Novak and Biddle, The Worrywarts of Venture Investing

By Terence O'Hara
Monday, April 10, 2006

Jack Biddle and Roger Novak seem to compete to be the biggest worrier at their venture capital firm, Novak Biddle Venture Partners .

Now in their 10th year together, they are personable, smart and at times quite funny. Their Bethesda-based firm's first three funds have been among the best-performing early-stage venture funds in the nation. Yet according to people who have known and invested with them for years, each man has a strain of chronic discouragement, as if deep down there's fear it could all come crashing down.

"I think they're out to prove something, to prove that they're not a fluke, even though they've really already proved it," said a longtime Novak Biddle investor who, like most, spoke on condition of anonymity about their private investment dealings.

"I'm the bigger worrier," Novak said last week at the end of the firm's five-hour annual meeting at the Mandarin Oriental hotel. It was attended by about 150 current and potential investors in Novak Biddle funds -- endowments, pension funds and rich folks. "The history of this type of investing . . . you almost can't be consistent. We've had a great run, but my job right now is to manage expectations."

"I'm not a worrier, I'm a low-baller," Biddle said. "I try to under-promise and over-deliver. . . . You can't stand up in front of your investors and say you [stink], but you want to surprise people on the upside."

Novak Biddle allowed me to attend its annual meeting, an event typically restricted to people who have more than a million dollars available to put into a venture fund. I was invited on condition that I not write about certain aspects of what was discussed, such as proprietary financial information about investments.

Over a buffet lunch (nothing fancy) and coffee in the hotel's grand ballroom, the annual meeting was a mix between a public company annual meeting -- minus the lawyers and accountants -- and a venture investing seminar. Novak and Biddle analyzed the early-stage venture market and reviewed their funds' winning and losing investments. There were expert panels, and several portfolio companies gave presentations.

The meeting provided a look into the state of early-stage technology investing, a source of financing that has helped create many of the region's technology companies. Attendees included some of the best-known names in local venture investing, including Art Marks , formerly of New Enterprise Associates, now of Valhalla Partners ; Frank Bonsal , a founder of New Enterprise Associates, now retired but advising a number of local venture partnerships, including Novak Biddle; Edward J. Mathias , a managing director at Carlyle Group who seems to have some connection, financial or social, to every private equity firm in town; William Schrader , founder of now-defunct PSINet and the chief executive of a Novak Biddle portfolio company; and Michael Chasen , co-founder and chief executive of publicly traded educational software firm Blackboard Inc ., one of venture capital's local-boys-make-good stories.

Some of the themes, and worries, that emerged from the Novak Biddle meeting:

· The technology needs of government, especially in defense and intelligence, will continue to fuel the creation of companies in the near term. But expect declines in federal discretionary spending that will increase pressure on companies to develop a private-sector business as backup.

· Sarbanes-Oxley and other corporate accountability requirements continue to make it difficult for small companies to go public. Venture investors can't count on initial public stock offerings as a way to cash out of many private firms. Selling portfolio companies -- either to bigger companies or to bigger private equity firms -- will be the most assured way to liquidate an investment. Last year, only 56 venture-backed companies went public, compared with 93 in 2004, and only 10 went public in the first quarter of this year, according to Thomson Venture Economics.

· Many venture-backed companies that do go public will have to wait longer and become much bigger first. This means the venture funds backing them will have to hold more cash in reserve to carry investments longer, so the funds will have to be bigger, and that could hurt returns. "I sometimes worry that we're under-reserved," Novak said, worrying again.

· Though investments in venture funds have fallen back to pre-bubble levels, there is still too much venture money chasing too few good companies. Biddle said his firm is getting beaten out on deals by other venture firms that put a higher value on a company than Biddle thinks it's worth.

Novak Biddle's partners can console themselves with money, of which they've made a fair amount. About a half dozen deals have been home runs. They include NEW Customer Services Cos. , a consumer electronics warranty company; Matrics Inc ., a radio frequency identification company; and Blackboard.

Fund I, begun in 1997, had an annual net return to investors of 79.5 percent, its biggest winner. Altogether, an investor in each of the firms' four funds would have earned a 46 percent annual return over nine years.

For Novak Biddle, being small is the sweet spot. The firm has only three partners in addition to the two founders: Andrea S. Kaufman , Philip L. Bronner and Tom Scholl . The firm will probably add a sixth partner in the next year. In an age of the mega-fund -- locally, New Enterprise Associates is raising a $2.5 billion monster for its 12th venture fund, and Carlyle and Grotech Capital Group are each in the midst of raising large funds -- Novak Biddle's funds have been relatively small. Its 1997 fund was $23 million, and its latest was $150 million.

Most of Novak Biddle's investments come at the earliest stages of a company, usually in the software, telecommunications or information security business, and almost all of them are in the mid-Atlantic region.

Of the 48 companies it has invested in, 21 came out of university or government research labs. Biddle said Novak Biddle's contacts among emerging technologists in the region are one of its more important advantages.

This type of investing is highly risky. It involves hand-wringing and hard work and intense involvement with, and coaching of, a company's management team. Mathias said Novak Biddle has proved it does it well.

"It's become the dominant early-stage investment firm" in the region, he said.

Biddle likes to quote the Private Equity Intelligence research service, which last year showed that the top-performing 25 percent of fund managers account over time for virtually all of the profits of venture investing. The research service put Novak Biddle among the 20 most consistent performers, in the company of legends such as Kleiner Perkins Caufield & Byers and New Enterprise Associates. Biddle fiercely aspires to be recognized as a member of that club, because such funds get the most prestigious investors and attract the most promising start-ups.

"I'd like to think we've entered the realm of 'The Franchise,' " said Biddle, dropping for the moment his low-ball persona.

Second Fund for Winning Firm

Arlington Capital Partners , the District-based corporate buyout firm, raised its second fund, a $575 million pile of cash.

It took nearly two years of work and some big fees paid to UBS to market the fund, but Arlington now has enough capital to do deals for at least another five years.

"The target was $500 million," said partner Perry Steiner . "We were pleased to be oversubscribed at 575, and in the end, we had to cut back a number of investors who wanted in."

Arlington was formed in 1999 by former Bell Atlantic chief executive Raymond W. Smith , Paul G. Stern , Jeffrey H. Freed and Robert I. Knibb . Stern has since left the firm. For this fund, Smith is chairman and senior adviser, not a managing partner. Steiner and Peter M. Manos joined the firm as partners after 2000.

After some early hiccups investing in money-losing early-stage companies, Arlington found its stride in recent years buying and building companies in core areas: radio stations, aerospace and defense, government contracting, business services, health care, and education companies.

One of the big wins for its first, $450 million fund was Apogen Technologies Inc ., a defense technology contractor that was an assemblage of Arlington acquisitions. It sold to British defense firm Qinetiq Ltd . for more than $300 million last year.

Steiner declined to disclose the investment return on the first fund, though he said it's in the black and in the top quartile of 1999-vintage middle-market buyout funds.

Arlington invests in companies valued at between $50 million and $250 million. At that size, using borrowing, the new fund will allow 10 to 15 investments. Steiner said the firm's investment strategy won't change. "There's a local angle to everything we've done, being close to the seat of government," Steiner said. "We love to invest in the mid-Atlantic. It's terrific to be based here and part of the Washington fabric."

Terence O'Hara's e-mail isoharat@washpost.com.

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