INTERVIEW—Taking a Longer View Mitigates Venture Firms’ Losses

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Paul Nadel, managing partner for East West Venture Group, believes that if local venture firms concentrate on adequately funding their existing portfolios they’ll be in a stronger position to weather the dot-com storm that has left a number of casualties in its wake.

But with that move away from the dot-com sector, fund managers have found that they have to shift to patentable technologies with a clear short-term path to profitability.

Meanwhile, venture capitalists’ eagerness to fund early-stage companies has been tempered. Financiers in Los Angeles as well as their counterparts in Austin, New York, Silicon Valley and elsewhere are scrutinizing deals much more closely, and funding far fewer of them.

As for East West, it invests its $250 million fund primarily in several layers of the digital media infrastructure, including digital media management, distribution and platforms.

In its portfolio are several publicly traded companies, including Loudeye Technologies, an Internet infrastructure company, and Digital River, a commerce service provider. Other investments include Broadstream, a streaming media distribution platform, and TrafficStation, a national provider of personalized traffic and travel information via the Internet.

A former partner with the Los Angeles-based law firm Christensen, Miller, Fink, Jacobs, Glaser, Weil & Shapiro, Nadel specialized in business transactions, corporate securities and corporate financing, making the switch to venture capital an easy transition.

Before joining East West, he was executive vice president and general counsel of Interactive Cable Systems, a private cable and telephone company that was acquired by MCI.


Question:

To what extent has the dot-com decline affected the venture capital industry in Southern California?

Answer: I think it has dramatically affected all regions. But I think L.A. is as pronounced as any other place, and the reason for that is you have an awful lot of follow-on venture capitalists here. A lot of them coming on board in the last 24 months in Los Angeles were content-centered. I think the feeling for a lot of folks was that the venture capital bubble was not going to burst for a long time, and that the next thing would be content and Southern California is the mecca of content. A lot of content deals got floated that didn’t have any business being invested in. As a result, a lot of those VCs that came on late in the game and focused heavily on those deals are gone. There was no viability to their portfolios because there was nothing there. They were nice ideas, but nothing to sell. So when the markets dropped, they found themselves holding an empty bag. On the flip side, the companies that are here and solid are in great shape because there will be a metamorphosis toward the kinds of things that L.A. is strong in.

Q: So how will Los Angeles fare relative to Austin and Silicon Valley in the wake of this shakeout?

A: I think we will do well. At this point, there is still a stronger technology pool in Silicon Valley than Southern California, but make no mistake about it, there is a lot of talent here. Not only because of some of the industries aerospace, entertainment and other industries that are located here but also because we have learned a lot. In the last three to four years, there have been a lot of companies here. They all haven’t weathered well, but there is a lot of talent here now. The shakeout is affecting Southern California like everywhere else, but I think L.A. will come out of it in a stronger position.

Q: Venture firms have been avoiding new investments and focusing on their existing portfolio. Is East West backing away from making new early- to mid-stage investments?

A: No. Our chairman has been through cycles before, and I’ve been through a few too. We understand that there may be a slow rebound or a fast rebound, but nonetheless there will be a rebound. We didn’t get into this because we thought we could make a quick buck. We got into this because we enjoy it, because it makes sense and there is money to be made. As long as you look at this on a three-year horizon, as opposed to a 12-month horizon, there are fewer problems. In fact, this downturn is an opportunity, valuations have come down, expectations have been managed and there are still some very strong companies out there. We are looking at those. So we are still investing.

Q: How has the lack of an IPO market affected the way Los Angeles venture firms manage their portfolios?

A: They don’t have any fresh powder to seed new deals, and any fresh powder they do have, they better use to focus on their existing portfolio. Those (VC-recipient) companies are going to need it for a longer period of time because they are not going to be able to go out into the public markets. So a lot of venture firms are saying that the reserves they have set aside for new deals will be used instead to restructure their current portfolios. The thinking is: “These are deals I know much better than any new deals that come across my desk, so I might as well stay with those.”

Q: One of the obstacles to Los Angeles’ growth as a venture capital hub is that it is so spread out. There are clusters along the 101 Corridor, in Santa Monica, and a few other spots. What are the strongest clusters locally and do you see any new clusters developing?

