details of its venture investments. Another option: less-established venture capitalists, who are happy to disclose their performance in exchange for the university's money. Mr. Russ hopes some of these will become the next generation of top-tier firms.

Write to Ann Grimes at ann.grimes@wsj.com1

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