Jerusalem Venture Partners (JVP) celebrated its tenth birthday this year. It was not an especially joyous occasion. After all, like the rest of the economy, the venture capital industry has mostly reported losses lately. In fact, the main event overshadowing the birthday party was investors' abandonment of Israeli venture capital funds.
The domino effect was instigated by a report from Calpers (California Public Employees' Retirement System) that revealed the performance of the six Israeli funds it had invested in, including JVP). JVP came out relatively unscathed by the report; although it lost $36 million from write-offs and write-downs on $121 million in investments in start-ups, the loss was considered reasonable compared with the losses accrued by other funds Calpers had invested in around the world. However, having their performance put down in print - as private entities, funds rarely involve the public in their business - added to the sense of discomfort and unpleasant mood in the industry.
The disputes that erupted between some fund management companies and the investors who wish to withdraw their investment pledges have been kept behind closed doors, for the most part. The write-offs by funds managed by AIG-Orion Venture Capital Fund, BRM Capital, and Jerusalem Global Ventures (JGV) were conducted quietly, even considered desirable, although these measures could have been evidence of worsening relations between the management companies and their investors.
The Bruce Rappaport affair upset the apple cart. Although after the story hit the media, Rappaport reached a compromise with the Challenge Fund - Etgar, managed by Joseph Ciechanover, in July, the affair suggested to investors an elegant exit from their now problematic venture capital adventures. The affair also put the funds on the defensive. In early June, Rappaport, through a foreign company, filed for an injunction against Etgar's acquisition of a stake in Blue Square Israel (NYSE: BSI; TASE:BSI). Rappaport alleged that he had long believed that there was no point in maintaining Etgar, since it was not achieving the goals in which he had invested, and its investments were losing value.
The affair degenerated into a personal clash between Rappaport and Ciechanover before the compromise was reached, one that the venture capital industry considers a precedent. The agreement released Rappaport from his obligation to Etgar, and stipulated that over the next six months he would get back 75% of the rights and investments made on his behalf in Etgar, whether in cash or negotiable securities or shares in start-ups.
The next story is a recent one from JGV and its founding partner Shlomo Kalish. In an unusual step, JGV foreclosed the investments of Koonras Technologies and Polar Investments (TASE:PLR) subsidiary Polar Communications (TASE: PLRC), Clal Industries and Investments (TASE: CII), and Alpenside International, after they rejected a request for money from JGV's management company and refused to transfer the balance of their outstanding commitments.
Sources in Israel's venture capital market claimed that the investors were not trying to browbeat Kalish, but merely to ensure that their money was used properly. JGV claimed the investors were running away from their legal obligations. Kalish foreclosed on the money, and the venture capital industry moved to a new stage, almost unique in Israel - a public spat between fund managers and investors.
This week, the investors asked Kalish to restore their investments in the fund or refund the value of the investments at the current values. JGV has not yet responded, but the affair will probably end up in court.
Comments by JVP founder and managing partner Erel Margalit, one Israel's veteran venture capitalists, should therefore be understood in this context. The interview was held at a time when the venture capital industry was on the defensive. Margalit was the first to declare that the crisis was real, both in Israel and worldwide. "The funds' business model has become problematical," he says. "The way we work, i.e. acquiring large holdings in companies to help them grow, and reaping the fruits when some of them succeed, generating extraordinary returns, is now under attack.
"There have been very few exits in the past two to three years, due to the U-turn away from unreal growth in high-tech sectors like the Internet and optical communications. The business models no longer work. The crisis is therefore a real one, and the question is how to respond."
No admission of error
Margalit carefully declines to offer suggestions to those funds recently making headlines. "I cannot tell the funds what to do," he says. "I assume that every Israeli fund that is currently more worse off than during the boom should do some soul-searching, and take appropriate measures."