A: Traditionally, you’d say Pasadena and Santa Monica are the two strong areas. Unfortunately, what grew out of those two areas for the most part was the dot-com wave. Now you can get office space in Pasadena and Santa Monica, and you couldn’t a year ago. You’ve got Caltech in Pasadena and the beach in Santa Monica. It’s not unusual to expect those areas to once again flourish after a shakeout. We have seen the 101 Corridor and Santa Barbara starting to grow. Those regions will continue to grow because of the universities that are located nearby. The Westside, however, will have renewed focus because of UCLA. I think UCLA is learning more about how to leverage their faculty and research base more, which will lead to more companies locating here in the next three to five years.

Q: Will the cost of doing business in West Los Angeles have an adverse affect on companies locating to the area?

A: No. Only because I’m mindful to distinguish what kinds of businesses will come here. Businesses that will grow and evolve out of Southern California will have a reason to be in Southern California, rather than just the weather. A company that is growing in Austin probably doesn’t have any reason to pick up and move to Los Angeles. But a company that wants to utilize some of the values of Southern California will. No one is going to open a business here because it’s a nice place to live. That doesn’t make any sense. Rents are high, home prices are high and everything is more expensive. You have to watch your pennies. But you have a lot of value here that will quick-start your enterprise in certain areas. I don’t expect a lot of biotech to grow here there’s no reason for it to. In some pockets maybe, but as a general rule, it’s not going to happen.

Q: It’s been said that another obstacle for Southern California to overcome before becoming a venture capital hub is its lack of seasoned mangers. Do you agree?

A: It depends on what level. CEO talent is still difficult to find anywhere, but on the business-development side and the financial side there is plenty of great talent here. It is a little bit more difficult on the CEO front. However, we are finding that, given the right opportunity, top talent is not a hard thing to attract.

Q: What about the quality and depth of mid-level management?

A: What we have found is that over the last two to three years we have built a base of talent with the likes of GeoCites, eToys, and Digital Island. Those types of companies have helped build a credible base of development talent in Southern California. We now have a base of talented middle managers here. A couple of years ago, if you went up north and were standing in line to buy a cup of coffee at Starbuck’s, there would have been a good chance that the guy in front of you was from Oracle and the guy behind you was from Intel. Here in Los Angeles, you most likely found a screenwriter in front of you and an actress behind you. And that was the problem. Now, you’re likely to have a programmer in L.A. too. So there is a talent pool here and it’s growing. It’s still not what it is in Northern California, but I’m not sure it needs to be.

Q: What type of business opportunities exist in this market?

A: I think the same opportunities that have always existed. It’s a much more difficult time to (do venture capital deals) than it was two years ago, but historically it’s not more difficult than it has been if you take more than a three-to-five-year view on life. Venture capital is a three-to-five-year cycle. You invest in companies that in three to five years will have some sort of liquidity. So from our perspective, this is a great time. The valuations of companies have come way down, people’s expectations have been declining and you’ve got some very strong management and mid-level employees that are available. From our perspective, the cream is going to rise to the top. So as long as we keep our focus during this turbulent time, we will be fine.

Q: Doesn’t East West have more flexibility than traditional VC firms, because it’s funded by individuals rather than by institutional investors?

A: Yes. We have high-net-worth individuals that know and trust us. So if we say, “Now is not a great time to invest,” they understand where we are coming from, which allows us breathing room during the shakeouts.”

Q: On what types of companies are you focusing?

A: We are focused on early- to mid-stage technology-related companies. There has to be something under the hood. The days of “if you build it they will come,” were never true for us, but the markets now realize that they are over. From our perspective, we look for core technologies, core management teams, and the product has to relate to the convergence between media and technology. It’s in vogue to say these days, but we’ve been saying it for years we value-enhance our companies. We bring them to the decision-makers that they need to see. We can’t force the decision-makers to choose one of these companies, but we can certainly start from a very good place with those people.

Q: So what is your strategy for survival in a depressed marketplace? Would you consider branching out and investing in sectors such as biotech?

A: No. We have to stay true to what we know. Once we venture into other areas that are not related to what we know, we are going to get in trouble then I’m picking stocks. One thing I learned early on, if I’m going to pick stocks, I’ll get a dartboard.

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