With IPO markets stalled and little relief in sight, some venture capitalists are beginning to look for other ways to put their funds to work methods that depart from traditional start-up equity financing.

Options considered range from private investments in beaten-down public companies to leveraged buyouts a controversial tactic that VCs have tried before during previous downturns, but met with little success.

“There are venture firms that are looking to do other things, and becoming an LBO is one of them,” said George Abe, venture partner with Palomar Ventures in Santa Monica. “There are people who are contemplating their navel about what to do next.”

The focus on alternative investments stems from changing market conditions. But it carries risks of alienating fund investors as well as competing in deals that are outside a firm’s start-up expertise.

“People always talk about (alternative investments) when the market hits a low cycle,” said Brad Jones a partner with Redpoint Ventures in West L.A. “Those people who end up actually doing something like that end up regretting it.”

Many VCs are still sitting on piles of cash, yet bargains aren’t in evidence among start-ups. Valuations have fallen since last year, but prospects for quick returns have dimmed as well.

Dismal IPO market

The IPO market is expected to remain depressed for at least the next year, and capital-spending cutbacks have cut off VCs’ other traditional exit route a buyout by an established company. Investing in start-ups, ever the risky proposition, looks more uncertain nowadays.

Meanwhile, many established companies are dirt cheap, sometimes selling for less than the amount of cash they have in the bank. Liquidity, in the form of publicly traded stock, and ongoing revenues are added security blankets.

“There is discussion in the industry at the moment about whether there are opportunities to look at distressed tech companies,” said one local VC who’s actively hunting for LBO candidates.

Leveraged buyouts involve borrowing funds often using junk bonds to finance the purchase of a company. During the mid-1980s, a number of venture firms jumped on the LBO bandwagon, said Jesse Reyes, a vice president with Venture Economics, a venture-capital research firm in New York. “A lot of their investors weren’t too happy about it, and from 1990 forward, most of them put out some fairly strict (restrictions).”

Those agreements usually include a disclaimer that allows the general partner some leeway in moving outside the fund’s main investment strategy. “Depending on who you are and who your investors are, that may be a hole large enough to drive a truck through, and it may not,” Reyes said.

Other financing vehicles

Other structures are also being contemplated.

“If the IPO window doesn’t reopen we will see increased creativity on the part of financing vehicles,” said Duke Bristow, an economist at UCLA’s Anderson School.

One strategy that’s gaining attention is the PIPE, or private investment in public companies. Some VCs are revisiting struggling companies that have already gone public, hoping to see them through the market downturn.

A Seattle company, Internap Network Services Corp., recently tapped venture capital sources, including Millennium Technology Ventures and Morgan Stanley Venture Partners, for $101 million in additional capital. The money-losing company, with a promising technology for speeding delivery of broadband content over the Internet, was down to its last $54 million in June. The investors agreed to lock-up arrangements that limit the pace of selling the new shares.

Jones said he would consider doing a PIPE, but it would otherwise have to meet the $1.25 billion fund’s venture criteria. He said he won’t do any LBO deals, though. “Our investors give us money to invest in venture capital deals for them, Jones said. “That’s what we’ll do.”

Reyes said venture funds that stray too far from their stated goals risk losing their ability to raise funds in the future. That could cripple many of the newer funds that were launched in the late 1990s but haven’t yet established track records. “A lot of funds will simply raise their money for one or two funds and never raise another,” Reyes said. “They’ll just collect their management fees, and wither away and die by attrition.”

“It’s safe to say we did market the transaction,” said Internap spokesman Bill Hankes. “But there were some very enthusiastic participants.” While the deal is dilutive to existing shareholders, it buys Internap time to get its expenses in line with a slower-than-planned growth rate, without burdening the company with any debt, he said.