Margalit puts the responsibility on the investors, although he is also highly critical of how the funds handled their relations with their investors. "It is necessary to distinguish between institutional investors who are truly committed, and opportunistic investors who joined the 2000 celebrations and then discovered the bright lights suddenly weren't so bright. They were the first to jump ship, often noisily."
"Globes": Maybe the investors are correct when they said venture capital investment had no future?
Margalit: "As someone who has been in the field for ten years, alongside other Israeli venture capitalists, I think it's still possible to make a lot of money in this business. It's still possible to found significant start-ups in Israel that will be financed by funds. Investors in the funds involved will earn profits.
"It won't happen overnight, because the market in general is still in a global recession, but the right way to work with investors must be found for the new reality, regardless of what is stipulated in an agreement with a particular investor."
So you're not worried.
"Some investors weren't committed. They didn’t think that venture capital was a long-term investment. For opportunists, it's not a good to get stuck in an investment in a sector that's underoing its worst two years in the past two decades.
"We had two private investors who invested a sum of money, but suddenly felt uncomfortable with the size of their investments. They spoke with us, found a buyer - a serious institution. They wanted to sell half; the buyer wanted everything. In the end, one investor sold everything and the other sold a part.
"We arrived at a situation in which those who felt they had to quit the fund could speak with us and we could find a solution for them, because there was demand. When we closed our fourth fund at $404 million, there were still many investors who had decided to stay out, but whom we convinced to come in. There are still investors sitting on the fence."
Speak with the investors
JVP focuses on early-stage companies in the enterprise networks, fabless semiconductors, and enterprise software sectors. In the past, the fund was well known for taking great risks. In the case of Precise Software Solutions, sold to Veritas Software (Nasdaq:VRST) in December 2002, the risk paid off handsomely, but the JVP's track record includes some failures where its stubbornness turned out to be a mistake. "Our first two funds increased in value several times over, but our third fund, closed in 1999, is not doing great," admits Margalit.
"Although it had one exit (Chromatis Networks, D.Y.), the value of investments is currently lower than the value of the fund's assets. We therefore voluntarily gave up our management fees for the fund, in order to give its portfolio companies a greater chance."
Management fees are supposed to decline gradually beginning with the fourth or fifth year anyway, when the fund's investment period expires.
"We did it a lot sooner. Quite a while ago, in fact. The third fund's situation may be better than the funds of other firms, but we're displeased by our own performance, and we have to work hard to restore the money and generate a return. We've made it possible for our investors to pay us management fees if they want to.
"Sometimes, when you do something before you're asked, it gives you an edge, because then no one pursues you. That is our responsibility. All in all, some of us want to be fund managers for a long time and investors are the customers whom you foster over years. That's great when the world is good; you're terribly successful and they loves you and you love it that they loves you. But you also have to know how to come up with ideas when things aren’t going so well, even if your contract doesn’t obligate you to do that.
"On the other hand, it must be understood that the fund, especially during hard times, must survive. There must be sufficient management fees to pay for the management company, even if it makes cutbacks. You must work hard to make a profit. We're all working harder now for poorer results, but you still must produce these results. It takes time to build a real company. Investors should realize that you can't just vanish. If you want a return on the money, if you want to develop a company, the management company must survive. But you can't be decadent."
"Chromatis has made us more modest"
In the ten years since its was founded as part of the government Yozma Venture Capital , - alongside Polaris (renamed Pitango Venture Capital), Gemini Israel Funds, Concord Ventures, Star Ventures, Vertex Israel Management, Walden Israel, and Inventech Investments (TASE:IVTC) - JVP has known good times and bad. JVP's counterparts also suffered, but JVP's case was more extreme, especially with regard to its image. Intentionally or not, JVP and its boss have been perceived as industry outsiders. Margalit has never hid his ambition to for JVP to become a global firm, and over the years, he has collaborated with US funds in many of his deals, without bringing in his Israeli colleagues. They in turn consider him a megalomaniac or lone wolf who wants to steal the show.
