I used to buy tech stocks -- in fact, a lot of tech stocks. For a number of years, approximately half of my purchases were in this sector, as I added some of the world's finest companies to my portfolio at, if not cheap, at least reasonable prices. But as valuations soared -- the Nasdaq rose more than 50% in the second half of last year, and another 4% so far this year -- I stopped buying tech stocks because I was increasingly uncomfortable with the risk/reward tradeoff at such high prices. In fact, for more than a year, beginning in mid-June, 1999, I purchased only one stock in this sector: the meVC Draper Fisher Jurvetson Fund I (NYSE: MVC), which I believe remains attractively priced.
The meVC Draper Fisher Jurvetson Fund I
The meVC DFJ Fund is a venture capital fund that invests in (from the prospectus) "information technology companies, primarily in the Internet, e-commerce, telecommunications, networking, software and information services industries." The fund focuses on mezzanine round investments, which are generally the last financing events prior to an anticipated liquidity event (e.g., a sale/merger or IPO).
The fund's manager is John Grillos, who has over 20 years of experience in the information technology industry, including 10 years as a venture capitalist. I spent an hour with Grillos in April and was very impressed. He's a no-nonsense guy with very little patience for the hype that still characterizes much of the dot-com sector in Silicon Valley.
Unlike most venture capital funds, which can tie up an investor's capital for 10 years or more, the meVC DFJ Fund is structured as a closed-end fund and its shares trade on the New York Stock Exchange, so investors have full liquidity. Because it's publicly traded, the price of the fund can fluctuate widely, which can create excellent buying opportunities for patient investors.
Like most venture capital funds, the meVC DFJ Fund charges investors a hefty 2.5% annual management fee and takes 20% of the net profits.
Why Venture Capital?
In my last column, "Twelve Internet Myths," I concluded -- despite my skepticism about many of the businesses in this sector -- that there are some excellent investments. Sometimes I buy the stock of a public company, but I've found that many of the best opportunities lie in private companies because they are generally priced much more attractively.
Getting in not just at the IPO price, but at the price one or more rounds of financing prior to an IPO can make an enormous difference in returns, as evidenced by the fact that average returns to venture capital investors were 146% in 1999. Over the past 10 years, later-stage VC returns have averaged 26.5% annually versus 18.2% for the S&P 500. That's more than a tenfold increase vs. a fivefold increase in the S&P 500. Pretty amazing, eh?
But very few people see enough deals or have the skills to invest directly in private companies, and you have to be an accredited investor ($1 million of net worth or $200,000 of annual income) and be well connected to invest in pretty much any venture capital fund.
Venture Capital for the Masses
So what's the average investor to do? One option is to invest in the stocks of the few corporations that are effectively VC funds, such as Safeguard Scientifics (NYSE: SFE), CMGI (Nasdaq: CMGI), and Internet Capital Group (Nasdaq: ICGE). In a spectacular mania, these stocks skyrocketed late last year and early this year -- and have since crashed by 63%, 71%, and 81%, respectively, from their 52-week highs. But even at today's lower valuations, they still appear to trade at significant premiums to their asset value (it's hard to calculate this number accurately). Also, as corporations, any distributions are double-taxed, just as dividends are.
Andy Singer, the CEO and co-founder of meVC, has a different vision. By creating a family of high-quality funds open to all investors on the same terms as traditional venture capital funds, he seeks to democratize this clubby world. The meVC DFJ Fund is the first of many funds he plans to create under the meVC name.
The Fund's Valuation
In March, 20,000 investors bought 16.5 million shares of the meVC DFJ Fund at $20 each, raising a total of $330 million. After the underwriting and other fees, adding back interest, the net asset value of the fund today is $19.07 per share. This is composed of $5.79/share of investments (Grillos has made 11 investments so far, including one today, totaling $95.5 million) and $13.28/share in cash that has yet to be invested. Yet the fund closed Friday at $16. That means that an investor is buying $5.79 worth of investments for $2.72 ($16.00 - $13.28) -- a 53% discount.
It's not quite this simple, of course. The cash isn't going to be paid out -- it will be invested over the next two years -- so an investor must have confidence that a significant number of the fund's current and future deals will be successful. But how? The future deals are unknown, as is key information about the 11 deals to date, such as the valuation at which Grillos invested or the financials of the companies.
A number of factors give me comfort, beyond Grillos' track record and my personal impression of him. First, the fund has co-invested so far with some of the top names in the venture capital business: Bain Capital, BancBoston, Battery, Bessemer, Bowman, GeoCapital, Hummer Winblad, Maveron, Mayfield, Morgan Stanley, Oracle, Sequoia, Technology Crossover Ventures, Trident, Venrock, Yahoo!, and Zero Stage Capital (you can read the press releases for a full list). Also, the first investment wasn't made until May 22, long after valuations had dropped markedly.
A final point worth noting is that the value of the fund's investments are likely to increase over time as the companies grow, yet this will often not be reflected in the net asset value calculation, which is based on the price paid for the investment or the valuation of the most recent round of financing, both of which can dramatically understate the true value of a holding. Thus, there's an argument to be made that the fund should trade at a premium to net asset value, rather than the discount that is typical of most closed-end funds.
Why Is the Market Mispricing the Fund?
To make an investment, I have to believe that the market is significantly undervaluing a stock. So why do I think that the market is undervaluing the meVC DFJ Fund? Two reasons. First, the fund is in a very unpopular sector. Since the end of March, the Nasdaq has fallen more than 10%, and the stocks of publicly traded VC funds have fallen far more. Once high-flying incubators (now scornfully called "incinerators" by many) have been unable to go public or, in the case of divine interVentures (Nasdaq: DVIN), gone public with uninspiring debuts. But the meVC DFJ Fund is not an incubator, nor is it doing the riskiest early stage deals. In general, it is investing in companies with established economic models, complete management teams, numerous customers, and meaningful revenues.
Second, the meVC DFJ Fund is new and has only been trading since June 26 (after the fund closed, the shares didn't trade for 90 days to give Grillos the opportunity to make the first investments). Thus, it is not yet well known and there is no Wall Street coverage. This will undoubtedly change.
Conclusion
Venture capital is not for the faint of heart. Even in a well-managed, diversified fund, investors run the risk of substantial losses, especially given the still-high (though much reduced) valuations. But if you're looking for exposure to the Internet sector -- something I'd only recommend for a small percentage of your portfolio -- I believe that buying the meVC DFJ Fund is one of the best ways to do it.
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected]. To read his previous guest columns in the Boring Port and other writings, click here.