This policy did not prevent JVP from generating a respectable list of exits, including Jacada (Nasdaq: JCDA), Ultracom Communications, Netro (Nasdaq: NTRO), Fundtech (Nasdaq: FNDT; TASE:FNDT), Scorpio Communications, Paradigm Geophysical, ViryaNet (Nasdaq: VRYA; TASE: VRYA), Precise Software Solutions, and Chromatis Networks. JVP leveraged these successes to ever-larger funds. JVP I raised $20 million; JVP II - $75 million; and JVP III - $160 million. Including the JVP IV fund, the firm manages a total of $660 million.
JVP's global aspirations are revealed by its expanding investments in companies in the US, Europe, and even China (United Platform Technologies) that have no connection with Israel. "Forbes" included JVP in its list of the world's top 50 venture capital funds in April 2003, the list's only Israeli representative.
The image of JVP and Margalit over the years can be measured as a line on a graph paralleling events in the life of its most famous portfolio company, Chromatis. Lucent Technologies (NYSE:LU) acquired Chromatis in May 2000 for $4.8 billion in shares.
Since Chromatis founders Orni Petruschka and Rafi Gidron preferred to avoid the public carnival surrounding the deal, the spotlight fell mostly on Margalit. The media marked him as representative of the new economic elite of venture capitalists, perceived at the time as wizards.
At the date of acquisition, JVP owned 13% of Chromatis, worth $700 million on paper. But JVP was in no rush to distribute its Lucent shares to its limited partners, and instead opened negotiations with Israel's Income Tax Commission, which wanted to impose a 50% capital gains tax. The shares were not distributed until February 2001, after they had lost 75% of their value. The result was that JVP's investors received a bloc of shares worth only $170 million.
Chromatis was closed in August 2001. The media, which had praised the deal, now condemned those involved, including Margalit, as conmen who had made a fortune from worthless promises.
It was a fiasco.
"It was one of Israel's most successful failures. When great success is followed by a great market crash, someone has to pay, and we one of those someones. The industry boom had already peaked, and Chromatis was emblematic of the boom. What happened between Chromatis and Lucent was a shame, and we were caught in the middle, as the leading investor in Chromatis.
"This is part of the dowry you get when you're involved with major companies that make great things. You have to deal with this, apparently especially in Israel. I think the affair has made us all more modest. The wind will blow out a small fire, but will fan a large one. The affair steeled in us a determination to build the next great Israeli company."
Maybe there shouldn’t be venture capital funds at all.
"We're done arguing."
"A strong dialogue with the world"
The Chromatis affair also put the issue of the taxation of foreign investors in Israeli venture capital funds on the agenda. Margalit and other fund managers subsequently launched a campaign to abolish the tax, in line with policy in other countries. Two years ago, then-Minister of Finance Silvan Shalom obliged, fully exempting foreign investors in Israeli funds, subject to a pre-ruling process. Margalit, who previously claimed that levying taxes on foreign investors might deter him from investing in Israeli-registered companies, says there is still more to be done.
"We've paid the price, but now things are clearer with the Israeli Income Tax Commission, which understands its limitations vis-à-vis Americans, and no longer goes after foreign investors. We said that until this matter was cleared up, it would be very hard to continue investing in Israel. We were among the first groups to lobby, and I think we've now achieved greater transparency.
"Yet, the exemption for foreign investors isn’t anchored in law as in the US, but is at the level of a ruling, and you still have to stand in line at the Income Tax office. This isn’t ideal, and I think it's not good for the country. The moment you legislate a major benefit, everyone knows what the situation is, and this clarity is a major advantage.
"The system of government benefits also needs to be overhauled. The entire technology industry should take a broader view of its next generation and look to Israeli society in general, not just at high-tech Herzliya.
"The next generation of companies, if the entrepreneur can stay in Israel and not emigrate for tax purposes, will allow for more company functions to be set up here. Not just R&D, but also initial manufacturing, and logistics and business functions. The funds have an important role in this."
In other words, you think the industry's comeback is a realistic supposition?
"Despite the hard times, I think that Israeli fund managers, like the industry as a whole, need to ask themselves what they will do so that technology will recover strongly in 2004-06. Israel will continue to be a key technology player in the European-Mediterranean Basin region, if it does the right things."
That is why international funds are expanding their investments in Israel, while JVP is no longer an Israeli firm. Half of your fourth fund's portfolio companies are not Israeli.
"60% of the fund's activities are in Israel, and it has a strong business dialogue with the US, Europe, and Far East. This greatly strengthens our ability to assist Israeli investments.
There is immense significance in an Israeli-based international fund. It is different than being a solely Israel fund. I'm not saying it's better or worse, but this sort of thing is missing in the market, and it could contribute. Many of our companies sell to Asian companies and it's hard giving them added value without an office in the region.
"You can love or hate the model JVP is building, but it's a model with an Israeli business foundation and core. It is a fund that operates internationally, and in every market it tries to hold a dialogue with the most interesting entrepreneurs.
"Believe me, bringing an Irish or American entrepreneur into a dialogue with an Israeli entrepreneur is an extraordinarily fertile process, and I think that's the future for Israel, too. Large companies will export from Israel thanks to their good dialogue with international markets. Many Israeli companies are now discovering China, which is an example that such instincts exist."
"Every successful company has difficult moments"
You invested in Precise Software when it was dying and it went on to become a success story. Is there a chance that you'd do something similar now?
"Certainly, that's our added value. There are all kinds of large funds that have a different advantage. JVP's most important capability is in locating very young companies, working closely with them, being the main shareholder, and through careful investment turning them into significant companies. We're not main shareholders in too many companies, and they know that we stand behind them, even in hard times.
"Almost every hugely successful company has had bad moments, and you always lose some shareholders at these times. JVP hasn’t always been able to identify terminal moments. We usually stick with a company, because when you succeed, your return is substantial.
"We've also invested in large financing rounds at very low valuations, and we were not so pleased with some of these steps. There are funds that specialize in these things, and we've participated once or twice, and learned from it. To help a company grow organically is the relative advantage of an international fund that comes from Israel."
That doesn’t conform with two investments you made in the optical communications sector: Kodeos Communications and Inplane Photonics. Both companies have a similar profile: founded by an Israeli and American entrepreneur, and in you invested in both with just one US fund. Why did you take this upon yourselves, especially in such a problematic market as optics?
"First, we're talking about major US funds: Highland Capital Partners (in Kodeos, D.Y.) and Morgenthaler Ventures (Inplane, D.Y.). The market for these two companies also changed during the investment. In such a situation you have to decide, together with the entrepreneurs and the other fund, whether the company has enough differentiation to be significant, despite the industry crisis, or whether the effort is too great and you should quit.
"There was a debate about both companies, and in both cases there was a feeling that it could be done precisely because the market was tough. But to do this in a market suffering from a severe image problem, you have to get the commitment of the fund partnering with you. You then take a larger position in the company, put in more money, and take a decision in which there are no certainties.
"There is a good chance that the time and money you've invested will bear a handsome return, even if it takes longer than expected. We may be making a mistake, but it's hard to obtain help from other funds in a market like optics, which has retreated greatly, worldwide. Time will tell.
"People think it's possible to read cards and predict what will happen to a company, but a company's future isn’t a given when you enter it; it's a function of what you build. Frequently, your faith in building something, even in hard times, is a factor.
"Some people say, 'Let's cut our losses and move on.' We've also said that sometimes, but apparently less often than others. A company that doesn’t succeed the first time, but still has a good market, usually carries a heavy debt from past mistakes. One of your jobs as an investor is to give the entrepreneurs the ability to believe in themselves, even if they're receiving strong negative feedback from the market, or the venture capital funds that abandoned them suddenly."
Published by Globes [online] - www.globes.co.il - on September 11, 2003